On June 14, 2018, the Securities and Exchanges Commission (“SEC”) marked a paradigm shift in the way that cryptocurrencies, protocol tokens, and other block-chain based digital assets (“Crypto Assets”) are being described or categorized in the securities regulatory environment. While giving a speech at the Yahoo All Markets Summit: Crypto Conference in San Francisco, the SEC’s Director of Corp. Fin. William Hinman confirmed that it is possible for a Crypto Asset that was originally offered in a securities offering to be later sold in a manner that would not constitute an offering of a security (referred to herein as the “Hinman Guidance”).1  Although many in the crypto community hoped for such a distinction, until now, the SEC has not publicly acknowledged that a Crypto Asset can reach a certain level threshold of decentralization to fall outside the category of a “security” and thus outside of the regulatory purview of U.S. securities laws.
The SEC took the crypto community by further surprise when Hinman explicitly stated that Ether, the world’s second largest cryptocurrency, is not a security. This admission was even more surprising, and welcomed, as Ether has been under high regulatory scrutiny, primarily due to Ether’s (ERC 20 protocol) heightened popularity as a funding vehicle for crypto-startups.
In the view of Locke Lord LLP’s FinTech Industry Group, the Hinman Guidance is the most meaningful guidance from the SEC to date on cryptocurrency and block-chain related assets and perhaps the most robust analysis that we have seen on the tokenization of cryptoassets in the context of U.S. securities laws.

Given the unprecedented nature of the Hinman Guidance, we thought it would be prudent to provide some commentary and context, which shall be structured as follows: (i) an overview of the Hinman Guidance; (ii) a brief overview of federal securities law; and (iii) context on the classification of “initial coin offerings” (“ICOs”) and Simple Agreement for Future Tokens (“SAFT”).

I. Overview of the Hinman Guidance.

Hinman first explained his outlook of what he “often” sees in ICOs: promoters raising funds from investors in order to build the network on which the coin will be operating. In turn, investors will generate returns by selling their coins on the secondary market once the value has increased. Under this model, according to Hinman, “the economic substance is the same as a conventional securities offering,” because the purchaser is dependent on the coin’s promoter(s)2  to build out the technology and make the enterprise successful. “At that stage,” Hinman continued, “the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”

Hinman stated in cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the Crypto Asset is likely to be deemed a security The SEC is clear that “calling the transaction an initial coin offering, or ‘ICO,’ or a sale of a ‘token,’ will not take it out of the purview of the U.S. securities laws.” Hinman’s commentary hones in on the central aspects of securities regulation outlined in the Howey Test (discussed in greater detail below) and reaffirms what securities experts have long contemplated: simply classifying a units/share of equity in an enterprise as a “token” is not going to exclude the issuer from purview of U.S. securities laws.

Although opening with a “bright-line standard” with respect to rights that give “the holder a financial interest in an enterprise,” Hinman added the following qualification: “but what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified ‘yes.’” What is exciting about this commentary is that Hinman is potentially opening the door for an entirely new asset class (i.e. Crypto Assets) that falls outside governance of the U.S. securities laws.3

Hinman went on to provide some detailed commentary of Crypto Assets in the context of the Supreme Court’s investment contract test first announced in SEC v. Howey4  (the “Howey Test”). What we found particularly useful was Hinman provided some factors in determining if a Crypto Asset is classified as a Crypto Security or Unregulated Crypto Asset, which ties to considering “whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.” The first set of factors (“Promoter Factors”) is intended in analyzing the role of the third party and if such Crypto Asset ties back to a common enterprise. In addition, Hinman added factors to determine if the relevant Crypto Asset behaves more like a “consumer item” vs. a security (“Utility Factors”).

Promoter Factors

  1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  4. Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Utility Factors

  1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
  2. Are independent actors setting the price or is the promoter supporting the secondary market for asset or otherwise influencing trading?
  3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, opposed to their investment, intent? Are the tokens available in increments that correlate with consumptive versus investment intent?
  4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held and transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in that compel using the tokens promptly on the network, such as having the tokens degrade in value time, or can the tokens be held for extended periods for investment?
  5. Is the asset marketed and distributed to potential users or the general public?

Both the Promotor Factors and the Utility Factors are highly fact-specific. Thus, it is important to confer with counsel at the onset of the system’s design, so that startup founders can ensure that they have a comprehensive strategy in place for U.S. security compliance.

II. Overview of Traditional U.S. Securities Law in the context of Crypo Assets:

Before any prospective startup initiates its proposed coin sale, it should consider whether the prospective Crypto Asset is subject to federal securities law. If the proposed Crypto Asset is subject to federal securities law, then the Company must comply with the SEC’s rules and regulations in order to conduct a legal coin sale. The prospective Crypto Asset will only be subject to federal securities law if the SEC deems them to be a “security.”

The SEC and federal courts use the Howey test to determine whether any Crypto Asset is security. If any prospective Crypto Asset satisfies all three elements of the Howey test, then the prospective Crypto Asset will be deemed to be a security. The three elements of the Howey test are:

  1. An investment of money
  2. in a common enterprise
  3. with an expectation of profits predominantly from the efforts of others.

Any prospective issuer of a Crypto Asset should discuss the these factors in great detail with counsel and ensure that any Crypto Asset offering is in compliance with U.S. securities laws.

III. Where does this leave ICOs, SAFTs, and how should U.S. startups proceed?

As discussed above, there is no bright-line test to determine if a proposed ICO falls within the purview of U.S. securities laws. Thus, in the abundance of caution, it is advisable that any startup considering conducting an ICO consult with counsel. In general, we believe that any funds initially raised should (at least initially) be in the form of a “private placement” limited to accredited investors relying on the exemption set forth in Rule 506(c) of Regulation D of the Securities Act.5  The next step of bringing such investors over to a protocol token (as applicable) should be done in the abundance of caution. An early and popular model for capturing investment to develop protocol and launch an ICO was the SAFT framework developed by Protocol Labs.6 

The SAFT framework (at least in its current form) is ultimately flawed in the context of the Promoter Factors and Utility Factors (collectively the “Hinman Factors”). There are several ways that the SAFT framework can be problematic for any ICO or network launch. Depending on the amount of money raised, token distribution, and token pricing (as applicable) and the number of token issued upon the “Network Launch” (as defined in the SAFT), the SAFT framework increases the likelihood of pushing a Crypto Asset that may otherwise be an Unregulated Crypto Asset toward being labeled as a Crypto Security.

The SAFT framework could offer a disproportionate amount of rights to the company and SAFT holders upon the ultimate issuance of the token (effectively the promotors for the purposes analyzing the Promoter Factors) and not enough rights to users participating in the system (at the eventual ICO or token distribution). Indeed, prior to the network being launched, the prospective company issuing the SAFT (and its related investors) will own an undetermined percentage of network tokens and the dominance of the issuing company and related SAFT holders is unclear from the moment that the SAFT is issued and quite possibly when the network is launched.

Moreover, although Hinman did not explicitly refute the concept of the SAFT, any investors who acquire any tokens via the SAFT framework will find that their only source of return on investment is going to be in relation to tokens received from the “Network Launch” (as defined in the SAFT).
Thus, the SAFT increases the likelihood that any issued tokens will be primarily held for investment purposes, if a significant amount of token holders are indeed the SAFT holders. That is, if a majority of token holders are investors from a SAFT instrument, then the token probably does not qualify as a utility token.

In sum, the ultimate flaw of the SAFT is that there is no assurances that prospective investors and/or issuing company will not have too much control and influence; pushing the Crypto Asset over threshold of being “Crypto Security,” because the issuing company and investors could have too much control over governance and protocol.

In the end, however, this ultimately boils down to disclosure. This is not to say that the SAFT model is completely without merit and cannot be restructured. Indeed, the SAFT framework still has elements that are worth retaining, assuming there are additional restrictions and disclosures put in place to prospective investors, and an alternative vehicle exists to apply investments proceeds toward. In the interim, however, startups and investors should be wary of using SAFTs and conducting an ICO. Lastly, if you are a startup founder, and have previously issued SAFTs, consult counsel so you can ensure that the SAFT will not place the startup in violation of U.S. securities laws.

1 Hinman, W. (2018). Remarks at the Yahoo Finance All Markets Summit. 
2 In practice, this is likely the company issuing the token or early investors, or agents of the same.
3 For purposes of discussion, we would like to refer to those tokens Crypto Assets under the purview of U.S. securities laws as “Crypto Securities” and those outside of the purview of U.S. securities laws as “Unregulated Crypto Assets.”  Moreover, please note that there are several other considerations that go into regulating Crypto Assets, so “unregulated” (for the purposes of this article) simply means unregulated with respect to U.S. securities laws.
4 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
5 Please note that other exemptions may be available depending upon the investors, promotional  techniques, etc.
6 Although theoretically a project may be able to issue a “utility token” immediately from the start (and assuming they satisfy the Heiman Factors), such “utility token” may be an Unregulated Crypto Asset, it is our experience that most projects are conducting ICOs in order to fund development of their platform. Thus, this commentary is in the context of a yet to be developed platform.