SEC Announces New Guidelines to Analyze Crypto Assets

The US Securities and Exchange Commission (SEC) announced a set of guidelines in early April aimed at “[providing] a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an ‘investment contract.’” The move is the latest effort from the SEC to clarify and enforce the digital asset and initial coin offering landscape long characterized by legal gray areas and a wild west mentality – occasionally to the detriment of investors, who have fallen victim to fraud and other malfeasance.

Prior legal rulings have found an investment contract to exist “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” Determining whether a digital asset falls into this category requires “[analyzing] the relevant transactions to determine if the federal securities laws apply” using a standard system for analysis called the Howey Test. This well-known methodology uses a three-prong approach to evaluate an asset for security-like characteristics.

The SEC calls the first prong the Investment of Money, which is “typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or another type of consideration.”

The second prong is Common Enterprise, defined legally as “an enterprise in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those offering or selling the investment or of third parties” – something the SEC clarifies in their guidelines as typical to digital assets.

The third is the Reasonable Expectation of Profits Derived from the Efforts of Others. This step is characterized by the SEC as “the main issue in analyzing a digital asset under the Howey test” – a process where courts typically look at “the economic reality of the transaction.” Key to this analysis is determining if the purchaser is relying on an active participant (AP) whose efforts are “undeniably significant…[to] the failure or success of the enterprise,” rather than “ministerial in nature.” The greater the managerial role of an AP, the more likely the asset should be classified as a security.

While the SEC guidelines are by no means ironclad – they advise that market participants use its FinHub service to keep up with the latest in the rapidly-evolving crypto world, while also working with securities counsel to stay on the right side of the law – they do represent another step closer to comprehensive regulation of the digital asset landscape and, ultimately, towards mainstream acceptance.

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