The SEC Drew New Crypto Lines. What Issuers Need to Consider Now

The Securities and Exchange Commission in March issued an interpretive release jointly with the Commodity Futures Trading Commission, clarifying the application of federal securities laws to crypto assets and certain crypto asset transactions.

Classifying crypto assets into five categories, the SEC provided its view on whether the assets would be considered a security and included further guidance on when securities transactions involving crypto assets may arise. The guidance is significant forward progress as crypto assets become more mainstream.

The immediate question for crypto asset issuers isn’t only how to launch, but also what happens afterward. In practice, the issuer’s ongoing communications and market-facing conduct, such as offering materials, marketing claims, website language, and public statements, can keep issuer “managerial efforts” connected to the asset in the eyes of purchasers.

Non-security crypto assets and investment contracts: The SEC expressed its view that four categories—digital commodities, digital collectibles, digital tools and certain stablecoins—aren’t inherently securities under federal securities laws. However, such crypto assets could be sold under investment contracts and therefore subject to federal securities laws. The fifth category, digital securities, are always securities under federal securities laws.

A non-security crypto asset becomes subject to an investment contract when an issuer offers it by inducing an investment of money in a common enterprise with representations or promises to undertake essential managerial efforts from which a purchaser would reasonably expect to derive profits, also referred to as the Howey test.

Representations must be conveyed to purchasers prior to or contemporaneously with the issuer’s offer or sale. If the non-security crypto asset is sold to a purchaser, post-sale statements by the issuer won’t convert it into an investment contract as to such purchaser.

Any transaction involving a crypto asset that is subject to an investment contract must either be registered under federal securities laws or exempt from those registration requirements. Traditional exemptions, such as private placements under Rule 506(b) of Regulation D promulgated under the Securities Act of 1933 and Regulation A offerings, may be the more palatable alternatives given their compliance conditions.

Private placements under Rule 506(c) (general solicitation private placements) and offerings on crowdfunding platforms may prove impractical for crypto asset use cases given their investor verification requirements. Each proposed offering of crypto assets involving an investment contract must be carefully analyzed by the issuer and its advisers to determine the most applicable path under the federal securities laws.

Becoming subject to an investment contract: The SEC indicated that investment contracts applied to primary issuances of crypto assets as well as to secondary market transactions.

This would occur in a secondary market transaction when a holder of a non-security crypto asset subject to an investment contract sells it to another purchaser, provided the purchaser would reasonably expect the issuer’s representations or promises to engage in essential managerial efforts to remain connected to the non-security crypto asset.

Under such circumstances, secondary market offers and sales of the non-security crypto asset would constitute securities transactions that must be registered under federal securities law or conducted pursuant to an available registration exemption.

The investment contract will continue to be transferred to subsequent purchasers of the non-security crypto asset in secondary market transactions until the non-security crypto asset separates from the issuer’s representations or promises.

Separation from an investment contract: Just as a non-security crypto asset could become the subject of an investment contract, the contract also can come to an end. When this occurs, further sales of the crypto assets wouldn’t be subject to federal securities laws.

A crypto asset is separated from an investment contract when its purchaser no longer can reasonably expect the issuer’s representations or promises to engage in essential managerial efforts to remain connected to the non-security crypto asset.

The SEC provided a few examples of this development:

• When the issuer has fulfilled its representations or promises to engage in essential managerial efforts
• If a sufficiently long period of time has passed and it’s clear the issuer neither has conducted nor intends to conduct the essential managerial efforts it represented or promised it would undertake
• If the issuer publicly announced that it no longer will perform the essential managerial efforts it represented or promised it would undertake.

The interpretive release clarifies that failure to fulfill an investment contract doesn’t result in the initial offering being something other than an investment contract. The issuer still may be responsible under the federal securities laws for material misstatements or omissions in its marketing materials.

Types of statements that can give rise to an investment contract: The SEC provided examples of the types of statements that can give rise to an investor’s reasonable expectation of profits.

Promises and representations are more likely to create reasonable expectations of profit when they are explicit and unambiguous as to the essential managerial efforts to be undertaken by the issuer, contain sufficient details demonstrating the issuer’s ability to implement the proposed project (such as milestones, timelines, personnel and funding) and explain how the issuer’s efforts will produce the profits that purchasers reasonably expect.

The form of the promises or representations also is relevant to an investor’s reasonable expectation of profits. For example, written or oral agreements, routine public communications, direct private communications, accessible public regulatory filings and documents clearly attributable to the issuer are modes the SEC views as reasonable for an investor to rely upon.

Conclusion

The interpretive release helps clarify the SEC’s position on non-security crypto assets and expands on its application of certain securities law tests to crypto assets. It reiterates that the issuers’ actions can heavily inform whether a transaction (primary or secondary) constitutes an investment contract and when it ends.

While more definitive in its application of the Howey test in the interpretive release, the SEC continues to stress the importance of issuer behavior. Consequently, issuers should remain mindful of the statements they make to the public when offering non-security crypto assets.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Kenneth M. Silverman is a partner in the mergers & acquisitions and corporate/securities law practice at Olshan Frome Wolosky in New York City.

John A. Corrado is an associate in the mergers & acquisitions and corporate/securities law practice at Olshan Frome Wolosky in New York City.

Write for Us: Author Guidelines