Digital Assets, Investing and Clarity
Is a three year safe harbor for digital tokens necessary for developers to determine if security law type disclosures are required when selling it? This is the question initially raised by Commissioner Hester M. Peirce in February 2021 and reiterated earlier this week by Commissioners Peirce and Elad Roisman (here). The suggestion was made at the time the Commission accepted the settlement offer in In the Matter of Blotics Ltd. f/d/b/a Coinschedule Ltd., Adm. Proc. File No. 3-20398 (July 14, 2021), a case centered on a popular website platform that publicized offerings of digital tokens.
Commissioners Peirce and Roisman agreed that selling securities without making the necessary disclosures violates Securities Act Section 17(a), the basis for the settlement in Coinschedule. There the company consented to the entry of a cease-and-desist order based on Securities Act Section 17(a) and agreed to pay disgorgement, prejudgment interest and a penalty totaling $154,434.00. The two Commissioners expressed concern regarding the clarity of the guidance available from the agency on which coins constituted a security on the platform: “There is a decided lack of clarity for market participants around the application of the securities laws to digital assets and their trading, as is evidenced by the requests each of us receives for clarity. . .”
Clarity is a key point when applying legal principles. Precisely what is unclear about the application of the investment contract test of SEC v. W.J. Howey Co., 328 U.S. 293 (1946) to digital assets is not specified in the comments however. Just why sellers of digital assets or coins should get a three year safe harbor to assess if under Howey those assets constitute a security is also not specified.
The Howey test is straight forward: The pooling of investor capital on the expectation that profits will be made through the efforts of others constitutes an investment contract, a security. Accordingly, if the point of the investment – a digital asset or otherwise – is to combine the investor capital with that of others and make money from the work of others, it is an investment contract.
The Howey test is hardly new. The decision has been on the books since 1946 – over 60 years. During that time, numerous court decisions have applied the test. And for those concerned about digital assets, the Commission issued the DAO report of an investigation centered on digital assets in July 2017. The report applied Howey to digital assets, adding clarity to the point. The DAO report is not mentioned by the Commissioners.
Also missing from the suggestion that crypto coin sellers should get a three year pass from complying with the securities laws is a rationale for the need for such a safe harbor. There is nothing unique about newly minted coins or digital assets that may be tied to a blockchain which would require three years to figure out if the Howey test applies. Indeed, none of the sellers of investment contracts over the last six decades since Howey was decided have had years to assess if they should comply with the decision.
While members of the public may express confusion about whether a digital asset is an investment contract, the confusion stems from not from Howey but from failing to recognize the key point. A digital asset in and of itself is not a security. It is the investment contract tied to it that is the security — no investment contract, no security. The same is true for corporate stock. Neither the paper certificate issued by the public company nor the digital manifestation of that certificate on the books of the transfer agent is the stock or the security. The certificate or digital record are each records reflecting that the stock was issued.
The corporation does not need a three year safe harbor to determine if the stock issued for the investor’s money is a security. The transfer agent does not need three years to determine if the electronic record it has reflecting an investment in a company means the investor purchased stock, a security. And, those involved with digital assets do not need three years to determine if they received money from an investor based on claims that the money would be pooled with funds from other investors and hopefully return a profit in the future from the work of others is an investment contract, a security. It is.