SEC Advises Bitcoin and Ether Are Not Securities

SEC Advises Bitcoin and Ether Are Not Securities

The Securities and Exchange Commission (SEC) does not consider bitcoin and ether to be securities, according to SEC Division of Corporation Finance director Bill Hinman. The pronouncement brings additional clarity to how the agency plans to regulate the growing cryptocurrency market.

Hinman addressed the oversight of the popular cryptocurrencies at Yahoo’s All Market Summit: Crypto in San Francisco, California. “Based on my understanding of the present state of ether, the Ethereum network, and its decentralized structure, current offers and sales of ether are not securities transactions,” Hinman said. “And, as with bitcoin, applying the disclosure regime of the federal securities laws to current transactions in ether would seem to add little value.”

SEC’s Prior Guidance on ICOs

As we have discussed in prior articles, virtual coins are created and disseminated using distributed ledger or blockchain technology. In an initial coin offering (ICO), buyers may use U.S. dollars or virtual currencies to purchase virtual coins or tokens. The capital raised from the sales may be used to fund the development of a digital platform, software, or other projects. In addition, investors may use the virtual tokens or coins to access the platform, use the software, or otherwise participate in the project. After they are issued, the virtual coins or tokens may also be resold to others in a secondary market on virtual currency exchanges or other platforms. 

Last year, the SEC advised that many ICOs are securities and, therefore, fall under the purview of federal securities laws. In reaching this conclusion, the SEC applied the U.S. Supreme Court’s long-standing “investment contract” test. In SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), the Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others. As explained by the Court, this definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

The SEC guidance also made it clear that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. In recent enforcement actions, the SEC has pursued entities that failed to register ICOs, as well as entities that outright defrauded investors. In his speech, Hinman reaffirmed the SEC’s position on ICOs. “Simply labeling a digital asset a ‘utility token’ does not turn the asset into something that is not a security,” he stated. Nonetheless, Hinman also acknowledged that there are ways to structure digital assets so they constitute consumer goods rather than securities. 

Applying Investment Contract Test to Bitcoin

As Hinman explained, the primary issue in determining whether cryptocurrencies and ICOs are securities is the expectation of a return by a third party. “Primarily, consider whether a third party — be it a person, entity or coordinated group of actors — drives the expectation of a return,” Hinman explained.

In the case of bitcoin and ether, Hinman noted that the answer to that question is no.

“If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract,” Hinman said.

Of course, that doesn’t mean that the cryptocurrencies could never qualify as a security. “Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security,” Hinman noted. “If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.”

Investment Contracts vs. Consumer Goods

To further clarify how to properly characterize a digital asset, Hinman outlined several factors to consider in assessing whether a digital asset is offered as an investment contract. The analysis centers largely on the role of any third party, as well as the economic substance of the transaction. The factors include, but are not limited to:

• Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
• Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
• Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
• Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
• Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
• Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
• Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
• Is the asset marketed and distributed to potential users or the general public?
• Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?

In his speech, Hinman highlighted that determining whether an ICO qualifies as a security is often fact dependent. Accordingly, the SEC is prepared to offer assistance. “We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.”

For businesses interested in conducting an ICO, the SEC’s latest guidance, as set forth in Bill Hinman’s remarks, provide a roadmap for structuring token sales so that they are exempt from U.S. securities registration requirements. As highlighted above, one of the key issues is the rights, expectations, and participation of token holders. For detailed guidance, it is always advisable to consult with an experienced New Jersey securities attorney.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work at 201-806-3364.