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Client Alert

April 11, 2019

How Far We Haven’t Come: SEC Resistance to Blockchain Securities Continues?


While SEC FinHub’s new framework announced last week for identifying crypto-securities suggests continued resistance for those using digital assets to access capital markets, an SEC no-action letter issued the same day to TurnKey Jet—concluding that tokens operating as digitized gift certificates are not securities—suggests a path forward for issuing tokens with a clear purpose other than raising funds, providing an opportunity in areas aside from capital markets, such as tokenized event tickets.

On April 3, 2019, the Securities and Exchange Commission’s Strategic Hub for Innovation and Financial Technology (FinHub) published a long-awaited framework for determining whether a digital asset offered and sold through an Initial Coin Offering (ICO) or Security Token Offering (STO) is a security.  The FinHub framework focuses on the Supreme Court’s Howey test for identifying investment contracts.[i]  Under Howey, courts have determined that there is an investment contract, and consequently a security, where there is an investment of money, in a common enterprise, with an expectation of profits from the efforts of others.  Any digital assets that meet Howey’s test for a security would need to be registered with the Commission unless an exemption applies.  The new framework focuses on Howey’s third factor: determining whether purchasers of a digital asset have a reasonable expectation of profits derived from the efforts of others.

On the same day as the announcement of FinHub’s framework, and applying some of the same guidance, the SEC’s Division of Corporation Finance (Corp Fin) issued a no-action letter to TurnKey Jet, Inc.  TurnKey, who provides charter flights on private jets,[ii] had proposed a plan to offer and sell digital tokens that could be used to book flights.  This was the first time Corp Fin issued a no-action letter addressing a blockchain tokenized project.  In the letter, on the basis of facts supporting the determination that the digital assets are not securities, Corp Fin opined that it would not recommend an enforcement action to the SEC if TurnKey offers and sells the tokens without registration under the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended.

The new FinHub framework and TurnKey’s no-action letter are notable developments, but lack clarity for the majority of the digital asset community.  In fact, there is no reason to expect that the new guidance will change the stranded fortunes of all the ICO and STO promoters trying to make crypto-securities a reality.  Together, however, the TurnKey letter and the new framework offer a hopeful glimpse of how the SEC’s Crypto Czar, Valerie Szczepanik, plans to influence policy going forward.

Notably, the push to deploy distributed ledger, or blockchain, technology to access U.S. capital markets has largely stalled: Regulation A+, which allows for crowdfunding, has yet to provide capital access for any blockchain-issued securities; Regulation D has provided some access to primarily accredited investors in private placements, but retail capital markets tend to remain out-of-bounds; and Regulation S, which covers the issuance of foreign securities, has seen more robust activity but excludes domestic markets by definition.  In sum, the Commission has policed U.S. capital markets aggressively to make clear that an exciting new technology does not avoid application of the securities laws, or their registration and disclosure requirements.[iii]

But blockchain enthusiasts should not be discouraged.  Instead, they should consider looking past capital markets and focus on applying blockchain technology to markets and payment schemes not falling under the securities laws.  For example, Corp Fin’s no-action letter to TurnKey suggests tokenization opportunities may be available for other instruments previously determined to fall outside the definition of a security—one example is tickets for concerts and sporting events.

FinHub’s New Digital Asset Framework—Continued Reliance on Howey

FinHub’s new framework was created to help market participants assess whether a digital asset is an investment contract, and if it falls within the definition of a security under the U.S. Federal securities laws.  The guidance explains that most digital asset sales reviewed by the Commission’s staff satisfy the Howey test’s first two prongs: (1) an investment of money;[iv] (2) in a common enterprise.[v]  The new framework is heavily focused on the Howey test’s third prong, “a reasonable expectation of profits derived from efforts of others.”  Traditionally, an asset purchaser has an expectation of profits if a stock pays dividends, a bond promises interest payments, or if the purchaser reasonably expects the asset to appreciate in value.[vi]  The Supreme Court has distinguished assets that are purchased with an expectation of profit from those where the purchaser intends to “use or consume the item purchased… .”[vii]  Even if there is an expectation of profit, the Howey test only includes circumstances where those profits come from the efforts of others, not solely from impersonal market forces or from the investor’s own efforts.[viii]  The “efforts” element is satisfied if the promoter retains a critical role, a role without which the enterprise cannot succeed.[ix]

FinHub’s framework provides important new information on two fronts.  First, the framework confirms the prior comments of Corp Fin Director Bill Hinman in acknowledging that a digital asset could be a security when it is first issued but may subsequently cease to be a security later in time, requiring reevaluation.[x]  For example, over time a digital asset’s value may no longer depend upon the efforts of the initial promotor or issuer.[xi]

Second, the framework provides guidance on how digital asset creators can avoid creating an expectation of profit by restricting marketability, transferability, and redemption rights.[xii]  For example, digital asset creators can preclude trading on secondary platforms and maintain tight control over user access to the primary platform, or prevent risk of market speculation by offering an unlimited quantity of the asset for sale at a flat price.

TurnKey Jet’s No-Action Letter—Gift Certificates are Not Securities

TurnKey operates two private business jets and provides air taxi and charter services.[xiii]  Because of the substantial expense associated with private jet charters, TurnKey found that some clients struggled with bankers’ hours—after five o’clock it was difficult for customers to transfer sufficient funds for last-minute bookings.  Seeing virtual currency as a potential solution, TurnKey proposed to Corp Fin that the company would sell tokens to customers that could be redeemed when booking a flight.  Each token would sell for $1, with no restrictions on purchasers or timing of purchases, which would prevent the value of the tokens from ever rising above $1.  The proceeds from token sales would be held in escrow and accessed only when tokens were redeemed for air travel services—the proceeds would not be used to develop TurnKey’s platform or for any other investment purpose.  In TurnKey’s proposal, its platform would extend broadly to air charter brokers and other carriers, so any private flight broker or charter operator willing to accept TurnKey’s tokens from customers could then redeem the tokens with TurnKey and receive funds from the escrow account holding the token sale proceeds.

TurnKey’s success in obtaining the no-action letter did not come overnight—the company reportedly worked with the SEC for eleven months, submitting multiple new versions of its proposal.[xiv]  Likely, those negotiations focused on characteristics of TurnKey’s program designed to prevent the tokens from being used for anything but private air travel.[xv]  In essence, TurnKey plans to offer digitized gift certificates for air charter services.  Although TurnKey has avoided registration under the securities laws, TurnKey emphasized in its letter to Corp Fin that it must still comply with stringent regulations as a member of the private charter industry, including anti-money laundering regulations.[xvi]

The SEC’s no-action letter focused on six key factors: (1) TurnKey’s platform will be built in advance, not developed using the proceeds from token sales; (2) tokens can be used as intended at the time of sale; (3) tokens will not be transferrable except to other TurnKey wallets; (4) TurnKey’s measures to ensure the tokens never climb above $1 in value; (5) TurnKey will not repurchase tokens except at a discount to the $1 face value; and (6) TurnKey will limit its marketing of tokens, emphasizing their functionality, with no suggestion that the tokens could increase in value.

Because of TurnKey’s extensive restrictions to prevent speculation or alternative use of the tokens, the no-action letter was not a difficult decision for Corp Fin.  Previously, the SEC has issued no-action letters for comparable proposals, including prepaid school tuition certificates and prepaid funeral services.[xvii]  As early as 1958, the SEC issued an opinion that although an item like one of TurnKey’s tokens might appear to be an “evidence of indebtedness,” like “streetcar tokens, meal tickets, Christmas gift certificates, box tops, railroad or theatre tickets… Congress did not intend to include such items within the scope of the statute.”[xviii]  It is clear that the Commission required TurnKey to have controls in place to make sure that its tokens were not too easily transferrable: if gift certificates are not securities, then digital gift certificates are not securities either. [xix]

Alternative Paths to Issuance Have Had Limited Impact

Even with FinHub’s new framework, in most cases, companies issuing digital assets to raise funds are unlikely to avoid the registration and disclosure obligations of the securities laws.  Prior to this new guidance, many companies accepted that digital assets are securities, and have worked creatively within the securities laws to find alternative paths to access capital markets, including Regulations A+, D, and S.  However, the results have been underwhelming, as no digital assets have been offered or sold by an issuer under Reg A+, and Reg D does not offer access to retail capital markets.  Moreover, Reg S is not a practical option for U.S.-based companies because the rule only covers securities transactions made to persons outside of the United States.

Regulation A+

Reg A+, a 2015 update to Reg A, was designed to offer issuers seeking smaller amounts of capital (less than $50 million) an easier path to access the U.S. retail market, when compared with the typical burden and expense of registering with the Commission.  Under Reg A+, new issuers must file an offering statement with the Commission.  Until SEC staff review and qualify the offering statement, the issuer cannot sell securities, though preliminary discussions with potential investors are permitted.  Secondary trading of Reg A+ securities is permitted, but generally the markets for these securities are thin.[xx]

Many companies have sought qualification for blockchain-based securities, but thus far, none have been successful.  For example, StartEngine, a crowdfunding platform, came close to issuing blockchain-based securities under Reg A+.  Its offering, qualified by the Commission staff, states that the company is working to develop and issue digital assets alongside traditional securities.[xxi]  The offering, however, is a scaled-back version of the original proposal, before Commission staff provided feedback, which stated that the securities offered would be issued “in the form of electronic tokens.”[xxii]  StartEngine is still required to use a traditional transfer agent, rather than having sales of securities recorded on a blockchain ledger.[xxiii]  Although StartEngine’s offering was finally qualified by the Commission to start selling securities, for many blockchain securities advocates this appears to be a pyrrhic victory.

Regulation D

In the U.S., Reg D is the most popular exemption for issuers of digital assets, but the investor pool is largely restricted to accredited investors.[xxiv]  Different subsections of Reg D provide issuers with different options—for example, under Rule 506(b), an issuer may sell to an unlimited number of accredited investors and up to 35 sophisticated but non-accredited investors, but the issuer cannot use general solicitation or advertising.[xxv]  Under Rule 506(c), an issuer can solicit and advertise generally, but all investors must be accredited.[xxvi]  Further, Reg D securities have restrictions on transfer after issuance.  Despite these restrictions, Reg D remains the most popular avenue for digital asset issuers targeting U.S. capital markets.

Regulation S

Reg S covers securities issued outside the U.S., including sales of digital assets.  To rely on Reg S, the offer or sale must be made as part of an “offshore transaction”—a transaction where offers are not made to a “person in the United States”—and there must be no “directed selling efforts” in the U.S.[xxvii]  The actual purchase must occur offshore as well—either the buyer is “outside the United States, or the seller and any person acting on its behalf reasonably believe that the buyer is outside the United States,” or the transaction is executed on an “established foreign securities exchange.”[xxviii]  Issuers of digital assets relying on Reg S must take reasonable care to identify purchasers to avoid selling to U.S. persons.  Secondary sales are generally unrestricted, except for equity securities of domestic issuers.[xxix]  Thus, while Reg S issuance may be practical for non-U.S. companies, it will not be a viable option for U.S.-based crypto companies.

The TurnKey No-Action Letter Provides an Opportunity for Policy Advancement in New Areas Aside from Capital Markets

The TurnKey no-action letter provides an interesting reveal of how Valerie Szczepanik, SEC’s Crypto Czar, may intend to influence policy in her role within Corp Fin.  Szczepanik started within the Commission’s Enforcement Division and oversaw some of the first-ever crypto enforcement cases.  The Commission’s decision to place Szczepanik’s position under Corp Fin, rather than Enforcement, suggested a forward-looking, policy-making approach with more opportunities for dialogue with digital asset companies.  TurnKey’s no-action letter is a positive example that the Commission is committed to working together with companies to advance policy and increase regulatory certainty.

The letter is also an opportunity for other companies or policy advocates to influence the SEC on digital asset regulation.  Instead of trying to establish new policy foundations, advocates should consider looking to prior guidance from the Commission that identifies other assets that are excluded from the definition of securities.  If TurnKey’s position can be summarized as, ‘gift certificates are not securities, and therefore digital gift certificates are not either,’ then comparable policy opportunities likely exist as well.

One such example is tokenized event tickets.  The U.S. retail market for event tickets, including sporting events, concerts, and movies, is worth more than $28 billion per year, increasing annually by 7% or more.[xxx]  Transaction costs are high with fees to brokers averaging approximately 30%.[xxxi]  With margins so high, it is no surprise that start-ups have identified the opportunity for blockchain technology to increase ticketing security and automation, while still lowering costs.[xxxii]  Beyond event tickets, the possibility of putting season ticket licenses for professional sports teams on the blockchain also appears within reach.

The Commission already has a long-standing opinion that “theatre tickets” do not fall under the definition of a security.[xxxiii]  Further, Corp Fin issued a 2003 no-action letter to Ticket Reserve, Inc. confirming that sports tickets and other event tickets were not securities.[xxxiv]  Ticket Reserve’s proposal went beyond just direct, retail ticket sales—it included a marketplace where tickets could be bought and sold, including by persons trying to resell tickets for profit.[xxxv]  In 2006, the owners of the San Francisco Giants baseball team received a no-action letter from Corp Fin confirming that seat licenses which entitle the holder to purchase season tickets were not securities either, at least as sold and transferred within the Giants program.[xxxvi] 

Based on such precedent, any blockchain event ticket company would be well-positioned to approach Corp Fin seeking a no-action letter for digital event tickets and a blockchain-based market for buying and selling tickets.  Notwithstanding these prior decisions, which make clear that event tickets are not securities, how a platform to buy and sell tickets is structured, and how that platform is marketed, could risk scrutiny from Commission staff.  The platform should be designed and marketed with the clear intent to facilitate ticket sales to retail consumers that want to use the tickets.  It should not be designed or marketed as a way to buy, sell, and speculate on event tickets with the hopes of making a profit.  As with the TurnKey proposal, marketing materials should be focused on consumers that will use the tickets to attend events.  Partial restrictions on ticket transfer may be helpful as well to reduce the risk of price speculation.  Just as TurnKey noted that it was still subject to substantial regulation and oversight, any other company that obtains no-action relief from Corp Fin will still be covered by other substantive laws and regulations.

Conclusion

FinHub’s new framework for determining which digital assets are securities and Corp Fin’s no-action letter to TurnKey are noteworthy developments, but they do not necessarily signal dramatic changes in the path forward for blockchain companies seeking to access U.S. capital markets.  But companies like TurnKey, who are using blockchain for goals other than fundraising, may have a new template for ensuring their activities do not inadvertently implicate the securities laws.

 

[i] Securities and Exchange Commission, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

[ii] TurnKey Jet, Inc., SEC No-Action Letter (Apr. 3, 2019).

[iii] In this sense, Chairman Clayton has delivered on his warning that the Commission would not relax application or enforcement of the securities laws for blockchain companies.  While some have argued for cutting red tape to allow nascent blockchain technologies to advance, Chairman Clayton’s position has been that technological progress is best aided through fair disclosure, investor protection, and market integrity.  SEC Chairman Jay Clayton and CFTC Chairman Christopher Giancarlo, Regulators Are Looking at Cryptocurrency, Wall St. J., Jan. 24, 2018, https://www.wsj.com/articles/regulators-are-looking-at-cryptocurrency-1516836363.

[iv] Courts have found investments of money based on almost any valuable exchange, whether something is sold for fiat currency, for virtual currency, SEC v. Shavers, No. 4:13-CV-416, 2013 WL 4028182, at *2 (E.D. Tex. Aug. 6, 2013), or in exchange for something else of value, Int'l Bhd. of Teamsters, Chauffeurs, Warehousemen & Helpers of Am. v. Daniel, 439 U.S. 551, 560 n. 12 (1979); Thomas Lee Hazen, the Law of Securities Regulation § 1.6(2)(A) (7th ed. 2016).

[v] “Common enterprise” may be shown based on close common interest among a group of investors, termed horizontal commonality, or close common interest between an investor and the promoter, termed vertical commonality.  S.E.C. v. SG Ltd., 265 F.3d 42, 49 (1st Cir. 2001) (explaining both horizontal and vertical commonality and noting vertical commonality theory accepted in some, but not all circuits).

[vi] United Hous. Found., Inc. v. Forman, 421 U.S. 837 (1975) (dividends and appreciation in value); S.E.C. v. Edwards, 540 U.S. 389, 396 (2004) (identifying regular periodic payments and stating that the Courts examples are not exclusive).

[vii] United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975).

[viii] S.E.C. v. W.J. Howey Co., 328 U.S. 293, 299 (1946); Sec. & Exch. Comm'n v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973), cert. denied, 414 U.S. 821 (1973); Stewart v. Ragland, 934 F.2d 1033, 1038 (9th Cir. 1991) (finding “efforts of others” element could not be satisfied where partners in oil-and-gas scheme had ample business expertise and substantial legal rights to control the enterprise).

[ix] Affco Investments 2001, L.L.C. v. Proskauer Rose, L.L.P., 625 F.3d 185, 190 (5th Cir. 2010) (“[T]he proper standard for analyzing the third prong of the Howey test is whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”) (quotation marks omitted); S.E.C. v. Goldfield Deep Mines Co. of Nevada, 758 F.2d 459, 464 (9th Cir. 1985) (finding satisfaction of the “efforts of others” element where investors in an ore refinement program were dependent upon promoter for refinement because of high barrier to using independent contractor for refinement); S.E.C. v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 (5th Cir. 1974) (“[T]he critical inquiry is whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”) (quotation marks omitted).

[x] Director William Hinman, SEC Division of Corporate Finance, Digital Asset Transactions: When Howey met Gary (Plastic), (Jun. 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.

[xi] Securities and Exchange Commission, Framework for “Investment Contract” Analysis of Digital Assets, at 5 (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

[xii] Id. at 6-7.

[xiii] James P. Curry, Letter to Securities and Exchange Commission regarding “TurnKey Jet, Inc” (Apr. 2, 2019), https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf.

[xiv] Brady Dale, SEC’s First Crypto ‘No-Action’ Letter Took 11 Months to Secure, CoinDesk (Apr. 3, 2019), https://www.coindesk.com/secs-first-crypto-no-action-letter-took-11-months-to-secure.

[xv] For example, making the tokens freely available for purchase for $1 should prevent speculation and any risk that token prices would ever rise above $1.  Further, the tokens will only be held in proprietary wallets created by TurnKey; users must register with TurnKey to obtain a wallet and token transfers will be limited to other TurnKey wallets.  Additionally, TurnKey customers cannot redeem tokens for cash, and redemptions are limited to brokers and carriers.  Without this limit, TurnKey tokens could theoretically operate as a stablecoin, a virtually currency with a fixed value, which could attract users trying to find a mechanism to transfer funds from person-to-person.

[xvi] 49 C.F.R. § 1540.107 (2016).

[xvii] Tuition Plan Consortium, LLP, SEC No-Action Letter, (Feb. 4, 2003); Fleet National Bank, SEC No-Action Letter (Sept. 5, 1990); Michigan Funeral Directors Association, SEC No-Action Letter (Sept. 28, 1987).

[xviii] Securities and Exchange Commission, Statement of the Commission Regarding Trading Stamps, 23 Fed. Reg. 498 (Jan. 21, 1958).

[xix] Id.

[xx] Anzhela Knyazeva, SEC Division of Economic Risk Analysis, Regulation A+: What Do We Know So Far? (Nov. 2016), https://www.sec.gov/files/Knyazeva_RegulationA%20.pdf.

[xxi] StartEngine Crowdfunding, Inc., Offering Statement (Form 1-A/A) (Mar. 7, 2019).

[xxii] StartEngine Crowdfunding, Inc., Offering Statement (Form 1-A/A) (Jun. 29, 2018); Max Dilendorf, Rika Khurdayan and Gleb Zaslavsky, Another Year in Review: Current State of Reg A+ Tokenized Offerings, Dilendorf & Khurdayan LLP (Mar. 14, 2019), https://dilendorf.com/resources/another-year-in-review-current-state-of-reg-a-tokenized-offerings.html.

[xxiii] StartEngine Crowdfunding, Inc., Offering Statement (Form 1-A/A) (Mar. 7, 2019).

[xxiv] 17 C.F.R. §§ 230.504-506.

[xxv] 17 C.F.R. § 230.506(b) (2013).

[xxvi] 17 C.F.R. § 230.506(c) (2013).

[xxvii] 17 C.F.R. § 230.902 (2005).

[xxviii] Id.

[xxix] See Offshore Offers and Sales, Securities Act Release No. 33-7505, 63 Fed. Reg. 9632 (Feb. 25, 1998).

[xxx] Statista: The Statistics Portal, https://www.statista.com/outlook/264/109/event-tickets/united-states (last visited Apr. 9, 2019).

[xxxi] U.S. Gen. Accounting Office, GAO-18-347, Event Ticket Sales: Market Characteristics and Consumer Protection Issues, at 6, (Apr. 2018), https://www.gao.gov/assets/700/691247.pdf.

[xxxii] Blockchain for Ticketing: A Complete Guide, https://www.eventmanagerblog.com/blockchain-ticketing (last visited Apr. 9, 2019).

[xxxiii] Securities and Exchange Commission, Statement of the Commission Regarding Trading Stamps, 23 Fed. Reg. 498 (Jan. 21, 1958).

[xxxiv] The Ticket Reserve, Inc., SEC No-Action Letter (Sept. 11, 2003).

[xxxv] Id.

[xxxvi] San Francisco Baseball Associate L.P., SEC No-Action Letter (Feb. 24, 2006); Lawrence B. Rabkin, Letter to Securities and Exchange Commission regarding “San Francisco Giants Charter and Club Seat License Program” (Feb. 2, 2006), https://www.sec.gov/divisions/corpfin/cf-noaction/sfba-020206-incoming.pdf.