Fenwick & West partner Michael Dicke.

When is a digital token a security? It has the ring of modern haiku, but it’s a serious question to securities lawyers operating on the cutting edge of the crypto-world.

We caught up with Fenwick & West partner Michael Dicke, the former enforcement chief of the San Francisco regional Securities and Exchange Commission office, to tackle the question. It was good timing, too, since the SEC issued some guidance on the topic Wednesday.

What follows is an edited transcript of our exchange.

So the SEC is out with its long-awaited guidance for token issuers. Does this guidance materially change what we know about the SEC’s position on whether digital assets are securities?

The guidance issued by the SEC Division of Corporation Finance essentially synthesizes and puts a sharper point on numerous factors the SEC has discussed in enforcement actions and speeches, although there are some points that could be considered new. For instance, one new aspect is that the guidance talks specifically about how to judge whether tokens, which were once securities, when issued may no longer be considered securities in later transactions because the associated blockchain project has become decentralized or otherwise evolved away from reliance on the efforts of a key group of people.

But mostly, the guidance reaffirms that the SEC will continue to look to the Howey test, and that the inquiry into whether a particular offering or sale of a digital asset constitutes a securities offering remains a facts and circumstances examination of multiple factors. In terms of what specific, real-world factors are relevant, the new guidance discusses numerous scenarios and which way they cut in terms of finding a securities offering.

In my view, the April 3 guidance reaffirms that the SEC usually will view digital assets designed to raise funds to be used by a central management team in building a new venture as securities offerings. In other words, if you selling a token or digital asset to raise funds to develop or build something, you are likely engaged in a securities offering. And that’s why for the past year most ventures that are raising funds to build projects through token sales have been counseled to do token offerings as securities offerings, under applicable exemptions from registration such as Reg D (to accredited investors in the U.S.) or Reg S (to overseas investors). Of course, it’s worth emphasizing that it is crucial that the strictures of such exemptions are met, and that proper records are kept to prove that the offering met each of the requirements of Reg D or Reg S.

It’s worth noting that as the SEC enforcement division works through its backlog of investigations relating to the 2017 and early 2018 ICOs, I think we will begin to see less new SEC and other regulatory actions involving token issuances and more focus on other areas involving digital assets. Such investigations and enforcement actions likely will include cases involving cryptocurrency exchanges, registered broker-dealers trading security tokens, funds holding digital assets, and derivate instruments whose value is tied to the price of particular digital assets. Questions the SEC likely will be grappling with include: what standards do independent auditors apply to audits of broker-dealers which trade digital assets that qualify as securities? What constitutes market manipulation of digital asset markets? How should fund managers value and report their holdings to investors, given the volatility and opaqueness of cryptocurrency markets? All of these questions are likely to be presented in the next wave of SEC enforcement investigations.

How much of what the industry knows comes from public statements and guidance, and how much comes from the agency’s enforcement actions and positions the SEC has taken in litigation?

What we collectively know about the SEC’s views on token issuances and related cryptocurrency issues comes from a combination of enforcement actions, public statements of SEC officials, and what defense lawyers and others have learned from one-on-one discussions with SEC officials. This later source is often overlooked but in some ways offers the most up-to-date insights about the agency’s views on particular emerging issues in this space.

Of course, what’s missing from this list is SEC rule-making. Many in the cryptocurrency industry have been clamoring for the SEC to pass specific rules to address when a particular token offering constitutes a securities offering, as well as rules governing secondary market sales of tokens, ETFs and related issues. I’m not surprised, however, that the SEC has failed to take steps to enact new rules in this space. The rule-making process is terribly slow and deliberate. With the rapid evolution of the crypto space, the rule-making process risks being overtaken by new developments in the industry.

Moreover, while I understand the frustration of the lack of clear rules in this space, I think that those wishing for specific SEC rules would likely be disappointed. The SEC inherently is a conservative organization and is uncomfortable making bold changes. And when it comes to investments offered to “main street” investors (to borrow Chairman [Jay] Clayton’s phrasing), the SEC always is going to err on the side of investor protection.

Think back five or six years ago when there was a clamor for crowdfunding rules. The SEC’s response, Regulation Crowdfunding, is so restrictive and modest that few entrepreneurs have raised meaningful capital under its provisions. I don’t think anyone in the digital asset space wants to wait years for the SEC to write rules that end up stifling, instead of enhancing, the burgeoning cryptocurrency industry.

In terms of whether the April 3 guidance provides the requested “clarity” that so many have hoped for, I would say it helps, but falls short of actual “clarity.”

So that essentially means that the courts and the SEC will continue to apply the “Howey test” to determine whether there’s an underlying “investment contract” in a token offering. How do you explain what the Howey test is, and what to look out for in it, to clients in the crypto space?

The April 3 guidance explicitly notes that the principal test for determining whether a particular digital asset offering is a securities offering remains the Howey test. When talking about straightforward token issuances, like we saw with the ICOs in 2017 and 2018, here’s how I explain to clients what likely will run afoul of the Howey test and result in the client’s offering being at risk of being seen by the SEC as a securities offering: if you are offering to sell a digital asset such as a token (or a right to a future token) for value (e.g., money or bitcoin), and you plan to use the funds raised to build the enterprise which will make that token functional or more valuable, then you likely are engaging in securities offering.

Similarly, as the SEC has emphasized, if you are marketing the sale of the digital asset to potential purchasers as something which should increase in value due to the efforts of a centralized group of people (e.g., the management of the enterprise), you likely are engaged in a securities offering.

It’s worth noting that there is another court-developed test for determining whether a particular instrument is a security, and that’s the Reves “family resemblance” test. While this test hasn’t been applied to digital assets yet, the SEC or courts could look to Reves in addition to the Howey test, in certain instances. The four-part Reves test is used to determine when a note should be classified as a security. For particular cryptocurrency projects, such as certain varieties of stablecoins, there is an argument that the instrument sold could constitute a note. So for such instruments, it is possible that the SEC and courts will look to the Reves test in addition to Howey to determine if the instrument is a security.

Along with the framework the SEC also released a “no action” letter in response to a letter from Turnkey Jet Inc., a Palm Beach, Florida-based company developing on “tokenized” jet cards. First off, any idea on what that is? Second, what do you make of the SEC’s response in that case?

The no action letter issued April 3 marks the first no action letter issued by Corp Fin [Division of Corporation Finance] involving a digital asset offering. According to news reports, it took the SEC 11 months to issue the letter. Basically, the SEC found a digital asset offering which was so restrictive and so obviously not a securities offering that it finally felt comfortable publicly saying “here’s one that’s not a security.” The problem is that few blockchain projects using digital assets are as restrictive as the Turnkey project.

According to Turnkey’s no action letter request, the token is essentially a pre-payment for on-demand private jet service, and is supposedly designed to avoid inefficiencies with the banking system. Key features that the SEC pointed to as demonstrating that the token is not a security are that token sale funds are not being used to develop the air charter system, the tokens are not transferable outside of a closed wallet system, and the tokens are being sold for the set price of one U.S. dollar and each token represents a Turnkey obligation to supply services at a value of one U.S. dollar.

When it’s all said-and-done, does the question of whether a particular token offering could be construed as a sale of securities come down to the facts and circumstances of a particular case? How so?

It does, although as noted earlier, the developing body of SEC actions and pronouncements have provided important guidance. Frankly, the need to delve into the specific facts and economic realities of a particular instrument or particular transaction to determine if the federal securities laws are implicated is not unique to the digital asset space. Whenever there is an issue about whether a particular instrument is a security, you need to analyze the particular facts against the applicable caselaw.

Are you seeing an uptick in private litigation involving token issuances, and what are the principal issues you’re seeing in those suits?

Most definitely. I am representing, or in discussions to represent, a broad array of participants in the digital asset space in disparate litigation matters. These matters run the gamut, from allegations of unregistered securities offerings and fraud in ICOs (on both the plaintiff and defense side), to breaches of agreements between digital asset issuers and consultants hired to market the offerings, to alleged cybersecurity failures which allowed investors’ digital assets to be stolen. Moreover, we have seen this past year the traditional securities class action plaintiffs firms filing class actions against ICO issuers. I would expect to see all these types of cases proliferate, and would also expect to see more intellectual property disputes ripen to litigation.

Every new innovative technology inevitably spawns disputes among the participants which find their way into the courts. Not surprisingly, then, we are seeing an array of disputes ripening into litigation across different segments of the cryptocurrency industry, and that will continue.