Against a backdrop of litigation centred on unregistered securities, the U.S. Securities and Exchange Commission (SEC) continues to work to clarify its position as to exactly when savvy coin offering structures cross the line.
In 2019, the SEC released a Framework for the “Investment Contract” Analysis of Digital Assets, a topic which SEC corporate finance director William Hinman has spoken at length about.
The investment contract analysis is particularly relevant to the world of digital currencies, as companies intending to raise the capital required to launch blockchain-based digital assets seek out capital-raising avenues without being caught up in the rigorous requirements of the SEC’s securities legislation.
The SAFT model—a Simple Agreement for Future Tokens—has been used extensively for this purpose. Under the model, purchasers enter into a contract in which they agree to provide upfront capital to a prospective token company in exchange for the right to the tokens, which are delivered once the tokens and the network underpinning them is developed.
The SEC has been vigilant in the pursuit of what it sees as the offering of unregistered securities, particularly in the cases of coin offerings pursued via the SAFT model. The aforementioned investment contract framework paper summarises their concerns nicely:
Absent the disclosures required by law about those efforts and the progress and prospects of the enterprise, significant informational asymmetries may exist between the management and promoters of the enterprise on the one hand, and investors and prospective investors on the other hand. The reduction of these information asymmetries through required disclosures protects investors and is one of the primary purposes of the federal securities law.
Despite that, a close look at what the SEC has said in this area reveals worrying misunderstandings of the practical realities on the ground of the digital asset ecosystem.
Is the SEC’s approach grounded in reality?
The U.S. courts use the Howey test to determine if a transaction amounts to an investment contract, and thus count as a security.
The fundamentals of the test itself are clear: it’s a three-pronged test, which at its most basic, is: Is there an investment of money, in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others? If yes, then the transaction is a security.
These questions won’t usually have straightforward answers. But looking closely at the language used throughout the SEC’s commentary on the topic, one can’t help but wonder if there is a gap in their fundamental understanding of digital assets, and in particular, Bitcoin.
For example, in a speech given at Yahoo Finance’s All Markets Summit, Hinman points to the likes of Bitcoin Core and Ethereum as examples of assets which are not captured by the SEC’s definition of securities.
In doing so, he says that “central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers.…this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”
Decentralization is a common thread throughout the SEC’s publications and regulatory decisions on the subject (it comes up again in the “Investment Contract” Analysis Framework).
While the framework is illustrative of the thinking coming from the SEC, it doesn’t hold any legal weight, nor does it represent a significant departure from the agency’s stance, based on prior litigation it has been involved in or statements made to date. But, the framework does break down the Howey test to its individual parts and comments on each:
- There must be an investment of money: typically satisfied in an offer and sale of a digital asset because the asset is purchased or otherwise acquired in exchange for value, whether real in the form of real currency or another digital asset,
- There must be a common enterprise: this will typically be satisfied, and
- There must have been a reasonable expectation of profits reliant on the effort of others: This is usually the contentious issue in any Howey analysis. What is relevant is the ‘economic reality’ of the transaction and ‘what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect.’
As the third test is where most of the discussion of the Howey test in the context of digital asset sales comes from, it is that which the framework mostly deals with. And, it is helpful in that it provides a list of characteristics that might point toward the third prong of the test being satisfied.
In determining the third prong of the test, there must be an analysis over whether there was a reasonable expectation of profits, and; whether those profits are expected to come as a result of the efforts of others. The SEC once again imports the concept decentralisation into this analysis as an indicator that the purchaser is relying on the efforts of others. For example, if there are essential tasks to be performed by an ‘active participant’ as opposed to a decentralized network of users, then this component of the third prong is more likely to be satisfied.
SEC Commissioner Hester Peirce said in February, “To avoid the securities classification…. the network would have to be decentralized, which means it is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control.”
In other words, the protocol upon which the network is built must be set in stone, unable to be changed by developers on the network—and certainly not by a small cabal of developers exerting massive control over the network.
The decentralization myth
It is interesting, then, that the SEC does not consider Bitcoin—the BTC version—as a security. William Hinman also says in his 2018 speech, regarding BTC:
When I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.
Hinman said the same for Ethereum.
That BTC would be held up by the SEC as the kind of network that is decentralized—and as a result is not caught by the Howey test—clearly runs counter to reality. By the SEC’s own definition, a network cannot be said to be decentralised if the protocol on which it is built is subject to change.
BTC is not decentralized. The protocols governing BTC are changing all the time, and they’re being changed by a small, organized number of developers. Far from the truly decentralized network described by the SEC, where the tasks essential to the network are performed by ‘an unaffiliated, dispersed community of network users’, in reality, BTC has less than 20 true nodes—true nodes being those which create blocks on the chain and in doing so, validating the transactions in the blocks created by other nodes. And among the true nodes, those are being controlled by protocol updates pushed by a small cabal of developers.
The original intent of Satoshi indeed was decentralization: the software built upon the network might be centralized, but the protocol governing the network was always supposed to be set in stone, unable to be changed by the developers that might be working with it.
Ultimately, the SEC is working toward a practical approach, and seems to be doing so with entrepreneurship in mind. But the waters are being muddied by the unintended legacy of the original vision for Bitcoin: the BTCs and the Ethereums of the world, which are in reality, out of step with Satoshi’s vision. The SEC has misconceived what is supposed to be meant by decentralization, and unfortunately, a good deal of the SEC’s thinking on the subject is that misconception.
This isn’t to say that the focus on decentralization is necessarily wrong: it’s encouraging the SEC recognizes that bringing decentralized networks (and the promotion and capital raising associated with them) within the ambit of the SEC is unnecessary. But the disconnect between this recognition and how the SEC has applied it in reality shows that would-be entrepreneurs in the U.S. are still a ways away from being able to operate within a robust, sensible regulatory environment in which to sell, build and distribute digital assets.
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