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SEC Digital Assets Framework + CryptoMom: Selected Thoughts

SEC Digital Assets Framework + CryptoMom: Selected Thoughts

By now, you’ve probably read (and read about) the SEC digital assets framework released yesterday. Link to the SEC press release (includes relevant links).   

SEC Digital Assets Framework

As others have said, the SEC’s Framework for “Investment Contract” Analysis of Digital Assets (the “Framework”) doesn’t offer a ton of new info, but still it feels like a step in the right direction. I found it particularly interesting to read the SEC’s guidance right after having listened to an interview with Hester Peirce (CryptoMom) on a well-timed episode of Laura Shin’s excellent Unchained Podcast (it probably should be said that any comments attributed to Commissioner Peirce express her personal viewpoint, not the SEC’s official position. But she makes up 25% of current SEC Commissioners).   

Commissioner Peirce didn’t address specifics of the Framework (her interview was recorded a week or so before it was released). She did (seemingly) refer to it as helpful. But she also seemed interested in the SEC implementing something more formal than this (technically) non-binding staff guidance.

Information asymmetries are bad

It’s helpful to think of the SEC’s work in the context of its objective to protect investors. The Framework cites reducing “significant informational asymmetries” between a project’s promoter and potential investors as “one of the primary purposes of the federal securities laws.” (p. 2) It also lists the absence of such asymmetries among the factors weighing in favor of determining something not to be a security (in the context of the expectation of profits): “No [promoter] has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset.” (p. 8)

Commissioner Peirce also named the “information asymmetry problem” as the main problem that securities laws seek to solve. She said that where no person or group has an information monopoly, the project under scrutiny looks a lot less like a securities offering.

Once a security, not always a security

Any doubt that lingered about this seems gone now. The Framework tries to give practical guidance by listing factors weighing in favor of a no-longer-a-security determination (both in the context of reliance on others’ efforts (p. 5) and expectation of profits (p. 8)). But a lot of the factors that’re list are just negatives of factors that weigh in favor of calling something a security.

What’s sufficient decentralization?

Lately there’s been a lot of focus on the notion of “sufficient decentralization,” the newish way to measure whether securities laws no longer apply to a network that was popularized by Dir. William Hinman’s speech from June 2018. The Framework seeks to add a bit of substance to that term – maybe too little for some critics, but still, it’s nice to have more words to define a tricky concept.

Particularly noteworthy is the suggestion that sufficient decentralization exists when essential tasks are done by “an unaffiliated, dispersed community of network users” instead of a “promoter, sponsor, or other third party (or affiliated group of third parties.” (pp. 3, 4)

Also, in her interview, Commissioner Peirce listed a few examples of how she interprets “sufficiently decentralized”; they seem in line with the Framework’s approach:

  • Lots of people contributing
  • No formal secondary trading market maintained by promoters
  • Network operating from grassroots up
  • Active community involved in decisions
  • Open-source code

One fact, one circumstance

The Howey test – the legal analysis of whether something’s an investment contract (and thus a security) – involves lots of different factors. We’re always cautioned that no one factor is determinative, but judging from what I’ve seen on, e.g., crypto Twitter, lots of us ignore that caution.

There’s some stuff that helps make the point in the Framework. Look at page 6, which includes this factor among those weighing in favor of finding a reasonable expectation of profit (and thus of finding that something’s a security):

“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” 

Wait, but “offered broadly” seems kinda related to “sufficient decentralization,” doesn’t it? Yep; the point is that the fact of a broad token distribution can cut both ways. Just like the other factors in the analysis, the breadth of distribution only really makes sense within the overall context (i.e., “circumstances”).

Airdrops remain cloudy

Speaking of broad distribution, the Framework mentions in a footnote that airdrops can constitute securities offerings. (p. 2, n.9) The context is an explanation that the “investment of money” element of the Howey test doesn’t require actual funds – it can be satisfied by some other thing of value. Something like services, which, when contributed in exchange for bounty tokens, led to a finding of a securities offering in a 2018 case. The idea that an airdrop might be a securities offering isn’t really a new one, but it would’ve been nice if the SEC staff included some examples or analysis. 

All that moons isn’t profit

In the context of the “expectation of profits” prong of the Howey test, it’s important to remember that not everything that increases in value (or might increase) is a security. The Framework highlights this point:

  • “Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test.” (p. 6)
  • One factor weighing in favor of something evolving away from being a security is “Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.” (p. 8)
  • Quoting a Supreme Court opinion, “where a purchaser is not “’attracted solely by the prospects of a return’ on his investment . . . [but] is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.”).”

Commissioner Peirce touched on this notion while making the point that the SEC should be careful in how far it extends its jurisdiction. She cited luxury watches as the kind of asset people buy with an expectation of value appreciation, noting that some watches are marketed as providing a legacy for future generations or described as great investments. Commissioner Peirce seems in favor of avoiding SEC overreach, seeing no “need to regulate watches.”

SEC’s no-action letter

The SEC also issued a no-action decision in response to a letter from TurnKey Jet, Inc., seeking guidance for a proposed token sale. The substance of the no-action letter isn’t terribly interesting; the token sale described in TurnKey’s letter looks a lot different from ones we’re used to seeing (permissioned blockchain; apparent impossibility for the tokens to appreciate in value; prohibition on transfer of tokens outside the network).

But what’s interesting is the mere existence of the no-action letter. It seems intended to signal that the SEC won’t go after projects that comply with securities laws. Or at least to be a semi-official walking-back of past statements that every ICO is a security offering. (It’s also mildly interesting that TurnKey’s letter is dated April 02, 2019, just a day before the SEC’s no-action letter)

Two final CryptoMom points

That’s it for the SEC Digital Assets Framework, but I’ll leave you with some innovation-forward thinking from Commissioner Peirce that might provide some encouragement:

  • Developers shouldn’t have to worry

Commissioner Peirce expressed her personal concern that someone who’s writing code shouldn’t have to worry down the road about what other people do with that code. She didn’t elaborate or frame it as a free-speech one, but, personally, I find her perspective to be welcome, especially in light of some of some rumblings I’ve seen about holding core developers accountable for their code. 

  • Regulators want to talk (and maybe even listen)

Finally, Commissioner Peirce seemed bugged by reports that projects sometimes spend more resources on compliance efforts than on innovation. She acknowledged that everyone needs to follow the current laws, but she described them as “prescriptive” and “intense.” She also wondered if now might be the time to ask whether we need more flexibility in securities laws. And she repeatedly encouraged dialogue from anyone affected by the current regulations, saying, if “there are things that need to change to allow this space to really flourish, then I think we need to have that conversation, too.” Plus she embraced her status as CryptoMom.

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