Is a Digital Asset a Security or … Is It Not?
Remember the game that kids used to play, where they would pick off the petals of daisies to determine whether their crush loves them, or loves them not?
Well, ever since the rise of digital assets, it feels as though the SEC has been playing a similar game in order to establish what constitutes a security.
And, according to some recent statements emanating from the Commission, the last petal standing seems to indicate that digital assets are indeed securities.
Well, sort of.
Earlier this month, and after much petal plucking, the SEC’s Division of Corporate Finance released a long-awaited – yet “unofficial” – staff guidance on the treatment of digital assets. As acknowledged by the Commission, the framework is not intended to be a comprehensive overview of the laws, but rather a mere framework offering a number of questions intended to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset.
The framework is neither a rule, regulation, legal advice or even a statement of the Commission itself. When you get to the meat and potatoes, it’s clear that the framework is nothing more than 13 pages of “staff views” and disclaimers that prompt more questions than it supplies answers.
According to Drew Hinkes, general counsel at Athena Blockchain, attorney at Carlton Fields, and law professor at the New York University, “for those clamoring for certainty, the framework doesn't create the “one checklist to rule them all” that so many have been clamoring for, as this appears to be nothing more than just another statement by a regulator. It’s not a rule, law, ordinance, or even guidance. It is more likely another tool for lawyers to use to analyze offerings and make legal arguments, leaving it for courts ultimately to decide whether a particular token is or isn’t a security.”
Not surprisingly, the SEC’s framework sets forth facts and circumstances to be considered in applying the Howey Test in determining whether or not a digital asset is a security. The Howey Test, which emanated out of the 1946 Supreme Court case SEC v. W.J. Howey Co., lays out a three-prong approach for judging whether or not something can be classified as a security: “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person  invests his money in  a common enterprise and  is led to expect profits solely from the efforts of the promoter or a third party.”
The third prong of Howey is where things get particularly dicey.
In its framework, the SEC sought to elaborate on the persons included in the third prong of the Howey Test and offered a new, broader definition of a “third party” by introducing the term: “Active Participant (AP).” The definition provided for AP is so broad that it may include any entity involved in a token sale, including managers, promoters, sponsors or any other third party with the potential to impact the possible success of an enterprise.
According to Hinkes, “As Active Participant is not clearly defined, it may be argued that an Active Participant is anyone who makes representations on behalf of the issuer about the offering that buyers rely upon when making an investment decision. In addition to possible first amendment implications, this overly broad definition could become a treasure trove for securities litigators who may see a number of new potential defendants joined into litigation matters as alleged Active Participants.”
On the very same day that its framework was published, the SEC also issued a no-action decision in response to a letter from TurnKey Jet, Inc. seeking guidance for a proposed token sale. The SEC responded by declaring that TurnKey’s loyalty token program for its members was NOT a security.
As if anyone had any doubts.
The TurnKey token is no more a security than the kale salad I just ate for lunch.
Even SEC Commissioner Hester Peirce (aka Crypto-Mom) has publicly stated that the no-action letter wasn’t the most helpful for cryptocurrency entrepreneurs as the token was “so obviously not a security.”
While there are many who view the SEC’s unofficial framework and its TurnKey no action letter as “nothing burgers,” there happened to have been some very significant regulatory movement in the U.S. during the month of April. One was the re-introduction of the Token Taxonomy Act of 2019 (HR 2144), and the other was Blockstack’s Form 1-A filing with the SEC.
Both could have enormous implications for digital assets.
If passed, the bipartisan HR 2144 would declare that digital assets are generally not securities, placing them out of the purview of the SEC altogether. Additionally, the bill would change tax law so that IRA investments in cryptocurrencies wouldn’t be considered a distribution for tax purposes. It would also create a tax exemption for exchanging one digital asset for another as well as exclude capital gains taxes for small sales of cryptocurrencies. (To learn more about the present tax implications of cryptocurrencies, visit The Consequences of Failing to Report Cryptocurrency Transactions and The Tax Consequences of Failing to Report Cryptocurrency Transactions).
Blockstack’s recent filing was equally as impactful.
Blockstack, the startup building a decentralized internet that inspired the main storyline in the HBO show “Silicon Valley,” has been in a confidential “test the waters” submission process with the SEC – a provision under the Reg A+ exemption which allows companies to gauge investor interest prior to filing and permits new issuers to submit a draft offering statement (“DOS”) for nonpublic staff review. The non-public DOS must be publicly filed on EDGAR no less than 21 calendar days prior to the qualification of the public filing. Clearly Blockstack has the investor interest. Many are also hoping that this move signifies an imminent Reg A+ token qualification. An SEC approval would set new precedents for Security Token Offerings (“STOs”).
But will it be the catalyst that fuels the growth of the STO marketplace?
According to Matthew Muscarnera, audit partner in the Financial Services Group at EisnerAmper, “While the SEC’s recently released framework for digital assets provides a helpful regulatory framework for issuers, it still leaves many questions unanswered – particularly from an audit perspective. Until auditors have regulatory clarity, I’m afraid the STO marketplace will be impeded from realizing its full potential.”
One thing is abundantly clear. Pending legislative progress or judicial rulings, token issuers in the U.S. should err on the side of caution and assume that their token is a security – unless, of course, it really is a kale salad.
This is no longer a petal game. Instead, it remains a waiting game. A very, very long waiting game