As previously discussed, in addition to the State Regulations and FinCen Rulings pertaining to Digital Assets and Cryptocurrencies, there are a host of other federal agencies with regulations that affect the industry. The Internal Revenue Service (“IRS”) determines how Digital Assets and Cryptocurrencies are taxed and the Commodity Futures Trading Commission (“CFTC”) has oversight regarding the derivatives built around Cryptocurrencies. Additionally, the Securities and Exchange Commission (“SEC”) has the authority to regulate all assets deemed a security, which can include a variety of Digital Assets depending on the characteristics of the specific asset. This article provides a high-level overview of the SEC’s stance on Cryptocurrencies, Initial Coin Offerings and Cryptocurrency Exchange Traded Funds (“ETF”).
The SEC is a federal agency that regulates the securities markets within the United States. The SEC enforces certain disclosure requirements and financial filings in the name of protection against market manipulation. Issuers of securities need to be registered with the SEC, as well as financial service firms and the professionals of those firms. The SEC has regulation over securities, and a security is generally defined as a financial instrument that holds some type of monetary value. This includes instruments such as stocks, bonds, options and investment contracts among many other instruments. More specifically in terms of Cryptocurrencies, the determination of whether a Cryptocurrency is an investment contract is critical. If the Cryptocurrency is determined to be an investment contract, and therefore a security, it is subject to SEC regulation and must either be registered or be subject to an exemption from registration.
The Howey Test and Cryptocurrency
The Howey Test is the standard to determine whether a financial instrument is an investment contract, and is therefore subject to SEC Regulation. This is a three-part test in which the Supreme Court determined that an investment contract exists when there is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others. If an asset does not meet all three prongs, it is not an investment contract, and not a security. Importantly, the SEC has stated that neither bitcoin nor ether are securities under the Howey test, but also specified that whether a digital asset is an investment contract at a particular time is unique to both the asset and the facts and circumstances at the it is being sold or resold. If the Howey Test is satisfied, then the issuance of the asset must be registered with the SEC, or be eligible for an SEC exemption.
Payment for a Cryptocurrency with either fiat currency or a different Cryptocurrency has been held to satisfy the first prong of the test. The second prong can be met in one of three ways. First, if two or more investors pool their contributions and receive profits on a pro-rata basis, there is a horizontal commonality. Second, if there is a common interest between the investor and the promoter or a third party in which all of the investor’s success is tied to the expertise of the promotor or third party, there is a vertical commonality. Third, if the investors and the promoter share in the profits, there is a narrow vertical commonality. So, if the asset, the investor funds, or the control over the asset is not held by a central entity; or there is not one person to whom the success of the asset can be tied to, the second prong of the Howey Test is not met. The third prong is the cornerstone of the Howey Test. An expectation of profit is likely when the asset gives the holder rights to share in the issuer’s income or profits, or to realize gain from the price increase of the asset. Statements by the issuers or promoters promising a return can lead to investors expecting profit as can marketing and selling the asset to members of the general public. If the increase in value of the asset is derived from the efforts of an identifiable third party, it is more likely to satisfy this prong as opposed to if the increase is from general market changes. Additionally, the activity of the developers after a digital asset is launched can be indicative as to whether the last prong of the Howey Test is met. Therefore, when the developers need to play a crucial role post launch in the maintenance and growth of the digital asset, it is much more likely to satisfy the last prong. On the other hand, generally the success of a purchase of a commodity depends on the general market changes, not on the efforts of an individual and will not satisfy the last prong.
An example of a cryptocurrency that does not meet the Howey Test and is not a security is bitcoin. Purchasing bitcoin definitely satisfies the first prong of the Howey Test, because it is an investor giving money for the asset, bitcoin. However, the second and third prongs of the Howey Test are not satisfied by the purchase of bitcoin. Bitcoin does not have a horizontal commonality because each investor acts on their own accord when purchasing bitcoin, there is not a pooling of funds among the investors. Additionally, bitcoin does not have a vertical commonality because there is no promoter or third party who controls the investor’s success when dealing with the purchase of bitcoin. The third prong is not satisfied because the success of an investor who purchases bitcoin is tied to the market price of bitcoin, and not the efforts of others. Accordingly, bitcoin does not satisfy the Howey Test because there is no common enterprise that all the investors are pooling their funds into, there is no promoter or issuer, and the success of the investor does not depend on the efforts of others.
As previously stated, a digital asset can have its status as an investment contract change over time. For instance, when ether (the token for Ethereum) was first launched, there was an investment of money (an investor purchased ether with bitcoin), in a common enterprise (all of the ether was sold from one entity, ethereum.org), with a reasonable expectation of profit (the set price of ether from the pre-sale increased after the first two weeks it was available for purchase), and the expectation of profits could be said to have been dependent on others (the investors were trusting the Ethereum developers to use the bitcoin to develop Ethereum). Therefore, it could be argued that ether satisfied the Howey Test when it was first launched. However, over time ether was no longer sold via an entity but rather was obtained via mining, in a manner similar to bitcoin. Recognizing the change in the Ethereum network, in 2018 William Hinman (at the time the Director of the Division of Corporation Finance for the SEC) stated that notwithstanding the fundraising that accompanied ether, based on the current state of ether, the Ethereum network and its decentralized structure, current offers and sales of ether are not securities transactions. Clearly, the changes a cryptocurrency undergoes throughout its lifetime can change its classification as a security. There is speculation as to whether Ethereum 2.0 will be classified as a security given that Ethereum is changing from a mining system to a staking system, but as of this writing there has been no definitive statement one way or the other by the SEC.
Cryptocurrency and The Howey Test
|1. An investment of money
||Payment of fiat or digital currency for an asset
||Buying a digital coin with US Dollars
|2. In a common enterprise
· Investors pooling assets for pro-rata profits
· Common interest between the investors and promoters
· Investor and promoter share in the profits
· A company is raising funds via the sale of a digital coin
· Both want the digital coin to increase in value
· Both receive profit from the performance of the company
|3. With a reasonable expectation of profit derived from the efforts of others
||Asset grants the holder the right to share in the issuer’s income or profits, or realize gain from the price increase of the asset
||The purchasers of a coin reasonably believed that the coins would increase in value based on the issuer’s efforts
Initial Coin Offerings
An Initial Coin Offering (“ICOs”) is a method a company can use to raise funds. The coin itself can represent a stake in the company or specific project, or may have some utility in using the product or service the company is offering. The SEC has classified that ICOs can be considered an investment contract, and therefore a security, because the tokens being offered can represent an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The SEC has found that the common enterprise aspect typically exists in the case of digital assets generally, as does the investment of money in a common enterprise. If the ICO promoter is responsible for the ongoing development, operation and promotion, there is a higher likelihood of finding the ICO as a security. Another factor indicative of an ICO being a security is if the promoter controls the creation or issuance of the coin, or acts to limit the supply to support the price. Notable examples of the SEC pursuing unregistered ICOs include actions against Ripple Labs Inc. (XRP), Telegram Group Inc., and Kik Interactive Inc. in addition to 73 other actions against various individuals or entities since 2013.
An ETF is a type of security that tracks an index or an asset and can be bought or sold on a stock exchange just like any other stock, and as a security, the SEC has the ability to regulate ETFs. In the last few months, there has been growing speculation as to whether or when the SEC will approve a Cryptocurrency ETF, mainly a Bitcoin ETF. As of this writing, there have been over a dozen applications submitted the SEC for a Bitcoin ETF including applications by Fidelity, VanEck, ARK Invest, SkyBridge Capital, Valkyrie and NYDIG among others. There have also been a few Ethereum ETF applications submitted. Additionally, in foreign countries such as Canada, ETFs for Bitcoin and Ethereum have already been approved and are actively trading. In a 2018 staff letter, the SEC stated that there were a number of investor protection issues precluding the approval of a Cryptocurrency ETF including the valuation of the ETF’s assets, the liquidity of the ETF’s assets, the custody of the ETF’s assets, arbitrage between the ETF price and its net asset value, and potential manipulation. However, Hester Peirce, an SEC commissioner, has stated that the prior rationale for not approving a Bitcoin ETF keeps getting weaker and that if the same standards were applied to Bitcoin ETFs as other products, at least one Bitcoin ETF would have already been approved. One concern that Gary Gensler, the SEC Chairman, has voiced is that none of the exchanges where Cryptocurrencies are traded are regulated by the SEC. In any event, a SEC ruling is expected to happen this year on one or more of the Bitcoin ETF applications, although the anticipated decision dates have been delayed numerous times. For example, the VanEck Bitcoin ETF has had its decision date delayed once in April and again a second time in June.
The rules determining whether an asset is a security, and therefore subject to SEC regulation, are extremely technical and very fact specific. This rings even truer in an emerging industry like Cryptocurrency. If you are considering pursuing an opportunity in Cryptocurrency, you should make sure to determine whether you will need to register with the SEC or if you qualify for an exemption from registration. If you are required to register with the SEC, and fail to do so, an ensuing action by the SEC can be very problematic and costly. These regulations and the SEC’s stance on Cryptocurrencies are subject to changes, specifically regarding whether it will approve an ETF. In fact, just this week Chairman Gensler spoke about regulation regarding digital tokens, Cryptocurrency trading platforms, and a Bitcoin ETF among other aspects.