August 5, 2020 - This week the LSTA’s Bridget Marsh and Tess Virmani are pre-recording a presentation with members, Joe Dewey of Holland & Knight and Arleen Nand of Greenberg Traurig on “Blockchain and Smart Contracts: Theoretical or in Use” for the Minnesota Bar Association’s Business Law Institute that will air next month during their virtual conference. With more attention than ever on the automation of so many different types of contracts in financial services, the presenters focused on how this advanced technology can be used to benefit the loan market.
The financial services industry is an ideal industry for this technology because its services are rooted in a payment system, and many financial instruments lend themselves to being data-modeled and standardized. A standard model can, of course, more easily be put into code, and this includes a credit agreement under which syndicated loans are made in the loan market. Because typically only certain portions of every “smart legal agreement” can be embodied in code, elements of an agreement will remain in human prose, and this is true for the typical credit agreement. The automation of a credit agreement involves the creation of tokens or other similar digital assets representing interests in syndicated term loans – basically this token would be a string of numbers like a bank routing number. Whether these tokens as formed and traded would be considered “securities” for purposes of the definitions contained in the securities laws is a threshold issue. Although it is established that loans and interests in those loans are not generally considered securities, the question of whether digital assets that represent interests in loans would be considered securities requires additional analysis. As noted in the memo produced by Milbank for the LSTA on this point, beginning several years ago, the SEC articulated its general position toward the regulatory classification and treatment of digital assets, and in April 2019, the SEC issued its Framework for “Investment Contract” Analysis of Digital Assets. As described in the SEC Framework, any person “engaging in the offer, sale, or distribution of a digital asset” must “consider whether the U.S. federal securities laws apply,” and a threshold issue is “whether the digital asset is a ‘security’ under those laws.” Central to the SEC’s own analysis has been the test articulated by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”). The Howey test “applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities” and is meant to determine whether a particular asset or arrangement is an “investment contract” (and therefore a type of security). Under the three prong Howey test, an “investment contract” exists if there is (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits derived predominantly from the efforts of others. The tokens should not be considered securities, because (i) the hallmarks of a “security” described in the SEC Framework and as applied to the Howey test are generally not present, in either form or substance, with respect to the tokens, and (ii) the factors that would indicate that a digital asset is not a security are present. Ultimately, the question of whether digital assets such as the tokens are considered “securities” is a fact-based inquiry that depends on both the form and terms of the asset as well as the manner in which it is offered and sold. It is settled that loans and interests therein are not considered securities, and for the same reason, tokens that merely emulate traditional assignment or participation interests in loans, and that are subject to identical restrictions on transfers, should not be considered securities.