Blockchain technology, a revolutionary innovation that enables peer-to-peer transactions without the need for an intermediary, has significantly transformed the financial landscape. Amidst this transformation, a critical question that often surfaces is whether a cryptocurrency falls under the purview of securities law.
When a cryptocurrency is classified as a security, it comes under the regulatory oversight of the Securities and Exchange Commission (SEC) in the United States, or equivalent bodies in other jurisdictions. This implies that the issuance, distribution, and trading of such a cryptocurrency must adhere to securities laws and regulations. Such a classification can significantly impact the cryptocurrency’s market dynamics and the conduct of its stakeholders.
By learning “Howey” you can “Reves” the “Tea Leaves” whether a given cryptocurrency falls under the definition of securities regulation, you can navigate the complex landscape of cryptocurrency investments with greater confidence and understanding, make more informed decisions, and better anticipate the potential legal and regulatory implications.
This article will explore the anatomy of a security in both traditional finance and cryptocurrency, learn from past case studies, compare different cryptocurrencies, discuss the consequences of being classified as a security, and examine the current landscape of crypto regulation.
The Short Answer
Anything can fall under the definition of a security, but it depends on various factors, including the nature of the digital asset, its intended use, and the economic reality surrounding its issuance and distribution.
Why is it so un-clear for crypto?
Decentralization as it applies to centralized laws and regulation, is really a contradiction.
Unrestricted access to capital + lack of new regulations = perfect storm for regulators.
The traditional means for raising capital has always involved some form of centralized component, whether it be through banks, investment firms, or regulatory bodies. With blockchain technology, anyone with a computer around the world has access to participate in the open market directly, without intervention.
Without comprehensive regulation guiding this new era of unrestricted access to capital, centralized governments are simply outnumbered in trying to regulate the tens if not hundreds of thousands of cases.
The Anatomy of a Security
Securities, in their essence, are financial instruments that hold monetary value. They are the building blocks of our financial system, underpinned by a complex web of regulations and legal precedents. From the birth of these regulations to the modern-day challenges posed by cryptocurrencies, the concept of a security has evolved and adapted. Understanding this evolution requires a deep dive into the criteria that define a security, the role of regulatory bodies, and the influence of landmark legal cases.
The Genesis of US Regulations
The regulatory landscape for securities in the United States was largely shaped by the fallout from the stock market crash of 1929 and the ensuing Great Depression. In response to these events, the U.S. Congress passed The Securities Act of 1933, Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence by increasing transparency in the financial markets and reducing the potential for fraudulent activities. They established a regulatory framework for securities, requiring companies to disclose vital financial information while prohibiting insider trading, market manipulation, and unfair practices that could compromise the integrity of the open market.
The Criteria for Classifying an Asset as a Security
The criteria for classifying an asset as a security are primarily based on the definition provided in the Securities Act of 1933. According to the Act, a security includes a wide range of financial instruments, such as notes, stocks, bonds, and investment contracts. An asset is considered a security if it is an investment in a common enterprise with the expectation of profit derived primarily from the efforts of others. This definition is broad and flexible, allowing it to encompass a wide range of financial instruments, including potentially some types of cryptocurrencies.
The Howey Test
The Howey Test is a critical tool for classifying assets as securities. It was established in the landmark Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which outlines the standard for an investment contract.
Under Howey, an investment contract is generally characterized by:
- an investment of money,
- refers to the commitment of financial resources in return for a financial interest.
- in a common enterprise,
- where the investors’ assets are pooled and the fortunes of each investor are tied to the fortunes of other investors, as well as to the success of the overall enterprise.
- with a reasonable expectation of profit from the efforts of others.
- examines whether the economic reality surrounding the sales led the buyer to have “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
Reves Test and Its Relevance to Cryptocurrencies
The Reves Test, also known as the “family resemblance test,” is another crucial legal framework used to determine whether a financial instrument is considered a security. This test, which originated from the Supreme Court case Reves v. Ernst & Young, 494 U.S. 56 (1990), is often applied when the instrument in question does not clearly fit the definition of a traditional security.
In the context of cryptocurrencies, the Reves Test can provide additional insights beyond the Howey Test. While the Howey Test focuses on investment contracts, the Reves Test is more concerned with notes, a broader category of financial instruments. It examines several factors, including the motivations of the buyer and seller, the plan of distribution, the reasonable expectations of the investing public, and whether some factor such as another regulatory scheme significantly reduces the risk of the instrument.
The Reves Test is particularly relevant to crypto regulation because it reflects the broad and flexible interpretation of the term “security” in U.S. law. As stated in Reves v. Ernst & Young, courts view the term “security” in sufficiently broad and general terms to include many types of instruments that fall within the ordinary concept of a security. This broad interpretation allows the test to accommodate the unique and innovative characteristics of cryptocurrencies.
a cryptocurrency is deemed a note under the Reves Test, it could be subject to additional regulatory requirements and restrictions. This could impact its market dynamics, investor base, and the legal obligations of the entities involved in its issuance and distribution.
Learning from the Past – Case Studies and Implications
As we’ve seen, the classification of a cryptocurrency as a security hinge on various factors, including the nature of the cryptocurrency, its intended use, and the economic reality surrounding its issuance and distribution. The Howey Test has been a main indicator to determine whether a particular asset qualifies as a security. Now, let’s delve into some case studies to see how these legal considerations have been applied in real-world scenarios involving cryptocurrencies.
Case Study 1: SEC v. Telegram Group Inc.
In 2018, Telegram raised $1.7 billion through private placements of investment contracts under an exemption from registration under Regulation D of the Securities Act of 1933. This was in return for the promise to deliver 2.9 billion Grams once it had developed and launched the TON network. The SEC sought to block the distribution of the Grams to Initial Purchasers on the ground that it was anticipated that upon distribution, the Initial Purchasers would act as “underwriters” and resell the Grams into a secondary public market in an unregistered offering of securities.
The court examined the Gram purchase agreements, anticipated distribution to Initial Purchasers, and the presumptive resale of the Grams by the Initial Purchasers as a single, aggregate transaction and distribution rather than independent transactions. The court did not find the Grams themselves or the Gram purchase agreements standing alone to be securities. Instead, it concluded that the entire pre-sale scheme as a whole, including the Gram purchase agreements and the accompanying understandings and undertakings made by Telegram, were securities.
The SEC v. Telegram Group Inc. case has significantly shaped the legal understanding of cryptocurrencies as securities. It has shown that the Howey Test, despite its age, can be a flexible and relevant tool for classifying cryptocurrencies. However, it has also highlighted the challenges and complexities involved in applying this test to digital assets.
Case Study 2: SEC v. LBRY, Inc.
The SEC v. LBRY, Inc. case is another significant case in the realm of cryptocurrency and securities law. The SEC alleged that LBRY, a blockchain-based video-sharing platform, had offered and sold “LBRY Credit” (LBC) coins that constituted unregistered securities, violating the registration provisions of Sections 5(a) and 5(c) of the Securities Act of 1933. LBRY had not used an Initial Coin Offering (ICO) to launch its tokens, which marked a departure from the common practice in previous cases.
It is also the first time that a federal court has held that a digital asset sold without an ICO is a security. This development is consistent with the view of SEC Chairman Gary Gensler, who has unequivocally stated on many occasions that he believes the vast majority of digital asset tokens are securities.
Case Study 3: The SEC vs. Ripple Labs (XRP as a Security)
The SEC v. Ripple Labs case is the latest and arguably the most impactful of the three. The SEC alleged that Ripple Labs and two of its executives conducted an unregistered offering of securities via the sale of XRP, a digital token. The Howey Test was once again employed to ascertain if Ripple’s two primary categories of unregistered XRP offers and sales were securities:
- Institutional Sales: These are sales under written contracts, from which Ripple received $728 million.
- Programmatic Sales: These are sales on digital asset exchanges, from which Ripple received $757 million.
In a departure from previous cases, Judge Analisa Torres of the U.S. District Court for the Southern District of New York ruled that the XRP digital token itself did not constitute a security. Instead, she examined the specific facts and circumstances surrounding the sale of the tokens.
Her findings were as follows:
Institutional Sales of XRP were deemed unregistered securities transactions. Under the Howey Test:
- Investment of Money: The Court determined that these sophisticated individuals and entities invested money by providing capital to Ripple in exchange for XRP.
- Common Enterprise: The Court found that a common enterprise existed between Ripple and the institutional investors. Ripple pooled the proceeds from Institutional Sales, and each institutional investor’s ability to profit was tied to the profitability of other institutional investors, as they all received the same fungible XRP.
- Reasonable Expectation of Profit from the Efforts of Others: Based on the totality of circumstances, the Court found that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts.
Programmatic Sales and Other Distributions of XRP were not deemed securities. The Court concluded that the undisputed record did not establish the third prong of the Howey Test:
- Reasonable Expectation of Profit from the Efforts of Others: Some Programmatic Buyers may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts. However, the inquiry is an objective one, focusing on the promises and offers made to investors, not the precise motivation of each individual participant. In the case of Programmatic Sales, Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it.
The SEC v. Telegram Group Inc., SEC v. LBRY, Inc., and SEC v. Ripple Labs cases have significantly shaped the legal understanding of cryptocurrencies as securities. They have shown that the Howey Test, despite its age, can be a flexible and effective tool for classifying cryptocurrencies. However, they have also highlighted the challenges and complexities involved in applying this test to digital assets.
Bitcoin and Ethereum
In this section, we delve into a comparative analysis of Bitcoin, Ethereum, and other cryptocurrencies, focusing on their classification in relation to securities law. We explore the unique characteristics of each cryptocurrency, their inherent value, and the regulatory perspectives surrounding them. Understanding these aspects is crucial in the broader context of the evolving legal landscape for cryptocurrencies.
Bitcoin
In 2008, following the financial crisis that caused many people to lose trust in traditional banks, a mysterious individual or group known as Satoshi Nakamoto created a digital currency that could be used without the need for a bank or other intermediary.
Given its nature and use as a medium of exchange, Bitcoin is generally not considered a security. It does not represent an investment in a common enterprise, nor is there an expectation of profit derived from the efforts of others, which are key criteria of the Howey Test. Instead, the value of Bitcoin is derived from its utility as a currency and a medium of exchange. The SEC has also publicly stated that it does not consider Bitcoin to be a security.
Applying the Howey Test to Bitcoin:
✔ Investment of Money: Bitcoin, like LBRY, Telegrams, and XRP, can be purchased with money. However, Bitcoin itself was not issued through an ICO or similar fundraising event.
❌ Common Enterprise: Bitcoin does not have a common enterprise. It is decentralized, and no single entity controls its supply or distribution. This contrasts with LBRY, Telegrams, and XRP, which were all issued by specific companies.
❌ Reasonable Expectation of Profit: While people may buy Bitcoin with the hope that its value will increase this expectation is not based on the efforts of a centralized entity or group. This is different from the cases of LBRY, Telegrams, and XRP, where the value of the tokens was tied to the efforts of the issuing companies.
❌ Efforts of Others: The value of Bitcoin does not depend on the managerial or entrepreneurial efforts of a centralized entity. Bitcoin operates on a decentralized network, and its value is determined by supply and demand dynamics in the market.
Bitcoin’s value is primarily derived from its utility as a currency and a medium of exchange, not from the managerial or entrepreneurial efforts of others. Therefore, Bitcoin does not meet this prong of the Howey Test.
Ethereum
Ethereum, the second-largest cryptocurrency by market capitalization, has also been the subject of scrutiny. Ethereum is an open-source, blockchain-based platform that enables developers to build and deploy decentralized applications (dApps). Its native cryptocurrency, Ether, is used primarily to facilitate and monetize the operation of these applications.
As of July, 2023, there is no court ruling determination for whether Ethereum does, or does not, fall under the definition of a security. However, when classifying the type of asset Ethereum is, and whether securities law applies, much like the past cases, the court will look at various factors, including the nature of the digital asset, its intended use, and the economic reality surrounding its issuance and distribution.
Applying the Howey Test to Ethereum:
✔ Investment of Money: Yes, people purchase Ether with money.
❓ Common Enterprise: This is a bit more complex. Ethereum is decentralized, and while the Ethereum Foundation does exist, it doesn’t have the same level of control over Ethereum as Ripple has over XRP or Telegram had over Grams. This could potentially argue against Ethereum being a common enterprise.
✔ Expectation of Profits: Many people buy Ether with the hope that it will increase in value, which could be seen as an expectation of profits. However, the expectation of profit alone is not enough to classify something as a security.
❓ Derived from the Efforts of Others: This is another complex point. While the Ethereum Foundation and other developers do work on the Ethereum platform, it’s also true that Ethereum is powered by a decentralized network of miners (and, as of Ethereum 2.0, validators). This decentralization could potentially argue against the idea that any profits from Ethereum are derived from the efforts of a central party.
The cryptocurrency landscape extends far beyond Bitcoin and Ethereum. There are thousands of other cryptocurrencies, often referred to as altcoins, each with its unique features and uses. Some of these altcoins, like Litecoin and Bitcoin Cash, function primarily as digital currencies. Others, like Binance Coin and Uniswap, are associated with specific platforms or services.
Whether these altcoins, meme coins, and NFTs can be classified as securities depends on their specific characteristics and use cases. If they meet the criteria of the Howey Test or other relevant legal tests, they could potentially be classified as securities and subject to corresponding regulations.Regulatory Implications of Cryptocurrency Classification
It is important to remember, the classification of cryptocurrencies as securities affects who can access a token, but not what they can do with it. The regulatory landscape surrounding cryptocurrencies is complex and multifaceted, with the classification of a cryptocurrency as a security playing a pivotal role in shaping its market dynamics and accessibility.
Securities Regulation and Investor Access
When a cryptocurrency is classified as a security, it falls under the regulatory purview of bodies like the SEC in the United States. This means that the issuance, distribution, and trading of such a cryptocurrency must comply with securities laws and regulations. These laws are designed to protect investors, ensuring transparency and fairness in the markets. As a result, the classification can influence who can access the token. For instance, certain securities can only be sold to accredited investors, which are individuals or entities that meet specific income or net worth criteria.
Token Utility and Investor Activity
However, the classification does not dictate what investors can do with the token once they have acquired it. Investors can still use the token in ways consistent with its design and purpose, whether that’s as a medium of exchange, a store of value, or a utility token within a specific platform or ecosystem. The classification as a security primarily impacts the token’s initial distribution and ongoing trading, rather than its utility or functionality.
Balancing Innovation and Investor Protection
This distinction is crucial to understanding the implications of the security classification. While it can impose certain restrictions and obligations, it does not fundamentally alter the nature or potential uses of the cryptocurrency. Instead, it provides a regulatory framework that seeks to balance the innovative potential of cryptocurrencies with the need for investor protection and market integrity.
As we’ve seen in the case studies of Telegram Group Inc., LBRY, Inc., and Ripple Labs, the application of the Howey Test and the classification of cryptocurrencies as securities can be complex and context-dependent. Each case presents unique circumstances and challenges, underscoring the need for a nuanced and flexible approach to regulation. As the cryptocurrency landscape continues to evolve, so too will the legal and regulatory frameworks that govern it.
Recap
In this article, we’ve journeyed through the intricate world of cryptocurrencies and their potential classification as securities. We’ve navigated the legal and regulatory terrain, dissected the role of the SEC, and analyzed the impact of pivotal court cases. We’ve scrutinized key case studies, including the SEC’s actions against Telegram Group Inc., LBRY, Inc., and Ripple Labs, and compared the status of prominent cryptocurrencies like Bitcoin and Ethereum.
This is a thrilling era, akin to standing shoulder-to-shoulder with a young Google, Apple, or Amazon. Yet, it’s vital to remember the due diligence and caution required when engaging with speculative assets. Those involved in cryptocurrency activities should seek appropriate legal counsel and stay abreast of ongoing developments in this dynamic field.
