Compiled by | Wu Shuo Blockchain
Original | SEC
This article compiles the main content of the “Framework for “Investment Contract” Analysis of Digital Assets” released by the SEC, which mainly outlines how to use the Howey test to determine whether encrypted assets are securities. The SEC also stated in the conclusion that “these factors do not intend to comprehensively evaluate whether encrypted assets belong to investment contracts or any other types of securities, and no single factor is decisive”. The original article was last modified on March 8, 2023.
A. Investment Funds
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When offering and selling encrypted assets, the first link of the Howey test is usually satisfied because encrypted assets are purchased in the form of value or obtained in other ways, whether it is real (or legal) currency, another encrypted asset, or other types of consideration.
(SEC note: Cash is not the only form of contribution or investment, and investment contracts can be formed without cash; for encrypted assets distributed through so-called “airdrops”, even if there is no currency consideration, it does not mean that the condition of investing money has not been met; therefore, airdrops may constitute the sale or distribution of securities. In the so-called “airdrop”, encrypted assets are distributed to holders of encrypted digital assets, usually to facilitate their circulation.)
B. Common Enterprise
Courts generally regard “common enterprise” as an independent element of investment contracts. When evaluating encrypted assets, we found that “common enterprise” usually exists.
(SEC note: Based on our experience so far, investment in encrypted assets constitutes investment in a common enterprise because the fate of the purchasers of encrypted assets is interlinked, or linked to the success of the promoter’s efforts.)
C. Expectation of Profits through the Efforts of Others
Usually, when analyzing encrypted assets based on the Howey test, the main issue is whether the purchaser has a reasonable expectation of obtaining profits (or other financial returns) through the efforts of others. Purchasers may expect to obtain returns by participating in distribution or by other means to increase the value of assets (such as selling at a high price in the secondary market). When promoters, sponsors, or other third parties (or related third-party groups) (each of which is called an “active participant” or “AP”) provide key management efforts that decisively contribute to the success of the enterprise, and investors reasonably expect to profit from these efforts, then this test link is satisfied. For this query, “the economic reality of the transaction” and “the tool characteristics given in the business based on the proposed terms, distribution plan, and economic incentives for prospects” are relevant. Therefore, this query is objective and focuses on the transaction itself and the method of providing and selling encrypted assets.
The following factors are particularly relevant when analyzing whether the third prong of the Howey test is satisfied:
1. Efforts of others
To determine whether a purchaser is relying on the efforts of others, two key questions are examined:
● Whether the purchaser reasonably expects to rely on the efforts of a promoter or third party;
● Whether those efforts are “undeniably significant managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature.
While none of the following characteristics are necessarily dispositive, the more that exist, the more likely it is that a purchaser is relying on the “efforts of others”:
● Active participants (APs) responsible for the development, improvement (or enhancement), operation, or promotion of the network or asset, especially where the purchaser of the crypto asset expects that the APs will perform or oversee tasks necessary for the network or asset to achieve or maintain its intended purpose or functionality.
○ When the network or asset is still in development and not fully functional at the time of offer or sale, a purchaser would reasonably expect APs to further develop the network or asset (directly or indirectly), particularly where the APs have promised to do so in order to make the crypto asset valuable or to increase its value.
● Certain fundamental tasks or responsibilities are performed or expected to be performed by APs, rather than an unrelated, dispersed network user community (often referred to as a “decentralized” network).
● APs create or support a market for the crypto asset, or the price of the crypto asset. For example, APs may: (1) control the creation and issuance of the crypto asset; or (2) take other actions to support the market price of the crypto asset, such as through restricting supply or ensuring scarcity, such as through buybacks, “burning” or other activities.
● APs have a leading or central role in the ongoing development direction of the network or asset. In particular, APs play a leading or central role in deciding governance issues, code updates, or how third parties are allowed to participate in verifying transactions involving the crypto asset.
● APs have a continuing managerial role in decisions about the characteristics or rights represented by the network or asset, such as:
○ Deciding whether and how to compensate those who provide services to the network or entities responsible for overseeing the network.
○ Deciding where the crypto asset will trade. For example, a purchaser may reasonably rely on APs to provide liquidity, such as where the APs have arranged, or committed to arrange, for the crypto asset to trade on secondary markets or platforms.
● Deciding who will receive additional cryptocurrency under what conditions.
● Making or contributing to business decisions by management, such as how to deploy funds raised through the sale of cryptocurrency.
● Taking a leading role in verifying network transactions or ensuring the ongoing security of the network in other ways.
● Making other managerial judgments or decisions that directly or indirectly affect the success of the network or the value of cryptocurrency.
● Buyers can reasonably expect that the AP will work to promote its own interests and increase the value of the network or cryptocurrency, for example:
○ The AP has the ability to realize capital appreciation from the value of cryptocurrency. For example, if the AP retains an equity or interest in cryptocurrency, buyers can reasonably expect that the AP will work to promote its own interests and increase the value of the network or cryptocurrency.
○ The AP distributes cryptocurrency as compensation for management, or the AP’s compensation is tied to the market price of cryptocurrency. In these cases, the compensated individuals can reasonably expect to take steps to increase the value of cryptocurrency.
○ The AP directly or indirectly owns or controls intellectual property related to the network or cryptocurrency.
○ The AP profits from cryptocurrency, especially when the functionality of cryptocurrency is limited.
Additional considerations related to “the efforts of others” may come into play when evaluating whether cryptocurrency previously sold as a security needs to be reevaluated when offered or sold in the future, including, but not limited to:
● Whether the efforts of the AP, including any successor AP, are still important to the value of the investment in cryptocurrency.
● Whether the manner in which the network is operated no longer gives buyers a reasonable expectation of managerial or entrepreneurial efforts on the part of the AP.
● Whether the efforts of the AP no longer affect the success of the enterprise.
2. Reasonable Expectation of Profits
Evaluating cryptocurrency should also consider whether there is a reasonable expectation of profits. Profit can be capital appreciation resulting from the initial investment or business enterprise development, or a share of earnings resulting from the use of buyer funds. Price increases resulting solely from external market forces, such as general inflationary trends or the economy, are generally not considered “profits” under the Howey test.
The more of the following characteristics exist, the greater the likelihood of a reasonable profit expectation:
● Cryptographic assets give holders the right to share in enterprise income or profits, or to benefit from the capital appreciation of cryptographic assets.
○ This opportunity may be at least partly due to the value of cryptographic assets rising as a result of positive developments such as network operation, promotion, improvement, or others, especially if there is a secondary trading market that allows cryptographic asset holders to sell their cryptographic assets and realize profits.
○ It may also occur when cryptographic assets give holders the right to receive dividends or distributions.
● Cryptographic assets can be transferred or traded on a secondary market or platform, or are expected to be able to do so in the future.
● Buyers reasonably expect that AP’s efforts will result in the capital appreciation of cryptographic assets, so they can get returns from their purchases.
● Cryptographic assets are widely offered to potential buyers, rather than users of expected goods or services, or those who need network functionality.
○ The offer and purchase of cryptographic assets indicate investment intent, rather than the number of network users. For example, the number of offerings and purchases is significantly larger than the number of assets that any reasonable user may need, or the number is so small that the use of assets in the network becomes impractical.
● There is little correlation between the purchase/provision price of cryptographic assets and the market price of specific goods or services that can be exchanged for cryptographic assets.
● The correlation between the amount of cryptographic assets usually traded (or the amount usually purchased by buyers) and the amount of basic goods or services that typical consumers would buy for use or consumption is small.
● AP raises more funds than are needed to establish a functional network or cryptographic asset.
● AP can benefit from its efforts by holding cryptographic assets of the same type as those distributed to the public.
● AP continues to use revenue or operating funds to enhance the functionality or value of the network or cryptographic assets.
● The marketing of cryptographic assets, either directly or indirectly, uses any of the following:
○ An AP’s expertise or its ability to establish or enhance the value of a network or cryptographic asset.
○ Cryptographic asset marketing language that suggests it is an investment, or that the solicited holder is an investor.
○ The expected use of the proceeds from the sale of cryptographic assets is to develop the network or cryptographic asset.
○ The future (not current) functionality of the network or cryptographic asset, and the prospects for AP to deliver that functionality.
● Committing (implicitly or explicitly) to establish a business or operation, rather than providing currently available goods or services for use on an existing network.
● The transferability of the digital asset is a key selling point.
● Emphasizing the potential profitability of the network operation or the potential appreciation in the value of the digital asset in marketing or promotional materials.
● The availability of a market for the trading of the digital asset, particularly when the AP represents or implies that it will develop or support such a market, or if secondary market trading in the digital asset is available or expected to be available.
Additional considerations with respect to whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales include, but are not necessarily limited to:
● Purchasers no longer reasonably expect that an AP will carry out the essential managerial or entrepreneurial efforts.
● The value of the digital asset has been demonstrated to be significantly correlated with the value of the good or service for which it may be exchanged or redeemed.
● The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
● The AP or its affiliates have a continuing involvement in the development or management of the network or the digital asset, making it more likely that purchasers will rely on the AP’s efforts.
● Purchasers will no longer look to the AP, the promoter, or a third party for essential managerial or entrepreneurial efforts.
● Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality, particularly if there are built-in incentives to ensure that the user is incentivized to use the digital asset on the network, rather than for speculation or investment.
● The holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to ensure that the user is incentivized to use the digital asset on the network, rather than for speculation or investment.
● AP does not obtain or retain a degree of control or influence over the digital asset such that it continues to be an investment contract.
● AP does not obtain or retain a degree of control or influence over the digital asset such that it continues to be an investment contract.
3. Other Relevant Considerations
When evaluating whether there is an expectation of profits solely from the efforts of others, a federal court looks to the “economic realities” of the transaction. In doing so, the court considers whether the instrument is being sold to “users” or to “investors.”
Although no one factor is determinative, the stronger their presence, the less likely it is that the Howey test will be met:
● The distributed ledger network and digital asset are fully developed and operational.
● Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to ensure that the user is incentivized to use the digital asset on the network, rather than for speculation or investment.
● The digital asset’s 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, the digital asset can only be used on the network, and it cannot be repurposed to serve other functions.
● The potential for appreciation in the value of crypto assets is limited. For example, the design of crypto assets stipulates that their value will remain constant or even decrease over time, so reasonable buyers would not expect to hold crypto assets long-term as an investment.
● With regard to crypto assets referred to as virtual currencies, they can be used immediately for payment in a variety of situations, or as a substitute for real (or fiat) currency.
○ This means that crypto assets can be used to pay for goods or services without first being converted to other crypto assets or real currency.
○ If it is classified as a virtual currency, then crypto assets actually serve as a store of value that can be stored, retrieved, and exchanged for something valuable at a later time.
● With regard to crypto assets that represent rights to goods or services, they can now be exchanged on an established network or platform for access to or use of those goods or services. Relevant factors may include:
○ The correlation between the purchase price of the crypto asset and the market price of the specific goods or services that it may be exchanged or traded for.
○ The crypto asset is provided in increments that match consumer intent, rather than for investment or speculative purposes.
○ If access to or more efficient access to crypto asset-based goods or services can only be obtained by using crypto assets on the network, then the intent to consume crypto assets may be more apparent.
● Any economic benefit that may be derived from the appreciation in value of crypto assets is an incidental result of obtaining the right to use their expected functional rights.
● The marketing of crypto assets emphasizes their functionality, not their market value.
● Potential buyers have the ability to use the internet and use (or have used) crypto assets to achieve their expected functionality.
● Restrictions on the transferability of crypto assets are consistent with the intended use of the asset and do not promote a speculative market.
● If AP promotes the creation of a secondary market, the transfer of crypto assets can only be performed by users of the platform.
Crypto assets with these types of usage or consumption characteristics are unlikely to be investment contracts. For example, consider a well-established online retailer that operates a business. The retailer creates crypto assets that allow consumers to purchase products only on the retailer’s network, offers crypto assets for sale in exchange for fiat currency, and crypto assets are exchangeable for products priced in that fiat currency. As part of these efforts, the retailer continues to market its products to its existing customer base, promotes its crypto asset payment method, and may “reward” customers with crypto assets based on product purchases. Upon receiving crypto assets, consumers can immediately use them to purchase products online. Crypto assets are not transferable; instead, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount below the original purchase price. Based on these facts, crypto assets would not be investment contracts.
Even if crypto assets can be used to purchase goods or services on a network and the network or the crypto asset’s functionality is under development or being improved, securities trading may still exist if, among other factors, the following conditions exist: assets are sold or offered for sale to purchasers at a discount to the value of goods or services; the quantity of crypto assets sold or offered for sale to purchasers exceeds a reasonable range of use; and/or there are limited or no restrictions on the resale of these crypto assets, particularly in situations where AP continues to work to increase the value of the crypto assets or to promote secondary markets.