On Thursday, June 14, 2018, the U.S. Securities and Exchange Commission’s (SEC) Director of Corporate Finance, William Hinman (Hinman), announced that the commission would not be treating Ether or Bitcoin as securities. The SEC’s announcement is in line with the recent comments of SEC Chairman, Jay Clayton, who recently noted the difference between cryptocurrencies and digital tokens, saying that cryptocurrencies as “replacements for sovereign currencies” were not securities, while digital assets revolving around a venture are often securities.
The SEC’s announcement was delivered via a speech by Hinman at Yahoo Finance’s All Market Summit: Crypto (a transcript of which can be found here), where Hinman spoke in depth about how securities laws apply to digital assets. His comments focused on how the entire economic reality of any given digital asset must be considered. In making this point, Hinman likened utility tokens to the oranges being grown on the parcels of land at issue in Howey1, the landmark U.S. securities case, stating “the token...all by itself is not a security, just as the orange groves in Howey were not.” Hinman then went on to note that Howey was selling an investment in orange groves with the expectation of return, not just oranges. Hinman’s point with respect to digital assets was that many tokens, no matter their utility, are being purchased with an expectation of profit derived from the efforts of others.
A significant take-away from Hinman’s statement regarding the analysis of a digital asset is that “the analysis of whether something is a security is not static and does not strictly inhere to the instrument,” meaning that a digital asset that is originally sold as a security in the eyes of the SEC could be sold in a manner that does not constitute a security in a future offering. In connection with the SEC’s previously issued report on the DAO, a digital asset is considered as a security “where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise.” However, if that same digital asset progresses to a point where there is sufficient decentralization of the network or where the asset is only sold “to be used to purchase a good or service available through the network on which it was created,” that digital asset that was once considered to be a security could be viewed in a significantly different light.
Following this more general discussion, Hinman focused on the SEC’s analysis of Ether, the utility token used on the Ethereum network, stating that despite the fundraising that was associated with the initial launch of Ether, “current offers and sales of Ether are not securities transactions.” Hinman’s rationale was based in large part on the decentralized nature of the Ethereum network, which influences the economic reality around the tokens. He explained that if a cryptocurrency is decentralized enough it creates a situation “where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” Expounding upon this analysis, Hinman noted that the disclosure regime of securities regulation as currently contemplated, if imposed upon decentralized networks, would not provide any protection to investors. As part of his analysis, Hinman provided a non-exhaustive list of questions to consider when analyzing the extent to which a digital asset is decentralized:
While the decentralized nature of a digital asset will be a topic of emphasis for the SEC moving forward, Hinman provided a secondary, non-exhaustive, list of questions to consider regarding the structure and purpose of the digital asset – making specific note that the factors below do not necessarily need “to be present to establish a case that a token is not being offered as a security”:
While Hinman’s announcement represents a significant development in the effort to establish a framework to characterize digital assets, it also raises many questions. How much decentralization is sufficient to make a token not a security? How will decentralization be measured? Will it be measured by how distributed token ownership is? Or the distribution of hashrate for proof-of-work networks? Or control of the network’s code? Will the distribution of nodes be a factor?
These questions and more will start to be answered on a case by case basis as the SEC and other regulators analyze the various economic realities of digital assets moving forward.
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1 SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
2 Speech by William Hinman, “Digital Asset Transactions: When Howey Met Gary (Plastic)”, June 14, 2018.