Susan I. Gault-Brown, F. Dario de Martino, Alfredo B. D. Silva, Daniel R. Kahan, Mara Elyse Goodman, and Dylan Kelsey Naughton
Corporate Finance | Capital Markets, Emerging Companies + Venture Capital, Financial Institutions + Financial Services, Financial Technology, Financial Transactions, Investment Management, and Mergers + Acquisitions
On April 3, 2019, the Strategic Hub for Innovation and Financial Technology (“FinHub”) of the U.S. Securities and Exchange Commission (“SEC”) published two pieces of guidance on when a blockchain-enabled digital asset will, or will not, be considered a security.
The first piece of guidance (the “TKJ No-Action Letter”) was a no-action letter issued by the SEC’s Division of Corporation Finance in response to a request from TurnKey Jet, Inc. (“TKJ”), a Florida-based air carrier and air taxi operator. The TKJ No-Action Letter represents the first time that the SEC staff has indicated that it would not recommend enforcement action to the SEC if, in reliance on counsel’s opinion that the digital assets are not securities, the subject entity offers and sells securities without registration under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
The second piece of guidance came in the form of a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that is intended to serve as “an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset.”
U.S. federal securities laws apply to a digital asset if the digital asset is deemed a “security” under these laws. Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange each provide a list of instruments captured by the term. Although the lists have some minor differences, they both include an “investment contract.”
To determine whether an instrument is an “investment contract,” the SEC and U.S. federal courts generally apply the test outlined by the U.S. Supreme Court in SEC v. W.J. Howey Co.—the so–called Howey test. Under the Howey test, an instrument is deemed an “investment contract” if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
The SEC has applied the Howey test to blockchain-enabled digital assets to determine whether such assets are securities, making clear that “[w]hether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction.”
The TKJ No-Action Letter
The TKJ No-Action Letter indicates that, in certain cases, the SEC staff will not recommend enforcement to the SEC if a digital token issuance does not constitute an offering of securities.
As described in TKJ’s letter to the SEC staff requesting no-action relief (the “TKJ Incoming Letter”), TKJ proposes to offer and sell blockchain-based digital tokens in order to facilitate air charter services through a membership platform. TKJ’s platform would enable consumer members of the program to purchase tokens, which could then be used in exchange for air charter services from the air carrier members; broker members would also facilitate such transactions.
In response, the SEC staff states in the TKJ No-Action Letter, that it will not recommend enforcement action to the SEC if, in reliance on the opinion of TKJ’s counsel that the tokens are not securities, TKJ offers and sells the tokens without registration under the Securities Act and the Exchange Act. In reaching this position, the SEC staff particularly noted that:
Consistent with any other no-action response, the SEC staff noted that its position is based on the representations made in the TKJ Incoming Letter, and that any different facts or conditions might require a different conclusion. The SEC staff also noted that the letter represented the Division of Corporation Finance’s position on enforcement action only and does not express any legal conclusion on the question presented.
In the TKJ Incoming Letter, TKJ’s counsel presented an analysis of the TKJ token under the Howey test in support of counsel’s opinion that “the proposed sale of Tokens under the TKJ program will not involve the sale of a ‘security’ within the meaning of Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, and, therefore, that registration under the Securities Acts is not required.” Counsel to TKJ also concluded that the tokens did not constitute an “investment contract,” a “note,” “evidence of indebtedness,” or any other form of security under the Securities Act or Exchange Act.
The TKJ Incoming Letter’s Howey Analysis
Investment of Money
According to the TKJ Incoming Letter, the first prong of the Howey test—i.e., whether or not there is an “investment of money”—is satisfied because the tokens will be sold by TKJ for value ($1 per token).
According to the TKJ Incoming Letter, the second prong—i.e., the existence of a “common enterprise”—is satisfied because TKJ is proposing to offer the tokens to create an ecosystem of air charter services where consumers, brokers and carriers members can collectively use the platform to connect with each other for such services.
Reasonable Expectation of Profits
The TKJ Incoming Letter’s main area of focus is the third prong of the Howey test— i.e., whether a purchaser of tokens has a “reasonable expectation of profits” through the enterprise—is not satisfied. In concluding that TKJ token purchasers could not reasonably expect to make a profit, the TKJ Incoming Letter highlights, among other things, the following:
Reliance on the Efforts of Others
According to the TKJ Incoming Letter, the fourth Howey prong— i.e., “reliance on the efforts of others”—is also not satisfied because purchasers would not be relying on TKJ’s efforts to develop the platform or network and those efforts would not affect the success of the platform. The TKJ Incoming Letter notes, among other things, that:
The TKJ Incoming Letter’s Reves Analysis
Beyond the Howey test, the TKJ Incoming Letter also included counsel’s opinion that, under the family-resemblance standard established in Reves v. Ernst & Young, the TKJ tokens were not securities because, as open-account debt, they bear a strong resemblance to instruments traditionally excluded from the definition of a “security” under the Securities Act and Exchange Act.
Implications of the TKJ No-Action Letter
The TKJ No-Action Letter is historic, in that it represents the first time no-action relief has been granted to a token issuer by the SEC staff. Projects that have used, or are considering using, tokens as part of a new service or platform should carefully consider the applicability of the SEC staff’s guidance.
The SEC’s “Framework for ‘Investment Contract’ Analysis of Digital Assets”
In order to provide more general guidance clarifying which offers and sales of digital assets constitute offers and sales of securities, FinHub published the Framework for analyzing whether a digital asset is an investment contract and whether offers and sales of such assets are transactions to which U.S. federal securities laws apply. The Framework sets forth the four key factors outlined in the Howey test and discusses each one in turn.
The Investment of Money in a Common Enterprise
The Framework very briefly explains that the first two prongs of Howey have typically been met in the offer and sale of blockchain-enabled digital assets because the digital assets have (i) been acquired in exchange for value and (ii) involved a “common enterprise.”
The Framework provides significant guidance relating to the “reasonable expectation of profits derived from efforts of others” prong of the Howey test. The Framework notes that “[a] purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market” and that “[w]hen a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an ‘Active Participant’ or ‘AP’) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.”
The Framework provides several examples where there is likely a reasonable expectation of profits. For example, it states that, while not determinative, the stronger the presence of the following, the more likely there is a reasonable expectation of profits:
The Framework notes that, to assess whether there is a reasonable expectation of profits, federal courts often consider whether an instrument is offered and sold for use or consumption by purchasers. For example, it states that, while not determinative, the stronger the presence of the following, the less likely the Howey test is met:
The Framework notes that there are two key questions with respect to the “reliance on the efforts of others” analysis:
For example, it states that, while not determinative, the stronger the presence of the following, the more likely that a purchaser is relying on the efforts of others:
Implications of the Framework
Although not a “rule, regulation, or statement of the Commission,” the Framework provides useful insight into the SEC staff’s analysis of whether transactions involving blockchain-enabled digital assets are investment contracts within the meaning of U.S. federal securities laws.
Key Takeaways and Conclusion
The TKJ No-Action Letter and the Framework, taken together, provide helpful guidance by the SEC staff to blockchain-enabled digital asset market participants. Although the new guidance reinforces or restates a number of points that have been made by the SEC staff previously, and the facts behind the TKJ No-Action Letter request are uncommon in the digital asset market, the guidance also marks the first time that the SEC staff has provided no-action relief with respect to the offer and sale of a particular token. Going forward, we expect market participants will find this guidance useful as they seek to determine whether particular tokens hew more closely to the facts of TKJ’s token offering, or those of token offerings that are characterized as investment contracts.
 TurnKey Jet, Inc., SEC No-Action Letter (Apr. 3, 2019), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.html.
 TurnKey Jet, Inc., SEC No-Action Letter (Apr. 2, 2019), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf.
 SEC’s Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), available at https://www.sec.gov/files/dlt-framework.pdf.
 Director of Division of Corporate Finance William Hinman and Senior Advisor for Digital Assets and Innovation Valerie Szczepanik, SEC Public Statement (Apr. 3, 2019), available at https://www.sec.gov/news/public-statement/statement-framework-investment-contract-analysis-digital-assets.
 328 U.S. 293 (1946).
 See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017) (the “DAO Report”), available at https://www.sec.gov/litigation/investreport/34-81207.pdf
 TKJ No-Action Letter.
 494 U.S. 56 (1990).
 TKJ Incoming Letter at 12-13.
 Framework at 2.
 Framework at 2.
 Framework at 2-3.
 Framework at 6-7.
 Framework at 8.
 Framework at 3.
 Framework at 4.
 Framework at 11 n.1.
 See, e.g., DAO Report; Munchee, Inc., Securities Act Rel. No. 10445 (Dec. 11, 2017) (settled order); Paragon Coin, Inc., Securities Act Rel. No. 10574 (Nov. 16, 2018); Carriereq, Inc., d/b/a Airfox, Securities Act Rel. No. 10575 (Nov. 16, 2018).
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