On April 3, 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a No-Action Letter to Turnkey Jet, Inc. and made a statement on both. Although all guidance is appreciated, there is really nothing new or different about the analysis, which is firmly based on SEC v. W.J. Howey Co. (the “Howey Test”). Moreover, as discussed below, even though the SECfound that Turnkey Jet did not need to comply with the federal securities laws in the issuance and sales of its tokens, the opinion and issued guidelines do not go far enough and still leave a great deal of uncertainty.
Framework for Investment Contract Analysis of Digital Assets
The SEC’s framework sets forth facts and circumstances to be considered in applying the Howey Test to determine if a digital asset is an investment contract and thus a security subject to state and federal securities laws in its issuance and subsequent re-sales. The U.S. Supreme Court’s Howey case and subsequent case law have found that an “investment contract” exists when there is (i) the investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits (iv) to be derived from the efforts of others. See by blog HERE for a general discussion of Howey HERE and HERE being applied to analyze a hypothetical token.
Howey doesn’t just examine the form of the asset or instrument itself (which, in the case of a digital asset, is computer code) but also the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold. The first prong of Howey, an investment of money, is usually easily satisfied as digital assets (or any investments) usually involve the exchange of money or other form of consideration. Case law progeny of Howey has long clarified that the “money” referred to in Howey can be any valid form of consideration or exchange of value.
In its framework analysis, the SEC points out that “bounty programs” also involve the exchange of value. As I discussed in this blog HERE, bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework.
The second prong of Howey, a common enterprise, also typically exists where there is an issuance or sale of a digital asset. That is, investments in digital assets usually involve a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.
The third element of Howey, a reasonable expectation of profits, involves a more in-depth analysis. Profits can include capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings. Price appreciation resulting solely from external market forces impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test. In analyzing whether there is a reasonable expectation of profits from an investment in a digital asset, the SEC considers:
- Whether the digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation. This could be from dividends or distributions or capital appreciation from secondary trading markets;
- The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future (the SEC gives quite a bit of weight to this factor);
- Purchasers expect the efforts of others to result in capital appreciation;
- There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset;
- There is little apparent correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption;
- More money is raised than is needed to establish a functional network or digital asset;
- Money continues to be expended to increase and improve the value of the network or digital asset;
- The digital asset is marketed, directly or indirectly, using any of the following: (i) the expertise of an Active Participant or its ability to build and grow the network or digital asset value; (ii) that the digital asset is an investment; (iii) intended use of proceeds is to develop the network or the digital asset; (iv) touting the future functionality of the network or asset; (v) the promise to build a future business or operations; (vi) secondary market or transferability; (vii) potential profitability of the network; or (viii) capital appreciation of the digital asset.
- Related to a re-sale of a digital asset, further consideration should be given to (i) digital assets’ value separate from the continued development of a network; (ii) value of digital assets correlation to the good or service for which it can be exchanged; (iii) trading volume corresponds with level of demand for good or service for which it can be exchanged; (iv) whether network is built out and functionality of the digital asset; (v) whether economic benefit from appreciation is incidental to functionality; (vi) insiders’ access to material non-public information.
The fourth element of Howey, “derived from the efforts of others,” also involves a more in-depth analysis. When a promoter, sponsor, or other third party (i.e., “Active Participant”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. A relevant portion of this inquiry is a review of the economic realities of the transaction, including the manner in which the digital asset is offered and sold.
The SEC focuses on two key issues:
- Does the purchaser reasonably expect to rely on the efforts of an Active Participant?
- Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?
In answering these two fundamental questions, the SEC guidance lists the following characteristics that support a finding that the purchaser is relying on the efforts of others:
- An Active Participant is responsible for the development, improvement (or enhancement), operation, or promotion of the network;
- An Active Participant will perform tasks and responsibilities rather than decentralizing performance to the community. This factor is not eliminated just because some tasks are decentralized, but rather an analysis is made as to the significance of the tasks;
- An Active Participant creates or supports a market for, or the price of, the digital asset. This can include (i) controlling the creation and issuance of the digital asset; or (ii) taking other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, “burning,” or other activities.
- An Active Participant has a lead or central role in the direction of the ongoing development of the network or the digital asset – for example, deciding governance issues, code updates, or how third parties participate in the validation of transactions;
- An Active Participant has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: (i) determining the compensation for service providers; (ii) determining whether or where the digital asset will trade; (iii) determining the issuance of additional digital assets; (iv) making or contributing to managerial level business decisions; or (v) responsibility for security of the network.
- Purchasers would reasonably expect the Active Participant to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such (i) the Active Participant retains ownership and has the ability to realize capital appreciation from the digital asset; (ii) the Active Participant distributes the digital asset as compensation or their compensation is tied to the value of the digital asset; (iii) the Active Participant owns or controls intellectual property rights related to the digital asset or network; or (iv) the Active Participant monetizes the value of the digital asset.
- Related to a re-sale of a digital asset, further consideration should be given to (i) whether or not the efforts of the Active Participant continue to be important to the value of the digital asset; (ii) whether the network is fully functional such that the managerial efforts of an Active Participant are no longer essential; and (iii) whether the efforts of an Active Participant are no longer affecting the enterprise’s success.
In addition to the Howey factors, the SEC provides a list of other relevant considerations, including:
- Whether the digital asset is offered and sold for use or consumption by its purchasers;
- Whether the network is fully developed and operational;
- Whether holders of the digital asset can immediately use its functionality;
- The digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network (for example, limiting use within the network);
- Prospects for appreciation in the value of the digital asset are limited;
- With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency;
- With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services;
- There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged;
- The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose; and
- Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market.
Turnkey Jet No-Action Letter
In the first SEC No-Action letter on the question as to whether a particular token distribution would be required to register as a security, the SEC opined that TurnKey Jet, Inc. could offer and sell its token without the need to register under the federal securities laws. The SEC’s conclusion was supported by the facts that (i) no funds from the sales would be used to develop the network which would be fully operational at the time of any sales; (ii) the tokens would be immediately usable for their intended functionality; (iii) the tokens could not be transferred outside the Turnkey system and thus no secondary market can develop; (iv) the tokens will have a fixed price; (v) if Turnkey repurchases the tokens, it will only do so at a discount to their face value; and (vi) the tokens are marketed for functionality and not investment.
Turnkey’s No-Action Letter is not surprising in its result – it seems from a reading of the company’s letter to the SEC that it checked every box to avoid a finding that it could be considered to be engaged in a securities offering. The issue is that the letter, together with the SEC guidance, continue to leave questions for those operating tokens that do not “check all the boxes.”
Turnkey’s letter to the SEC made several representations regarding the token including that “[A]t no time will Token sales include a rebate program, rewards program, or similar or otherwise allow for the monetization of an economic benefit or bonus for buying Tokens.” My question is, what if it did include a reward program? In the SEC guidance it lays out an example of a retail point system, concluding that such a system would weigh in favor of not requiring compliance with the federal securities laws. In particular, the SEC example is as follows:
For example, take the case of an online retailer with a fully-developed operating business. The retailer creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately priced in that real currency. The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. The digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price. Under these facts, the digital asset would not be an investment contract.
The SEC’s example of a point system and the basis for its opinion in Turnkey does not match with the reality of loyalty or reward points in the consumer world. The fact is that there is a large secondary market for airline and other loyalty points, as I discussed back in June 2018 (see my blog HERE). Anyone with an American Express card knows they can trade and transfer points among many different award systems and even use the points for cash on Amazon.com, Walmart, Saks Fifth Avenue and a list of other partner providers. Although a particular point provider may fix the value for issuance of the point, the value that same point gets when traded for other points in other systems fluctuates. Points are generally marketed and sold or distributed for consumer consumption and not for their value appreciation, but not completely.
The SEC also puts weight on the fact that Turnkey is not using the tokens to raise working capital, but rather as a form of selling their product (purchasing air charter services); however, the entire loyalty point industry uses the proceeds from the sale of their points for working capital. According to its Form 10-K for the FYE December 31, 2018, Delta Airlines generated $2.651 billion from the sale of loyalty travel awards in 2018, representing approximately 15% of its total passenger revenue.
As I talked about back in 2018, online platforms such as www.points.com and www.webflyer.com operate using contractual partnerships with entities that issue loyalty points. In fact, points.com is owned by Points International Ltd., which trades on the TSX and Nasdaq and refers to itself as “the global leader in loyalty currency management.” In a 6-K, Points has this to say about the loyalty industry:
Year-over-year, loyalty programs continue to generate a significant source of ancillary revenue and cash flows for companies that have developed and maintain these loyalty programs. According to the Colloquy group, a leading consulting and research firm focused on the loyalty industry, the number of loyalty program memberships in the US increased from 3.3 billion in 2014 to 3.8 billion in 2016, representing an increase of 15% (source: 2017 Colloquy Loyalty Census Report, June 2017). As the number of loyalty memberships continues to increase, the level of diversification in the loyalty landscape is evolving. While the airline, hotel, specialty retail, and financial services industries continue to be dominant in loyalty programs in the US, smaller verticals, including the restaurant and drug store industries are beginning to see larger growth in their membership base. Further, newer loyalty concepts, such as large e-commerce programs, daily deals, and online travel agencies, are becoming more prevalent. As a result of this changing landscape, loyalty programs must continue to provide innovative value propositions in order to drive activity in their programs.
Points’ recent annual report provides that “[T]he Loyalty Currency Retailing segment provides products and services designed to help loyalty program members unlock the value of their loyalty currency and accelerate the time to a reward. Included in this segment are the Corporation’s buy, gift, transfer, reinstate, accelerator and status miles services. These services provide loyalty program members the ability to buy loyalty program currency (such as frequent flyer miles or hotel points) for themselves, as gifts for others, or perform a transfer of loyalty currency to another member within the same loyalty program.”
I also have trouble differentiating loyalty reward programs with bounty programs. Like in a bounty program, a loyalty reward is issued as compensation for an action such as shopping at a retail outlet, using a credit card, or staying at a hotel.
In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”
In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.
In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.
Certainly in those cases the companies were issuing common stock which is defined as a security without needing to reference the Howey Test; however, more recently, in the Matter of Tomahawk Exploration LLC, the SEC found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token.
I see the need for further guidance from the SEC on tokens vs. rewards as the “token economy” continues to flourish and develop.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journalop-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
Laura Anthony, Esq.
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Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.