SEC Issues Guidance On ICOs

The US Securities and Exchange Commission (SEC) gave us two developments today that we absolutely need to dive into.

The No-Action Letter

First, the SEC revealed that it has issued a no-action letter to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service. In doing so, they cleared Turnkey’s tokens, deciding they are not securities and that they’re free to sell them to the public under very specific conditions.

In accordance with the letter, the terms of TurnKey’s ICO are as follows:

• TurnKey must not use any funds derived from the token sale to develop its platform, network, or app. “Each of these will be fully developed and operational at the time any Tokens are sold,” the SEC notes in its letter.
• TurnKey’s tokens must be “immediately usable for their intended functionality” when they are sold.
• The company must also restrict transfers of the TKJ tokens to TKJ wallets only. No external wallets allowed.
• TKJ tokens will be priced at 1 USD per token “through the life of the program,” with each token essentially functioning as a pre-paid coupon for TurnKey’s air charter services. If TurnKey tries to buy back the token (coupon), it must do so at a discount (less than 1 USD).
• And lastly, the token must be “marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.” In other words, don’t make sound like it an investment, which this clearly isn’t.

While TurnKey avoids registering its sale with the SEC or abiding by registration exemptions (such as only selling to accredited investors), this barely resembles what we’ve come to know as an ICO.

Nonetheless, this is an important but highly incremental step for the SEC. There has been lots of previous guidance around prepaid services, including tuition and funerals. Blockchain can and will do much, much more than that, but we have to start somewhere.

It goes without saying that the no-action letter is helpful in finally having at least one token that the SEC does not view as a security.

But, the big caveat here is we shouldn’t expect the letter to have broad implications for the industry as a whole. The letter very much situation specific, and not necessarily intended for broader implications.

Thankfully, that’s what the second development was for.

The Framework

The framework, a “Framework for ‘Investment Contract’ Analysis of Digital Assets”, is a product of the SEC’s FinHub, and the Commission.

The major takeaway is that this is not a “rule, regulation, or statement of the Commission” nor intended to “replace or supersede existing case law, legal requirements, or statements or guidance” from the SEC.

Call it anticlimactic, but there’s really nothing new here. Any lawyer looking at token sales will have given advice along these lines for years.

Nevertheless, the framework does provide a more detailed analysis of how the SEC is thinking about the application of the Howey Test for digital assets, reinforcing much of what SEC Director William Hinman said on the matter last June.

The framework goes deep on a tenant of the Howey Test in relation to ICOs and token projects: the “reasonable expectation of profits derived from the efforts of others.”

With this, the SEC has introduced a brand new concept: the “Active Participant.”

“When 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,” reads FinHub’s framework for token sales.

My take is that the Active Participant concept is interesting and conceptually troubling. Does this include YouTube promoters or promoters who are otherwise not officially affiliated with an issuer? Does this concept violate First Amendment rights? It’s unclear.

The new concept of an ‘Active Participant’ on the role of ‘others’ in ‘efforts of others’ is very broad and lacks analytical rigor. It doesn’t cut down on the fuzziness of the Howey test, which is understandable in a way, because the SEC is not empowered to make new securities laws.

But, don’t be misled to believe this isn’t a good development. For the first time in an official statement, the SEC recognized that closed-source IP vs. open-source IP is a material factor in determining whether tokens are securities. It begs the question if the software is open-source can development and maintenance of the software be decentralized under the Hinman factors.

While the analysis supports the idea that the definition of a security is fluid, and blockchain-based tokens and digital assets that might securities today could no longer be securities tomorrow, FinHub’s framework fails to answer the hard questions: “How does this happen? Who decides? When is it appropriate to check? Are parties required to submit their transaction to the SEC through some procedure to be explained later?”

Plenty of questions remain, but it appears the SEC is pondering them right along with the rest of us. While the framework would have been more impactful if issued as official guidance, we’ll take what we can get because this is a step in the right direction.