Peter A. Jaslow, left, and Paul D. Hallgren Jr., right, of Ballard Spahr.

Cryptocurrencies and other digital tokens are digital assets that utilize encryption to secure and verify transfers. Markets in cryptocurrencies function without centralized oversight through the use of blockchain technology, which serves as a digital, and in most cases, public, ledger of all cryptocurrency transactions. Though Bitcoin is the most commonly known form, new cryptocurrencies can be established at any time, and their number continues to grow. In the past two years, the increasing number of marketplace participants, cryptocurrency issuers, and transfers of cryptocurrency have caused many to ask whether increased guidance or new regulation by the Securities and Exchange Commission (SEC) and other regulators is necessary in order to facilitate growth of this this novel technological development. Although some commentators continue to push for further clarity, in recent months, the SEC has taken steps to clarify the application of federal securities laws to cryptocurrencies. These measures are particularly helpful since continuing development in the industry, including by major technology companies and large banks, as well as ongoing volatility in core cryptocurrencies such as Bitcoin, will keep the industry in the spotlight for regulators and legislators.

Applying the ‘Howey’ Test to Offerings of Digital Assets

While direction on cryptocurrency regulation has been provided in statements by members of the SEC staff, the SEC through its Strategic Hub for Innovation and Financial Technology (FinHub) issued new guidance on April 3, 2019. The guidance, titled “Framework for ‘Investment Contract’ Analysis of Digital Assets,” prescribes a framework for determining whether federal securities laws apply to the issuance and sale of cryptocurrencies and digital tokens. On the same day, the SEC’s Division of Corporation Finance (CorpFin) released a response to a no-action letter stating that it would not recommend an enforcement action in connection with one company’s offering of a digital asset.

• FinHub’s Framework

Initial coin offerings and other token sales (ICOs), also sometimes called token generation events, are a method of fundraising comparable to an initial public offering (IPO) but adapted for the cryptocurrency space. Instead of receiving funds in exchange for equity in a company, however, purchasers pay money, using fiat currency (i.e., dollars) or other digital assets, in exchange for the new cryptocurrency unique to the company’s ICO. One major question that arose from these offerings was whether the coins or tokens sold in an ICO constitute a security subject to regulation similar to shares sold in an IPO.

With its guidance, FinHub sought to provide some clarity to those considering an ICO. The guidance provides a method for analyzing whether a cryptocurrency or digital token should be regulated as a security. In doing so, and as practitioners had contemplated for some time, FinHub applied the mid-twentieth century framework of Securities Exchange Commisssion v. W. J. Howey to the modern development of cryptocurrency. According to Howey, a security exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. This is also commonly known as the Howey test. Under the test, a contract or other transaction, including cryptocurrencies or other digital assets, will constitute a security subject to SEC regulation when all three parts are met.

According to FinHub, the first two parts of the Howey test are typically satisfied in the context of ICOs. In these offerings, purchasers exchange money or another asset of value and receive cryptocurrency in return. Further, FinHub has found that investments in cryptocurrency are common enterprises because the outcome of the investment for a purchaser hinges on the success of the issuer or promoter. For ICOs, then, the question of whether the particular cryptocurrency is a security turns on whether there is a reasonable expectation of profits to be derived from the efforts of others.

For FinHub, there are several questions that can help those considering ICOs determine if their sale of cryptocurrency satisfies the third part of the Howey test. First, does the purchaser reasonably expect to rely on the efforts of the promoter, sponsor, or other third party selling the cryptocurrency on behalf of the company? For example, if purchasers believe this person will perform or oversee projects “necessary for the network or digital asset to achieve or retain its intended purpose or functionality,” or if the seller “creates or supports a market for, or the price of, the digital asset,” it becomes more likely that purchasers are relying on the efforts of others under the third part of the test. Similarly, FinHub suggests that certain characteristics of ICOs may indicate a reasonable expectation of profits by purchasers. If, for example, ownership of the digital asset grants rights to a share of the company’s income or allows purchasers to realize gain from capital appreciation (other than by external market forces such as inflation), the digital asset is currently or expected in the future to be traded on a secondary platform, or if the digital asset is marketed to a broad base of potential buyers rather than a targeted group of expected users, it is increasingly likely that purchasers have a reasonable expectation of profits. Conversely, FinHub elaborated on certain circumstances when a digital asset is less likely to constitute a security, many of which were consistent with practitioners’ expectations.  These circumstances include when the digital asset is fully developed and operational at the time of sale and when the creation and structure of the system is designed to meet users’ functional needs, “rather than to feed speculation as to its value or development of its network.”

• Division of Corporate Finance’s No-Action Letters

CorpFin, also on April 3, 2019, released a no-action letter response stating that it would not recommend an enforcement action against start-up interstate air charter company, TurnKey Jet, Inc. (TKJ), in connection with its offering of “‘tokenized’ jet cards.”

TKJ’s no-action letter applied the Howey test to its token offering. It agreed that the first two parts of the test are likely satisfied but claimed that their digital assets did not trigger an expectation of profits to be derived from the efforts of others. In particular, TKJ’s letter noted that its platform would be fully developed by the time TKJ sold any cryptocurrency, and as such, the proceeds from the sale would not be used for such development. The digital tokens were likewise immediately exchangeable for the purchase of TKJ’s air travel services. Another important characteristic was that transfer of the tokens was restricted to TKJ’s proprietary wallets, and therefore, would not be tradeable on secondary platforms. Last, the tokens would sell to purchasers at a consistent price throughout the program, any repurchase of the tokens by TKJ would be at a discount, and the tokens were marketed in a way that promotes their functionality, rather than their speculative value. CorpFin noted each of these factors in declining to recommend action in connection with TKJ’s offer and sale of its token.

More recently, CorpFin released another no-action letter response on July 25, this time in connection with the offering of digital “Quarters,” a universal gaming token, by Pocketful of Quarters, Inc. (PoQ). CorpFin’s response to PoQ applied similar reasoning to TKJ. Importantly, the Quarters platform was fully developed and would be functional prior to the first sale, and the Quarters would be immediately usable for their intended purpose, transferrable only to PoQ or users of the platform, and marketed for their functional use as digital gaming tokens, rather than as assets that may increase in value, among other reasons.

Conclusion

As the popularity and intrigue in cryptocurrency grew over the last several years, the question of how and when federal securities laws apply has become a more prevalent issue for potential issuers, purchasers, and broker-dealers in digital assets. The recent guidance from the SEC is helpful in clarifying these issues and establishing standards for issuers and token sellers to follow going forward. As interest in the industry continues to proliferate, it will be interesting to watch whether legislative developments arise that could change this framework for cryptocurrency issuance.

Peter A. Jaslow is a partner in Ballard Spahr’s business and finance department. He advises clients regarding securities matters, including corporate governance, disclosure and compliance matters. He can be reached at [email protected] or 215-864-8737.

Paul D. Hallgren Jr. is an associate in the firm’s business and finance department. He has experience in corporate and transactional matters, including federal securities law compliance, mergers and acquisitions, and debt securities offerings. Contact him at [email protected] or 612-371-6236.