The growth of blockchain and Web 3.0 offer an increasingly broad range of digital assets to customers – ranging from stablecoins to non-fungible tokens (“NFTs”) to crypto-assets such as Bitcoin and Ethereum and many different configurations of security tokens. Yet underlying this diversity of products is the fundamental question of what regulatory framework such digital assets may be governed by, which largely depends upon specific facts and circumstances.

One of the central questions surrounding this discussion is determining whether a digital asset is defined as a “security” as per the U.S. securities laws. The process of evaluating whether or not a specific digital asset would be considered a security relies on existing cases and precedents that have shaped the boundaries of U.S. securities law for nearly 100 years.

This blog will introduce some of the key questions, regulations, and policy statements that impact the evaluation of whether a digital asset is or is not a security, including:

• What types of financial instruments can be included under the SEC’s classifications of securities?
• What are the “Howey Test” and the “Reves Test”, and how does the SEC apply them to digital assets?
• What are some of the challenges in analyzing digital assets under these frameworks?
• What are some examples of how digital assets fit in this framework according to statements by the SEC and its staff?
• What are the other regulatory challenges for the development of markets in blockchain-based securities?

What types of financial instruments can be included under the SEC’s classifications of securities?

The term “security,” as defined under the Securities Act and the Exchange Act, includes not only traditional “securities” such as notes, stocks, bonds, security future, security-based swap, and a range of other financial instruments, but it also includes a range of other assets or offerings which can be captured under a catch-all category of “investment contracts.”^[1]

How do the SEC and U.S. jurisprudence evaluate what an investment contract is?

Courts and the SEC typically use the “Howey Test” to evaluate whether an instrument is an investment contract and accordingly if it will be governed by the relevant securities laws.^[2]

What is the “Howey Test”?

The Howey Test is a set of criteria for determining whether an offering, financial investment or other scheme is an “investment contract” and thus defined as a “security” under the federal securities laws.  The Howey test is based on a landmark 1946 U.S. Supreme Court case, brought by the SEC against W.J. Howey & Co.^[3]

The Howey Test generally includes four criteria that are used to determine if an “investment contract” exists.  All criteria must be met in order for the instrument to be classified as an investment contract, and the analysis must be grounded in the specific facts and circumstances of the instrument in question. The test requires the instrument involve:

1. An investment of money
2. In a common enterprise
3. With a reasonable expectation of profits
4. The expectation of profits is based upon the entrepreneurial or managerial efforts of others.

The focus of the Howey analysis is not only on the form and terms of the instrument itself but also on the circumstances surrounding the instrument and the manner in which it is offered, sold, or resold (which includes secondary market sales).  Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset should analyze the relevant transactions to determine if the federal securities laws apply.

How does the Howey Test apply to digital assets, and what has the SEC and its staff said about its interpretation in this context?

Although the Howey Test originated in a very different context (the original court case it is based on contemplated interests in a Florida orange grove), the SEC has continued to apply the framework and principles of the test to review a broad range of digital assets.

When looking at digital assets, the SEC repeatedly has stressed that its application of the Howey Test is built on a facts-and-circumstances analysis of each asset to evaluate whether it is an investment contract and therefore a security. The SEC also has commented that in this analysis that “form should be disregarded for substance,” and its analysis must focus on the “economic realities underlying a transaction, and not on the name appended to it.”^[4]

In 2019, the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) published the SEC Digital Assets Framework. Although the Digital Assets Framework is not a law or regulation, it provides guidance on how the SEC would apply the Howey Test to digital assets.^[5]  It highlighted how each of the elements of the Howey Test could be interpreted in light of the facts and circumstances of digital assets, and also provided a range of factors that make it less likely that a digital asset could be considered a security. Both of these are discussed in the sections below.

Additionally, in 2018, William Hinman, then the Director of the SEC’s Division of Corporate Finance, highlighted some considerations around the application of the Howey Test to digital assets.^[6]  Among other considerations, he noted the importance of “whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return,” and highlighted factors that could indicate whether or not this is the case.  These included the role of the person or group that sponsored the asset and any stake they hold, how the funds raised are used, and the expectations of purchasers for a return, among others.^[7]  He also highlighted economic and operational considerations, such as how the token could meet the needs of its users, and whether or not it has been designed and promoted for use/consumption or investment, as well as other factors.^[8]

 Looking specifically at the elements of the Howey Test, what does “an investment of money” mean in the context of digital assets?

The SEC and the courts have taken a broad interpretation of what contributions an investor can make in return for an interest in a financial instrument.  Although fiat currency is clearly covered, the SEC has stated that an investment of “money need not take the form of cash,” and could include instead other tokens or digital assets.^[9] The Digital Assets Framework also suggests that “an investment of money” could extend beyond straightforward exchange of assets to cover other promotional programs to promote newly launched tokens and initial coin offerings, such as bounty programs and “air drops” to holders of other tokens.^[10]

Does the work provided by “miners” for certain types of cryptocurrencies and other digital assets count as “an investment of money” under this element of the Howey Test?

A number of digital assets rely on services of “miners” to create new assets or to authenticate transactions.  Although there are a broad range of operating models for miners (i.e., proof of work vs. proof of stake), and substantial variation in how they support these ecosystems, at this time neither the SEC nor the courts have confirmed if the services provided by miners meet the first element of the Howey Test. There has been a range of attempts to make analogies between the process of digital asset mining and examples of the creation of traditional securities, but for now, this remains an open question.^[11]

Looking at the next element of the Howey Test, what does “a common enterprise” mean?

A “common enterprise” generally looks to identify ties among the persons who own the asset. The SEC has stated that “when evaluating digital assets, we have found that a ‘common enterprise’ typically exists.”^[12]  However, when looking at the elements of a common enterprise as developed by the courts, SEC statements and court decisions suggest that certain digital assets, including Bitcoin, may not meet this test, as discussed further below.^[13]  A common enterprise has been interpreted to exist through horizontal and/or vertical commonality (see below).^[14]

What does horizontal and vertical commonality mean for digital assets?

Horizontal commonality has been interpreted to mean there is a pooling of investors’ contributions and distribution of profits or losses on a pro-rata basis.^[15]  Applications of the horizontal commonality to digital assets have assessed the role of a central entity in supporting the digital asset, whether investors’ assets are pooled in a central location, and whether those pooled assets are controlled by any entity.^[16]  For example, proposed offerings by Telegram were found to meet the test of horizontal commonality because the organizers “themselves continue to represent the initial Purchasers’ pooled funds” and “there was a pooling of assets and that the fortunes of investors were tied to the success of the enterprise as well as to the fortunes of other investors both before and after launch.”^[17]

Vertical commonality looks to see whether the success of the investors is dependent on the efforts of the promoters (i.e., those who direct the organization of the company in question).^[18] The SEC has argued that a number of digital assets do meet this requirement. For example, the proposed offerings by Kik and Telegram were seen to meet this test based on their developers’ reputational and financial interests in their success, suggesting that purchasers would expect the developer to work to enhance the value of their digital asset offers. In the Kik case, the court found that “Kik had a unique incentive to increase demand for Kin because it retained for itself 30% of the tokens created.”^[19]  In the Telegram case, the court found that “anticipated profits were directly dependent on Telegram’s success in developing and launching” the digital asset since the developer controlled a large portion of the asset and was contractually bound to return any unspent funds to investors.^[20]

Additionally, commonality could change as individual assets grow and develop.  For example, the governance structure and incentives of a digital asset may change since its inception, changing the evaluation of whether it meets the tests of either horizontal or vertical commonality compared with its structure when launched.

How do regulators interpret the final elements of the Howey Test – “A reasonable expectation of profit” and “based on the efforts of others” – for digital assets?

The SEC has often combined the third and fourth conditions together as one element: “a reasonable expectation of profits (or other financial returns) derived from the efforts of others.” Much of the focus and commentary on the Howey Test analysis for digital assets focuses on this last element. The SEC’s Digital Assets Framework elaborates further on the role of an “active participant” (“AP”) in driving the success of the enterprise that the digital asset supports, and the creation of any expected profit from that, as well as other structural characteristics such as whether the digital asset gives the holder rights to share in the enterprise’s income or profits or to realize a gain from capital appreciation of the digital asset. ^[21]

When determining whether an asset’s success is based on the efforts of others, the SEC has said it looks to see factors that include an AP being responsible for developing or promoting the network, the AP having responsibility for key tasks to support the network (in contrast to decentralized networks), the AP supporting the price of the asset, and the AP having a managerial role in decisions about the network and use of funds raised, among other considerations. ^[22]

From the SEC Digital Assets Framework, the SEC has also suggested that a “reasonable expectation of profit” can also depend on a number of characteristics that, when present, are more likely that there is a reasonable expectation of profit. These include the digital asset giving the holder rights to share in the enterprise’s income or profits or to realize gains from appreciation of its value (such as resulting from the AP’s efforts) and where a secondary market for it exists. They also include cases where the AP can expect to profit from holding the same class of digital assets as those distributed to the public, certain features related to the pricing and trading volumes of the digital asset, how the asset is marketed, and the degree to which there are actual, current uses for the asset, among other considerations.^[23]

What other considerations shape the application of the Howey Test to digital assets?

The applicability of the Howey Test is also shaped by the economics of the transaction, such as whether the instrument in question is offered and sold for use or consumption by purchasers.^[24] In its SEC Digital Assets Framework, the SEC outlined a number of characteristics and noted that while none of them are determinative, the stronger the presence of these characteristics, the less likely the Howey Test would be met.

These characteristics cover a range of factors, such as whether the digital asset and its supporting network are fully operational and can be used immediately for their intended functionality, as well as the degree to which prospects for appreciation in the value of the digital asset are limited. It also notes that for digital assets which can be referred to as a “virtual currency”, one should consider the degree to which they can immediately be used to make payments directly and function as a store of value.  For digital assets which represent the rights to a good or service, it asks whether it can be presently redeemed within a network for that good or service.^[25]

Have SEC staff commented on how the Howey Test could be applied to Bitcoin and Ether?

In a 2018 speech, the SEC’s Director of the Division of Corporation Finance at the time, William Hinman, expressed his view that two of the most broadly held digital assets—Bitcoin and Ether (in its then state)—are not securities under the Howey test.^[26]  He said that Bitcoin lacks “a central third party whose efforts are a key determining factor in the enterprise” and operates on a decentralized network, and as a result “applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”^[27] Similarly, for Ether, former Director Hinman wrote that “applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.”^[28]

What is the “Reves Test” and how does it apply to digital assets?

Recent SEC staff statements and enforcement actions have also pointed to the “Reves Test” as another threshold test for determining what is a security.^[29] Where the Howey Test focuses on the analysis of an investment contract, the Reves Test focuses on whether the financial instrument or offering is a “note,” and thus a security under federal securities.  The Reves Test draws on Reves v. Ernst & Young, which covered the question of whether demand notes bought from an agricultural cooperative could be considered securities.^[30]

The Reves Test identifies four factors, the balance of which can indicate whether or not a note is a security. They are: 1) the motivations of the buyer and seller, 2) the plan of distribution, 3) the reasonable expectations of the investing public, and 4) any risk-reducing considerations.^[31]  In the SEC’s 2021 cease-and-desist proceedings against Blockchain Credit Partners d/b/a DeFi Money Market (“DMM”) and its founders, the SEC applied the Reves Test to determine that tokens being offered were in fact securities. Using the elements of the Reves Test, they argued that DMM and its founders sold tokens to raise funds for its business, and buyers purchased them solely to earn a designated return. Additionally, the tokens were offered to the general public and were promoted as an investment, without any other risk-reducing factors, meeting all four elements of the Reves Test.^[32]

In the SEC’s 2022 cease-and-desist proceedings against BlockFi Lending LLC, the SEC argued that BlockFi offered and sold BlockFi Interest Accounts (“BIAs”) to “obtain crypto assets for the general use of its business, namely to run its lending and investment activities to pay interest to BIA investors.” The SEC argued that purchasers bought BIAs to receive interest on the loaned assets. Second, the SEC discussed that the BIAs were offered and sold to a broad segment of the general public, arguably fulfilling the second element of Reves. Third, the SEC argued that BlockFi promoted the BIAs as an investment, in particular, “as a way to earn a consistent return on crypto assets and for investors to ‘build their wealth’ ” Lastly, the SEC argued that no alternative regulatory scheme or other risk-reducing factors exist with respect to BIAs.^[33]

What does it mean if a digital asset is determined to be a security?

If a digital asset is a security, it will be governed by a broad range of Federal and potentially state securities laws and regulations. These regulations will shape how it can be offered to investors, sold and distributed, what disclosures may need to be provided, and how the financial institutions and infrastructure providers who support its issuance, management and trading can handle it. Moreover, unwitting digital assets that may be considered investment contracts or notes may trigger the full breadth of the U.S. securities laws for its issuers, investors, and other partners that may facilitate transactions in the asset. Accordingly, it is important to understand the U.S. securities laws, amongst other rules and regulations, when embarking upon a digital asset project.

 Looking beyond the question of defining a security, what are some of the key challenges for securities firms as they look to develop markets and services for blockchain-based securities?

By and large, SIFMA is of the view that blockchain-based securities (also known as digital asset securities or security tokens) can be accommodated within existing regulatory frameworks, with limited modifications as necessary to reflect the unique ways in which blockchain or distributed ledger technology allows asset ownership to be tracked and transaction history to be recorded.  We encourage the SEC and other regulators to adopt a technologically neutral approach that focuses on the asset or activity conducted rather than on the technology used to deliver them.

SIFMA explored the way blockchain-based securities can be incorporated into the existing securities lifecycle in our 2020 white paper “Security Tokens: Current Regulatory and Operational Considerations and a Look Towards the Future.”

—

Charles DeSimone is a Vice President with the Securities Industry and Financial Markets Association (SIFMA). He is responsible for a range of initiatives related to emerging technologies, risk and resiliency, particularly within the operations and technology functions.

 

^[1] Section 2(a)(1) of the Securities Act and section 3(a)(10) of the Exchange Act each define the term “security” and include the term “investment contract” within those definitions. For instance, Securities Act § 2(a)(1) defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security . . . or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

^[2] SEC, Strategic Hub for Innovation and Financial Technology, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets [hereinafter “SEC Digital Assets Framework”].

^[3] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

^[4] Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission: Hearing Before the Senate Committee on Banking, Housing, and Urban Affairs, 115th Cong. (2018) (Statement of Jay Clayton, Chairman, SEC) [hereinafter “Chairman Clayton Statement”]; SEC, REPORT OF INVESTIGATION PURSUANT TO SECTION 21(A) OF THE SECURITIES EXCHANGE ACT OF 1934: THE DAO, Securities Act Release No. 81207, at 11 (2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf; Stephanie Avakian and Steven Peikin, Directors, SEC and CFTC Divisions of Enforcement, Joint Statement by SEC and CFTC Enforcement Directors Regarding Virtual Currency Enforcement Actions (Jan. 19, 2018), available at https://www.sec.gov/news/public-statement/joint-statement-sec-and-cftc-enforcement-directors (stating that “the SEC . . . will look beyond form, [to] examine the substance of the activity and prosecute violations of the federal securities . . . laws”) [hereinafter “DAO Report].

^[5] SEC Digital Assets Framework, supra note 2.

^[6] William Hinman, Dir., Div. of Corp. Fin., SEC, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418.

^[7] Hinman, supra note 6.

^[8] Hinman, supra note 6.

^[9] DAO Report, supra note 4.

^[10] SEC Digital Assets Framework, supra note 2.

^[11] Operating models where proof-of-work miners use computational power to produce a crypto currency are giving up the opportunity cost of their time and resources, which is distinct from past cases which looked at contribution of labor or wages such as Uselton v. Commercial Lovelace Motor Freight, Inc or International Brotherhood of Teamsters v. Daniel.

^[12] SEC Digital Assets Framework, supra note 2.

^[13] Hinman, supra note 6.

^[14] Although Federal courts have required that there be either “horizontal commonality” or “vertical commonality,” the SEC itself has stated that it does not require vertical or horizontal commonality per se, nor does it view a “common enterprise” as a distinct element of the term “investment contract.” SEC Digital Assets Framework, supra note 2.

^[15] SEC v. Infinity Grp. Co., 212 F.3d 180, 188 (3d Cir. 2000).

^[16] SEC v. Telegram, No. 19-cv-9439, 2020 U.S. Dist. LEXIS 53846 (Mar. 24, 2020).

^[17] Telegram, supra note 16.

^[18] U.S. Code 15 U.S. Code § 80a–2, available at https://www.law.cornell.edu/uscode/text/15/80a-2

^[19] SEC v. Kik Interactive Inc., No. 1:19-cv-05244 (S.D.N.Y. Sept. 30, 2020), ECF No. 88.

^[20] Telegram, supra note 16.

^[21] SEC Digital Assets Framework, supra note 2.

^[22] SEC Digital Assets Framework, supra note 2.

^[23] SEC Digital Assets Framework, supra note 2.

^[24] SEC Digital Assets Framework, supra note 2.

^[25] SEC Digital Assets Framework, supra note 2.

^[26] Hinman, supra note 6.

^[27] Hinman, supra note 6.

^[28] Hinman, supra note 6.

^[29] Caroline A. Crenshaw, SEC Commissioner, Digital Asset Securities – Common Goals and a Bridge to Better Outcomes (Oct. 12, 2021), available at https://www.sec.gov/news/speech/crenshaw-sec-speaks-20211012; Gurbir Grewal, Director of SEC Division of Enforcement, 2021 SEC Regulation Outside the United States – Scott Friestad Memorial Keynote Address (Nov. 8, 2021), available at https://www.sec.gov/news/speech/grewal-regulation-outside-united-states-110821; In re Blockchain Credit Partners d/b/a DeFi Money Market, Securities and Exchange Commission File No. 3-20453 (Aug. 6, 2021), available at https://www.sec.gov/litigation/admin/2021/33-10961.pdf (DMM Order); In re Blockfi Lending LLC, Securities and Exchange Commission Fole No. 3-20758 (Feb. 14, 2022), available at  https://www.sec.gov/litigation/admin/2022/33-11029.pdf.

^[30] Reves v. Ernst & Young, 494 U.S. 56 (1990), available at https://supreme.justia.com/cases/federal/us/494/56/.

^[31] Reves v. Ernst & Young, supra note 29.

^[32] In re Blockchain Credit Partners d/b/a DeFi Money Market, supra note 28.

^[33] In re Blockfi Lending LLC, Securities and Exchange Commission Fole No. 3-20758 (Feb. 14, 2022), available at  https://www.sec.gov/litigation/admin/2022/33-11029.pdf.

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