SEC clarifies guidelines for classifying an ICO as an investment contract

Crypto ICOs showing a comeback, after major drop off in 2018

Crypto attorneys that support Initial Coin Offering (ICO) promoters in the United States have been requesting for some time more clarification from the SEC on how it interprets current securities legislation to determine whether or not an ICO qualifies as an “investment contract”, thereby necessitating formal registration and investor disclosure requirements under the law. At long last, the SEC has responded by publishing a set of digital asset guidelines to assist those parties planning to launch or invest in crypto enterprises to assure themselves that they are compliant with existing legislation.

The two SEC commissioners responsible for releasing these guidelines were Bill Hinman and Valerie Szczepanik. Their document is entitled “Framework for ‘Investment Contract’ Analysis of Digital Assets”, and it provides clarifying explanations and examples of when a proposed ICO could fall under the rules defining an “investment contract”. There are also accompanying materials in which Hinman and Szczepanik make it clear that these documents do not carry the weight of an SEC ruling and that the list of examples are by no means a complete list. The staff intends to update its “FinHub”, as new regulations and interpretations evolve.

In the past year, the SEC has halted a number of high profile ICO’s, frozen funds, and assessed penalties and fines in a fashion that many attorney groups have contended was arbitrary. In order to prevent further misunderstandings and potential fines and incarcerations, law firms have been adamant that the SEC come forward with a published framework that associated firms could follow to comply in future. These guidelines should go a long way to appease these firms struggling with the unknown.

These same groups may still, however, be dissatisfied with these recently published guidelines. They only address one type of security, that being an investment contract, and it should not come as a surprise that the authors posited that, “The long-established Howey Test should be used”. The so-called “Howey Test” resulted from a Supreme Court ruling in 1946 over specific definitions in the Securities Act of 1933, having to do with what constitutes an investment contract. The applicable phrase that is paramount in these determinations is whether there is “an expectation of profiting from the actions of others”. The guidelines explain how the Howey Test applies to both cryptos and ICOs.

The primary focus of these guidelines is on how the Howey Test can be applied. There are several examples that attempt to clarify what “the actions of others” can mean, but the authors explain that there is no one guiding principle that will turn the tide toward an investment contract, but all characteristics must be viewed together before a true determination can be rendered. Although there are quite a few examples provided, these three items give a hint as to what must be considered:

  1. Where the digital asset was still in development at the time of the sale.
  2. Where an active participant in the project gets to determine where funds raised from the sale of a digital asset are spent.
  3. Where an active participant controls the total supply of an asset through creation or burning of tokens.

There is one guideline that specifically addresses the fact that most ICOs propose that token purchasers might achieve their returns by appreciating valuations of the tokens in the marketplace, an indirect form of “profiting from the actions of others”. This guideline states:

The opportunity may result from appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains.

By the shear number of examples provided, it would not be too difficult to assume that many existing crypto programs are already in violation of the law. As the guidelines portend, if the Howey Test comes back “positive”, then an “investment contract” is in play, and standard registration and disclosure requirements apply.

Will the SEC begin looking in the rearview mirror for previous transgressions or will these guidelines be applied on a “going forward” basis only? Law firms may have gotten more than they bargained for, as clarification may have come at a hefty price.

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