On June 7 2022, US Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) announced the anticipated introduction of the bipartisan Lummis-Gillibrand Responsible Financial Innovation Act (RFIA). If enacted in its current form, the RFIA will be the first comprehensive federal legislation to tackle the most significant issues arising at the intersection of traditional financial regulation and digital assets across all aspects of the regulatory spectrum, including tax, securities, commodities, banking, and consumer protection. Even though it is unlikely that the RFIA will become law in the current Congress (now winding down in anticipation of the US midterm elections in November), the bill nonetheless introduces a variety of innovative solutions to the issues affecting the digital asset and blockchain sectors that are likely here to stay.
Perhaps of greatest importance to transactional attorneys, the RFIA provides an answer to the most foundational question affecting clients in the digital asset space - when is activity involving digital assets governed by the federal securities laws and when do the federal commodities laws properly apply? To answer this question, the RFIA adopts a novel approach, addressing the concerns raised by the US Securities and Exchange Commission (SEC) by imposing disclosure obligations on companies that raise funds through the sale of digital assets, even where the funds were raised in private placement transactions.
The RFIA introduces a new term, “ancillary asset” and various additional related provisions to what would be a new Section 41 of the US Securities Exchange Act of 1934 (the Exchange Act) to create a disclosure regime tailored to the needs of users of digital assets. The term ancillary asset in the RFIA is used to describe a fungible intangible asset that is offered, sold or otherwise provided to a person in connection with the purchase and sale of an “investment contract” , but does not provide the holder of the asset with: (i) a debt or equity interest in that entity, (ii) a profit or revenue share derived from that entity, (iii) an entitlement to an interest or dividend payment from that entity, (iv) a profit or revenue share in that entity derived solely from the entrepreneurial or managerial efforts of others, or (v) any other financial interest in that entity.
Background
The purported applicability of the federal securities law to transactions involving digital assets has been the subject of extensive discussion among regulators, academicians, practitioners and entrepreneurs. Initially, much of this attention focused on the many transactions (often styled as “initial coin offerings” or “ICOs”) in which newly minted digital assets were sold or otherwise distributed, usually to the general public, as part of the process of creating a new “decentralised” blockchain-based protocol.
For those seeking to create these decentralised projects, the use of a finite or provably scarce number of unique but fungible digital assets was essential to facilitating the economic incentives needed to drive engagement with the new platform. The alternative – fundraising for the development of the protocol through the sale of traditional equity in a company – would usually mean that the value of the network would be owned and controlled by the founding company seeking to recover value for its shareholders (the “web 2.0” business model), rather than by the network users themselves (the hallmark of “web3”). However, when the solicitation of funds in exchange for digital assets was made to the general public without any registration or disclosure, it was quickly recognised that the supposedly commercial sale transaction was in “economic reality” more akin to a securities transaction and should, in the US at least, be treated as an “investment contract” – best understood as a constructive securities offering.
Without either regulatory or market-based constraints, the ICO market based around frothy (often fraudulent) sales of new digital assets imploded. Along the way, though, an examination of the legal nature of the digital assets, as separate from the fundraising transactions pursuant to which they were sold or distributed, was blurred or lost entirely. Instead, many regulators and other commentators asserted that “most” digital assets were themselves securities simply due to having been sold in a securities transaction. Project developers responded by ensuring that any fundraising was done in compliant “private placement” transactions. However, this left a cloud hanging over third-party users of the digital assets – persons who were many steps removed from the original investment contract transaction. Were these users, investors and dealers involved in securities transactions solely by virtue of engaging with the assets?
It is broadly recognised that most digital assets themselves do not fall within any of the main categories of assets enumerated in the definition of “security” in the US Securities Act of 1933 (Securities Act), focusing the analysis on the catch-all provision in the definition – “investment contract”. In elucidating the meaning this otherwise undefined term, the U.S. Supreme Court in the seminal case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946) found that an investment contract had to involve a contract, transaction, or scheme, placing the focus squarely on whether a given transaction would be considered a “securities” transaction (not on whether an asset would be a type of “security”). A longitudinal review we conducted across all 259 federal appellate and Supreme Court decisions following Howey confirms that the judicial focus is inevitably on transactions potentially triggering securities law compliance, not on the assets being sold (which have not otherwise been themselves considered “securities” solely by virtue of having been sold as part of an investment contract transaction).
The distinction between “transactions” and “assets” in this context would however be largely academic unless the assets sold in an investment contract transaction retained value and were transferred among persons not related to the original investment contract transaction (as is often the case with digital assets). With an apparent impasse among different regulatory bodies and with market participants, the climate for cooperation in the US has deteriorated in the last 12 months, with increasingly entrenched positions on all sides of the question of where and when securities laws should apply to secondary transactions in fungible digital assets. It is this issue that the RFIA seeks to address.
Towards codification - ancillary assets
The concept of “ancillary assets” in the RFIA allows statutory law to align better with existing Howey jurisprudence by providing a clear way of distinguishing between assets sold investment contract transactions which are not otherwise “securities”, and the transactions by which these assets are sold, which sometimes are. Focusing specifically on digital assets, the large majority of these assets currently in the market will likely be considered “ancillary assets” under the RFIA, since very few of these assets provide the holder with equity or debt-like rights in a separate “business entity” – they simply allow for instructions to be given to a network of computers.
To resolve the status of these assets, the new Section 41 of the Exchange Act introduces a presumption that ancillary assets as so defined are not “securities”. For a seller of ancillary assets (and certain of its affiliates) this presumption is conditional – for those persons to benefit from it, the seller must be in compliance with the above-mentioned tailored disclosure requirements, to the extent that they are applicable. On the other hand, persons simply using the relevant assets and not otherwise affiliated with the asset seller are provided with an unconditional presumption that the ancillary asset is not a “security”, promoting liquidity but also bringing these assets within the newly expanded jurisdiction of the US Commodities Futures Trading Commission (CFTC), which is given jurisdiction over spot markets in fungible digital assets. With a tough federal regulator (CFTC) now in charge of secondary markets in most digital assets and the SEC charged with overseeing the disclosure regime applicable to sellers of digital assets, the RFIA balances the competing policy concerns in a way that provides much enhanced protections to the market while allowing offering technologists seeking to build new projects in the US a viable path forward.
At the same time, the RFIA recognises that there is a broad design space available when digital assets are created. Where a digital asset does create (or at least purports to create) actual legal rights that can be enforced in a traditional judicial proceeding (as would be the case with equity or debt rights), then the parties would need to carefully consider whether a “security” had been created. This determination is left to existing Howey and related jurisprudence.
In addition, far from being blind to the real concerns associated with the information asymmetries that can arise between entities that create and deploy digital assets and subsequent digital asset owners, the RFIA imposes new disclosure obligations on the companies that fundraise through the “investment contract” sales of ancillary assets—even where the deemed securities offering was validly conducted as a private placement.
In this respect, if a company with jurisdictional ties to the US offers, sells, or otherwise executes investment contract transactions that provide their counterparty with an “ancillary asset”, that company will be subject to the periodic disclosure requirements targeted at the asset sold and the involvement of the seller beginning on the date that is 180 days after the first date on which the investment contract is offered, sold, or otherwise provided by the company. However, the disclosure is conditional upon there being an active trading market for the asset and the seller (or certain affiliated entities) remaining the driving force in determining the value of the relevant assets. Said differently, the disclosure obligations under the RFIA continue until the project to which the relevant assets relate is “sufficiently decentralised”. Every six months this is tested again and when the seller entities are no longer actively involved, the requirement for them to provide disclosure to the market ceases.
One online observer noted that the RFIA “elegantly deals with requiring the disclosures necessary for consumer protection, without taking the untenable position that tokens themselves are securities”. We tend to agree. By distinguishing between the contract, transaction, or scheme, and the digital asset sold, the RFIA correctly seeks to codify existing jurisprudence while balancing the real need to protect consumers through disclosure. This novel solution to a very real and expensive problem, both for companies and consumers, represents the very best of legislative thought - and we look forward to seeing its principles permeate throughout the regulatory community as the RFIA itself begins the process of becoming law.
