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From Securities Regulation Daily, March 13, 2019

Chairman Clayton replies to digital tokens letter from Rep. Budd, hints at more guidance

By Mark S. Nelson, J.D.

SEC Chairman Jay Clayton, while hinting at more guidance, said regulators look to statutory definitions and the Howey test on whether digital tokens are securities. Clayton also suggested a token’s status is not "static" and depends on its decentralization.

According to SEC Chairman Jay Clayton, the SEC has deployed a variety of its tools to provide the digital marketplace with guidance on when a digital token may fall within the definition of security and that such guidance goes beyond the principles to be gleaned from the agency’s many related enforcement actions. Clayton commented in reply to a letter from Rep. Ted Budd (R-NC) and others who queried the chairman last fall. Clayton also said SEC staff are considering preparing more guidance on digital assets.

Security status not "static." The letter from Rep. Budd to Chairman Clayton, according to an article by Coin Center’s Jerry Brito, was the result of a collaboration between Coin Center and Rep. Budd, and others. The original letter, issued without a list of signatories, was sent to Chairman Clayton in late September 2018 and asked three questions: (1) how does the SEC determine that a digital token is an investment contract and, thus, a security; (2) whether Chairman Clayton agrees with William Hinman, director of the SEC's Division of Corporation Finance, that a token that is initially an investment contract can become a non-security (Director Hinman gave a speech suggesting this possibility in June 2018); and (3) what tools can the SEC use to provide additional guidance about digital tokens.

With respect to first question, Clayton reiterated that the SEC looks to the Securities Act and Exchange Act definitions of "security." These statutes contain numerous items that are deemed to be securities, but they also contain phrases such as "investment contract" that are somewhat more flexible. The Supreme Court’s Howey test, said Clayton, informs whether something is an investment contract and that the SEC would look to the facts and circumstances and to the economic reality of a transaction in applying that test. Clayton also said the "detailed legal analysis" in the SEC’s The DAO Report explained how the agency applies Howeyto digital tokens. Clayton also noted that SEC staff continue efforts to provide additional guidance on digital assets.

The second question asked if Clayton agreed with the analytical approach offered by Director Hinman, who focused much of his June 2018 speech on the concept of decentralization. In that speech, Hinman said the following while discussing the Bitcoin and Ether virtual currencies: "If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract." Hinman also suggested in a footnote to the speech in which he briefly discussed the Simple Agreement for Future Tokens (SAFT) that a token can morph from being a security into something that is not a security: "From the discussion in this speech, however, it is clear I believe a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction."

In reply to Rep. Budd’s letter, Clayton made two points, appearing to echo portions of Hinman’s speech with respect to the changeability of a token’s security status and the role played by decentralization. Said Clayton:

  • "I agree that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument."
  • "I agree with Director Hinman's explanation of how a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts."

Clayton answered the third question by pointing to the SEC’s FINHUB as an example of how the agency has marshaled its resources to help the public learn about token offerings and related regulatory issues. He also noted the several SEC Investor Bulletins on digital tokens and the SEC’s warning to investors dramatized in the agency’s fictitious "HoweyCoins.com" initial coin offering announcement.

The press release announcing the letter from Rep. Budd and promising an update with a list of all 15 signatories (the updated letter appears to be unavailable publicly) acknowledged Reps. Warren Davidson (R-Ohio), Tom Emmer (R-Minn), and Darren Soto (D-Fla) for "leading this letter" along with Rep. Budd. Representatives Budd, Davidson, Emmer, and Soto all are members of the Congressional Blockchain Caucus(Reps. Soto and Emmer are two of the caucus’s four co-chairs).

In addition to the three main questions, the letter to Chairman Clayton said its signatories agreed that digital assets that meet the test of a security must abide by federal securities laws. The letter also said its signatories agreed that some digital tokens are not securities and that all digital tokens should not be lumped together under the definition of security. Moreover, the letter expressed concern that the SEC was clarifying the securities status of digital tokens through enforcement actions instead of through more formal guidance. Lastly, the letter noted the "speed" at which digital markets have evolved and suggested that any further guidance issued by the SEC should not be too "stringent" lest it become quickly "obsolete."

Legislation on tokens. The reaction to Coin Center’s publishing of the Clayton response was swift among those associated with the original letter to Clayton. Representative Budd re-tweeted the Coin Center article by Brito, which Brito also tweeted about. Representative Davidson also re-tweeted the Coin Center article but added that Congress should pass the Token Taxonomy Act.

Under the Token Taxonomy Act (H.R. 7356), co-sponsored by Reps. Davidson and Soto in the 115th Congress and not yet re-introduced in the 116th Congress, the term "digital token" would be excluded from the definition of security and an exemption from the Securities Act registration requirement would apply when a developer or seller of a digital token that has been notified by the SEC that it has run afoul of federal securities rules stops sales and returns sale proceeds. This last part about repaying investors would clarify that transactions of "digital units" would be excepted from the Securities Act’s registration requirement and mandate a claims process similar to the one developed by the SEC in enforcement actions against AirFoxParagon Coin, and Gladius Network.

Representatives Davidson and Soto said in a press release announcing the bill in the last Congress that the genesis for the bill was a desire to clarify the use of the Howey test for when an offering is an investment contract and, thus, a security. "This bipartisan legislation draws a bright line for businesses and regulators by defining a ‘digital token’ and clarifies that securities laws do not apply to companies that use blockchain once they reach their goal of becoming a functional network," said Reps. Davidson and Soto. "Implementing this fix will stop fraud from spreading and provide the certainty innovation needs to flourish."

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