The SEC’s William Hinman, Director of the Division of Corporation Finance, in a wide-ranging speech to an audience at the Yahoo Finance All Markets Summit: Crypto, reprised themes from existing agency guidance that "economic substance" is key to determining whether a digital asset is a security, while the label ascribed to a digital asset is not. But Hinman also spoke about the legal status of bitcoin and ether, and he addressed the question of whether a digital asset initially presented as a security can morph into something that is not a security. The speech also included lists of questions counsel can ask about the role of third parties in digital asset transactions and the consumability of digital assets, plus an invitation to discuss these issues with SEC staff.
Virtual currencies. Although the SEC generally would not be the lead regulator of a currency, as opposed to a security, there have been persistent questions about whether virtual currencies like bitcoin, ether, or ripple run afoul of securities laws. For example, former CFTC Chairman Gary Gensler, in remarks at MIT’s Business of Blockchain 2018, suggested that ether and ripple may have violated securities laws.
Hinman, by contrast, said that neither bitcoin nor ether would require application of the federal securities laws because they are decentralized and lack the informational asymmetries typical of assets for which securities-style disclosures are needed. With respect to ether, however, Hinman emphasized that his understanding of that virtual currency was confined to its current iteration and he declined to comment on whether securities laws might apply to ether’s original fundraising. Hinman also cautioned that a digital asset initially functioning as a means of exchange can, depending on how it is later packaged, become subject to federal securities laws.
But Hinman did not address issues surrounding Ripple Labs Inc.’s XRP token, which is the subject of at least one private securities class action suit that also raises many questions about the scope of the Supreme Court’s Cyan decision and the applicability of the Class Action Fairness Act (CAFA). The plaintiff sued Ripple Labs in state court alleging the sale of unregistered securities under both the Securities Act and California law. Cyan held that state courts retain concurrent jurisdiction over suits that assert only Securities Act claims and that these cases cannot be removed to federal court. But the Securities Litigation Uniform Standards Act (See Securities Act Sections 16 and 22(a)) would otherwise require removal of a covered class action regarding a covered security that asserts an untrue statement or omission of a material fact, or that asserts the use of a manipulative or deceptive device or contrivance. Ripple has sought to remove the case from California court to federal court under CAFA, while also asserting that Cyan is inapt.
Tokens and the SAFT. One of the big questions in the coin and token space is the extent to which a digital asset can morph from a security into something that may not be a security. Hinman opened his speech by addressing this topic, but would later come back to the related issue of the Simple Agreement for Future Tokens (SAFT), albeit by footnote, when he discussed the availability of SEC staff to discuss these issues.
According to Hinman, the proper way to phrase the question is this: "Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?" He said the answer is "likely ‘no’" if the digital asset affords its holders rights akin to financial interests. The answer, however, may change in the absence of a "central enterprise" or if the token only allows its holders to buy goods or services. In this second scenario, Hinman answered with a "qualified ‘yes.’"
The issue of a digital asset morphing from one thing to another raises the question of where the SAFT fits into the framework of federal securities law. The SAFT, modeled broadly after Y Combinator’s Simple Agreement for Future Equity, begins as a security, but contemplates the later issuance of tokens that would not be securities. In a footnote, Hinman cautioned that he was not commenting on the legal status of the SAFT. That said, however, Hinman noted that while others may disagree with him, it may be possible for a security to morph into a non-security. "From the discussion in this speech, however, it is clear I believe a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction," said Hinman.
Potential SEC staff guidance. Hinman said SEC staff are available to discuss a variety of issues with counsel representing persons who create and promote digital assets. He even suggested the possibility of interpretive or no-action guidance regarding the "characterization" of digital assets. Specifically, Hinman said counsel should focus on two sets of questions, one dealing with the role played by third parties in any transaction involving digital assets, and a second one dealing with questions about whether a digital asset is consumable. The lists are reproduced below verbatim.
With respect to third parties, Hinman posed six questions:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers "investing," that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
Hinman posed seven questions regarding the consumability of a token:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
Companies: Ripple Labs Inc.
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