Is The Latest SEC Guidance A Green Light For Blockchain Utility Tokens
Probably it's because blockchain technology accurately changes the asset-transaction system human society is using, it's the only technology that excerpts double pressure on innovators ever since it's out ---- not only are innovators forced to constantly challenge themselves to keep their competitive advantages, they also need to pay close attention to legal compliance environment all over the world, especially in the US, to avoid unnecessary troubles.
Therefore, the Framework for Investment Contract Analysis of Digital Assets and the first No-Action-Letter issued to a business traveling startup, both published by SEC, are thrilling to the industry and might have a larger long-term impact.
One of the most significant takeaways from the document was that the SEC has confirmed that not all ICOs represent actual “securities” as defined by the SEC.
Last week, the US Securities and Exchange Commission (SEC) issued the "Digital Asset Investment Contract Analysis Framework" (Framework) giving token issuers and cryptocurrency related businesses new regulatory clarity if they want to operate in the United States including rules governing tokens and what elements will be required to validate if a token qualifies as a security.
Although the SEC states that this framework represents the views of the Strategic Hub for Innovation and Financial Technology (“FinHub,” the “Staff,” or “we”) of the SEC. It is not a rule, regulation, or statement of SEC and this framework does not replace or supersede existing case law, legal requirements, or statements or guidance from the SEC. However, with the release of the Framework represents a starting framework based on the SEC’s own investigative report on Decentralized Autonomous Organization (DAO) issue in July 2017. With this release, blockchain startups now have more clarity on how to assess whether the digital assets they issue and sell are considered “securities”. Over the last few years, many tokenized businesses have worked to obtain clarity on the rules as unlike utility tokens, securities are subject to specific US federal securities laws that in turn create significant costs to the issuers.
In a nutshell, the Framework applies the “Howey Test” to verify if digital assets are securities (ie, using blockchain technology to issue transfers, including but not limited to “virtual currency”, “coins” or “tokens”). Qualitative analysis of assets such as “tokens”, describes the different considerations for determining when a digital asset may constitute an "investment contract" under federal securities laws based on the actions of promoters, sponsors, or other parties (referred to as "Active Participants" or "APs").
The Howey Test came out of the 1946 Supreme Court case SEC v. W.J. Howey Co., which laid out a three-prong test 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 1) invests his money in 2) a common enterprise and 3) is led to expect profits solely from the efforts of the promoter or a third party.”
The latest guidance issued by the SEC is not indulged in analyzing the first and second factors of “invest personal money in a common enterprise” in the “Howey Test” as the fait accompli of the digital asset offering but focus primarily on whether there is a "reliance on the efforts of others" and a "reasonable expectation of profits."
Factors in determining whether a purchaser is relying on the efforts of others include, for example, whether:
- There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a "decentralized" network).
- An AP creates or supports a market for, or the price of, the digital asset. This can include, for example, an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, "burning," or other activities.
- An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset.
The following factors contribute to whether there is a "reasonable expectation of profits":
- The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
- The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network.
- The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. For example, it is offered and purchased in quantities significantly greater than any likely user would reasonably need, or so small as to make actual use of the asset in the network impractical.
If the above comparisons result in more positive results, the greater the likelihood that the digital asset should be considered to be a security. However, the Framework also allows for some flexibility by citing a number of considerations that where the digital asset may no longer be considered a security or virtual currency. The considerations are:
- The distributed ledger network and digital asset are fully developed and operational.
- Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.
- With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency.
- If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.
Although there are blockchain legal experts pointing out that there are still many vague generalities in the Framework, for example, the AP definition is too broad - the founder, core team, core developer, miner, supernode delegates, etc. may all be APs. If the network or digital assets are determined to be securities, innovation in the blockchain space may be greatly reduced. To increase visibility and awareness for our users and partners, ArcBlock joined the world's largest blockchain industry association, the American Digital Chamber of Commerce to stay current and up to date on the latest progress of the SEC.
With the release of the SEC’s Framework and Turnkey Jet No-Action Letter, the crypto industry feels that the two publications may have opened the way for application-based innovation for the first time since the creation of the ICO.
TurnKey Jet, an interstate air charter services company in the United States is planning to issue digital tokens to their customers in an effort to make it easier and more efficient to purchase and use the charter services they provide. The SEC stated that it will not recommend enforcement action to the Commission based on the program described by TurnKey Jet because:
- funds from digital token sales will not be used to develop its blockchain platform, network, or app; tokens will be immediately useable upon purchase;
- the tokens will only be tradeable in the TKJ wallet and not wallets external to the platform;
- the price of tokens will be maintained at $1 USD and can only be resold to TurnKey Jet at a discount to their face value;
- the marketing promotion focuses on the functionality of the token over its potential increase in market value.
I think that although the content of the terms listed in the No-Action Letter seems to be more restrictive than the one proposed in the Framework, it is actually quite positive for the blockchain industry overall especially around the use of decentralized applications (DApps). While the SEC's latest guidelines and No-Action Letter did not let the ICO go, the funds raised through the issuance of digital assets are still subject to high standards of US federal securities laws, it provides a reference “decentralized app” implementation that others can now follow including guidelines to help companies implement appropriate governance controls and how to ensure that their assets are easily classified as a security or utility token.
While we cannot provide clarity on why TurnKey Jet decided to use blockchain technologies to develop its customer loyalty program, ArcBlock, which focuses on the DApps development and deployment platform, is able to easily support DApps compliance using the unique design of “interconnected blockchains” to easily build the necessary components needed to be compliant with the SECs requirements. With this ArcBlock’s customers quickly gain several strategic advantages:
- Components used in the ArcBlock development platform can be reused, allowing DApps to meet easily meet the "ready-to-use" requirements immediately;
- ArcBlock's Decentralized ID (DID) implementation runs through the entire application, and using the ABT wallet's decentralized design, developers are able to easily meet the SEC requirements. ;
- Using the Proof of Stake (pledging) mechanism implemented inside the ArcBlock platform ensures that applications cannot deceive users.
While public blockchains were all the rage last year, we are now moving into a new era of blockchain platforms that are focused on real use cases and solving real-world problems versus just providing a generalized platform to build a smart contract or one that is driven by a consultant. With the introduction of the latest US SEC guidelines, we have more legal clarity on what we can and cannot do. For developers and entrepreneurs working to the next generation of internet services, this can only be seen as good news.