Principles for Clarifying SEC Jurisdiction over Cryptocurrencies and ICOs
A framework for policymakers
A framework for policymakers
One question we often get from members of Congress and staff on Capitol Hill is what exactly causes the lack of clarity in securities law when it comes to cryptocurrencies and crypto tokens, and what can be done about it. In this post we will outline the main issues and suggest how they could be clarified through legislation or perhaps through SEC guidance.
The SEC uses a flexible standard, the Howey Test, to determine whether a particular scheme qualifies as an investment contract. The application of that flexible standard to cryptocurrency-related activities is unclear and can chill innovation. Here we examine this problem from both the regulator’s and the innovators’ perspectives and offer possible solutions.
There are two subproblems to keep in mind:
The existing standard: The Howey Test. It has four prongs and all of them must be present for the scheme to be an investment contract and, therefore, a security.
(1) An investment of money in a (2) common enterprise with an (3) expectation of profits (4) reliant on the managerial or entrepreneurial efforts of a third party or promoter.
Why it is unclear: Token activities may engender these prongs to varying degrees.
Investment of money: Tokens may or may not be sold by their developers; they may emerge exclusively through mining or as a reward for participation on a decentralized computing service. Therefore there may not be an investment of money inherent in a token’s origins. However, such tokens will likely trade for money on secondary markets.
Common enterprise: The test for common enterprise could perhaps be satisfied merely by showing that there is a pro-rata distribution of profits amongst investors or common/correlated fortunes between the promoter and the investor. Most tokens and cryptocurrencies are fungible and, as such, every token-holder’s fortunes will rise and fall together. However, some courts have held that both profit sharing as well as pooling of invested money is necessary to find a common enterprise. While there is generally commonality in the returns made amongst token holders, there may not be “pooling” of invested moneys in any particular common enterprise.
If a small group of developers raises money on the promise of creating a new token-powered network, funds are self-evidently pooled between persons who will work to generate and share profits. However, in the case of established and decentralized token projects, particularly those wherein tokens have emerged only through mining, purchasers will be obtaining the token by buying them on the open market from other token holders. In this case, the seller may use those funds to enhance the value of the token network but they are certainly under no obligation to do so. By analogy, a person who has sold gold to another person is not obliged to use the sale proceeds to mine for more gold or to find more valuable uses for gold in science and industry. The cumulative investment in a decentralized token such as bitcoin is no more pooled than the cumulative investment in gold; it is diffused amongst a large industry and ecosystem composed a various unafiliated participants (e.g. market participants, developers, miners, exchanges etc.). Nonetheless, the relative importance of pooling to the test for common enterprise is uncertain. Different Circuit Courts have taken differing approaches.
Expectation of profits: Tokens may be useful for various purposes aside from investment. Tokens may be useful as a currency (e.g. for peer-to-peer payments online), as a coupon, license, or access credential to obtain a good or service (e.g. a token that allows you to store files on a decentralized cloud), or as an algorithmically granted reward for honest participation in providing goods or services to a decentralized network (e.g. tokens that are granted to miners who maintain the blockchain for the network). Therefore, tokens may be sought by those not expecting profit or by those for whom profit is a secondary concern.
However, given that most tokens are durable and transferrable peer-to-peer, they may become profitable as collectables or long term stores of value (as could be the case with gold or any other durable and scarce commodity) even if the original purpose of the token was not profit. From the standpoint of the law, it’s not clear whether it is the intent of the developers of the token that matters in determining expectation of profits (e.g. did they advertise profitability) or whether it is the intent of the users of the token that matters to determine if there is an expectation of profits. If it is the intent of the users that matters, then what is to be done in situations where some users buy as consumers (little or no expectation of profits) while others are speculating about future profits (expectation of profits)? What if it’s 80:20 of the users that expect profits, or 60:40? This is not a helpful or predictable standard.
Reliant on the managerial or entrepreneurial efforts of others: At root a token is made up of (1) software, (2) computing resources provided over the internet, and (3) any contractual obligations that may or may not exist between holders of the token and persons promoting the token. In some cases a single person or small group of persons may be relied upon exclusively to write the software, provide the computing resources, and honor any obligations toward token holders. In other cases, there may be no obligations owed to a token holder in law (e.g. holding a bitcoin does not legally entitle you to anything) and the software may be developed openly by several hundred otherwise unaffiliated persons while the computing resources are being provided by several thousand otherwise unaffiliated persons (e.g. bitcoin miners). At these extremes, the question of whether the token is a security is straightforward. Bitcoin and Ethereum have hundreds of developers and thousands of computing resource providers, and there is no contract between holders and third parties that grants any legal rights to bitcoin or ether holders. For less-decentralized projects, however, things are less clear and there may be reliance on the managerial efforts of a discrete third party.
Further complicating factors: There are no common standards for how tokens work or how they should be developed or offered to the public. Some have been sold to the general public, while others have been offered only to accredited investors. Some do not have initial sales at all (e.g. Bitcoin or Litecoin). Some have sales that occur before the token software or network resources have been developed and deployed (e.g. Filecoin or Ether). Some have sales that are ongoing after the software and network resources have been developed and deployed (e.g. Ripple).
Many tokens are traded on liquid secondary markets provided by companies known as cryptocurrency exchanges (e.g. Coinbase or Gemini). These companies are regulated as money transmitters or state-chartered trust companies, and they are subject to CFTC policing if market-manipulation or fraud are detected. However, these companies are not regulated as National Securities Exchanges or ATSs and therefore cannot legally make markets in securities.
Finally, the investment contract analysis found in the Howey case and associated case law always involves a non-security asset coupled with a contract to maintain and draw profits from that non-security asset. Coupled together, the contract and the non-security asset are an investment contract and therefore a security. In the Howey case, the asset was land in Florida and the contract was an agreement between Howey and the landowner for Howey to maintain the land and sell the fruit at market. In isolation there is no security, just a contract for farming and a deed to land. Together they are a security. If the landowner ever chose to sell the land to another purchaser, and if that new purchasers did not become the new beneficiary of the original contract with Howey or else separately negotiate a new contract, then the security ceases to exist. The new purchaser does not own an investment contract, she just owns land in Florida.
In the token context, some developers have sold a promise to develop a future decentralized token to interested purchasers in a pre-sale. Here we, again, have a combination of an asset, the token, and an agreement, the promise to make the decentralized token functional and productive. Taken together, the agreement and the token may reasonably be construed as a security under the investment contract analysis. Once the token has been delivered, however, the contract for a future token has been fulfilled (assuming performance was described as mere delivery of the decentralized token). Without an ongoing agreement to match with the token, the token, on its own, is not a security any more than the land in the Howey case is a security in the absence of Howey’s promise to develop it. This commonsense analysis, however, is not clear in existing authorities. There is little case law established on the question of what happens to assets involved in investment contracts after such contracts expire.
We need a clear and justiciable line between tokens that are securities and those that are not, and some level of amnesty and safety from liability for persons (whether issuers or exchanges) who have made or will make reasonable mistakes with respect to that line, which today is unclear.
There are two policy challenges to discuss:
We could imagine several ways to draw the line for tokens more clearly than it is currently drawn by the Howey Test. However, some approaches may be no more justiciable and certain than the existing flexible standard.
A popular mode of interpreting the line has been to call some tokens “utility” or “consumptive” tokens and thereby indicate that they are sought by purchasers for their use rather than in expectation of profits. This analysis is sensible because a prime difference between a typical security and a decentralized token is that the token provides the holder with certain abilities free of any further action from any third parties. A bitcoin allows its user to write new bitcoin transactions to the blockchain, and thus transfering money online or notarizing records. An ether allows its user to create or interact with smart contracts (self-executing agreements between persons or devices) on the Ethereum blockchain. In contrast, a share of Apple stock allows its owner to claim profits from Apple, but on its own it does nothing, it is just a paper certificate.
While the utility argument is important, it is not particularly strong or justiciable from a legal reasoning perspective. All economic goods carry some form of utility—at least subjective utility. They can all also have the potential for profits if demand rises or supply shrinks. There is no “quantum of utility” that would guarantee non-security status to any particular token; Howey is a spongy standard amenable to subjective interpretation. As the chief counsel for the SEC’s division of corporate finance recently put it, “the orange groves in Howey had utility.”
We believe it would be more fruitful to approach the line drawing question to first presume that the token is intended to be useful and decentralized (and if it isn’t, it falls out of this analysis), but then make a clearer distinction between the token itself, on the one hand, and any contractual agreements between issuers and token holders, on the other. This approach refocuses the inquiry on the “reliance on the efforts of others” prong, best addresses real investor protection concerns, and should be more justiciable.
Contract vs. Token
Draw a line between any legal agreements surrounding the token and the token itself. The agreement is potentially a security, but the token is not. Agreements may be a promise of future tokens by developers to purchasers in return for payment, or a promise that token holders will receive certain rights or benefits from the issuers in the future or on an ongoing basis.
This approach focuses on the “reliance on the efforts of others” reasoning already inherent in the Howey Test. It stresses that a security is a relationship between persons rather than a thing (the token). If the relationship includes reliance and profit expectation, then the relationship is a security. If, however, the token holder and the the original developer have no contractual relationship (i.e. they are not in privity) then the token is not an investment contract.
This approach would treat most token pre-sales as securities, as well as token-selling activities where actual promises of profits, revenue-sharing, or dividends are being made. Thus it would address the most clear examples of investor risk from which the most egregious examples of retail investor harm have emerged. It would not treat running network tokens as securities unless a third party was making actual promises of profits upon which investors were relying. Thus it would make clear that these functioning tokens are not securities irrespective of whether they were originally sold in a pre-sale agreement that qualified as a security.
Many (if not all) token pre-sales involve an obvious relationship between the seller and the buyer as well as reliance (the token hasn’t yet been developed so there is at least reliance on the seller to develop the network and make delivery of the tokens). Similarly, this relationship will be clear in situations where a token has already been developed, and certain persons are actively promising that they will undertake efforts to make profits for token holders (e.g. all token holders will get a dividend payment, all token holders will be able to liquidate their investment through us for a set minimum price).
A primary advantage of this approach is that it avoids vague hypothesizing about whether the token is sufficiently useful or sufficiently free of profit expectations. Instead of focusing on the token’s relative “functionality,” or the motivations of investors, it would focus exclusively on whether there is a discernible third party that is making promises upon which investors rely.
This line could be drawn roughly as follows:
No developer or seller of an open blockchain token shall be treated as issuer of a security unless either:
The line would then also need to be applied to exchanges as follows:
No token exchange shall be treated as an exchanger of securities unless they facilitate the trade of either:
Liability Shield Options
Similarly—whether by informal guidance, regulation, or legislation—some shelter from liability for innovators could be provided as follows:
A developer, seller, or token exchange shall be free from civil and criminal liability for violations of securities laws if they: