INTRODUCTION
This article is the sixth in a series that explains how the SEC has structured a campaign to suppress and eradicate cryptocurrency and digital tokens, why the SEC lacks jurisdiction over creators of cryptocurrencies and digital tokens, and how best to challenge these actions.
In 2018, the Securities and Exchange Commission (SEC) proclaimed that a cryptocurrency is a “security” under the Securities Act of 1933 (Securities Act) and must, therefore, be registered under the Securities Act before it is offered or sold to the public.[1] Its program of enforcing the registration provisions of the Securities Act is ostensibly intended to encourage and compel compliance with these rules, but although registering units of a security is not complex or necessarily expensive, no cryptocurrency producer has registered — or, perhaps more appropriately, succeeded in registering — its cryptocurrency coins or tokens with the SEC’s Division of Corporation Finance.[2] This so-called non-compliance has engendered numerous SEC civil enforcement actions and enabled the Agency to shut down non-fraudulent cryptocurrency producers and cause their coins to become near-worthless.
In the almost-five years since its 2018 pronouncement, the SEC has neither disclosed the number of cryptocurrency producers that have attempted but failed to have their cryptocurrency coins registered, nor has it discussed why these efforts failed. Relatedly, the Commission has not offered any public guidance about how cryptocurrency producers can register their coins or tokens as securities under the Securities Act.
The problem is obvious: cryptocurrency producers cannot register their tokens because they are not securities and cannot be accounted for as such. While the characterization of digital tokens as investment contracts enables the SEC’s Division of Enforcement to bring shut-down lawsuits, the correct financial accounting for these items makes registration with its Division of Corporation Finance impossible. In other words, the SEC’s enforcement program is predicated on impossible compliance with the statute it claims to be enforcing.
SECURITIES ACT REGISTRATION REQUIRES A BALANCE SHEET
Registration of securities is not a unilateral or one-way process. A company that seeks to register a given number or currency amount of securities prepares and files a proposed registration statement, which includes the prospectus, and the SEC’s Division of Corporation Finance makes comments on that statement. If and only if the company complies with those comments will the Division of Corporation Finance allow the offering to become “effective,” which is the only basis on which the company does not risk having the Division of Enforcement bring a legal action for violating the registration provisions.
A BALANCE SHEET INCLUDES ASSETS AND CLAIMS AGAINST ASSETS
Among the items required in the prospectus are the company’s financial statements, one of the most important being the balance sheet. A balance sheet shows the financial “position” of the company at a given point in time, and it has two key parts: the assets, and what can be characterized as the claims against those assets. If the balance sheet is laid out horizontally, the assets are on the left side and claims against assets are on the right side.
The assets include a list of classes of assets with their fair values and include product inventory, cash and receivables (mostly, contract-based rights) obtained from operations (sales), investment disposals, and financing transactions. The claims against those assets lists the company’s classes or specific instances of liabilities (or debt) and equity (or ownership)[3] and arise from different sources: debt claims arise from contracts between the company and lenders and creditors, while equity or ownership claims arise from state law (typically, the state’s business corporation law).
The total value of the listed assets must equal (or balance) the total value of the listed claims against them, as reflected in the classic accounting equation: assets equal liabilities and equity. In effect, all of a company’s assets (as a pool of assets) must be ultimately owned by and allocable to the claimants of those assets. The “securities” must be among the claims against assets because the assets, which are on the other side of the balance sheet, “secure” the claims against those assets. While all ownership (equity) claims are securities, not all liabilities (such as credit obligations to suppliers) are debt securities.
CLAIMS AGAINST ASSETS ARISE FROM SALES OF FINANCING ITEMS
So, how do securities end upon the right side of a company’s horizontal balance sheet? They get added into the balance sheet because the company sells financing items that provide the buyer with claims against the company’s assets. A company’s sales transactions fall under one of three types of activities: operating activities, investing activities, and financing activities. Operating sales transactions are sales of goods (from inventory) and services, and investing sales transactions are dispositions of investments, such as property and equipment not sold as part of the company’s operations. Operating sales convert inventory assets into cash or receivables, and sales of investments convert such investments into cash or receivables, with any differences being earnings or losses or gains or losses. These transactions do not change the list of claimants on the right side of the balance sheet, only the values of the (typically equity) claims against those assets.
In financing sales transactions,[4] however, the company sells only claims against its assets for cash or other property. The buyer of the financing item (the security) performs under the contract by paying and the selling company gives the buyer promise to pay, in the case of debt, and rights against the assets, in the case of debt or equity. These are the security-holders’ claims against the company’s assets.
Accounting for any given transaction requires the following considerations (1) the contract is the key element of a transaction;[5] (2) the seller’s performance obligations in a contract determine the type of transaction the sale represents; (3) the type of sales transaction determines the accounting treatment; and (4) the accounting treatment determines where the item and its value appear on the balance sheet. Thus, what the buyer gets for his or her payment determines whether the sale is of a financing item or not. If the buyer gets no future rights or claims against the seller-company’s assets, whether based on a promise or otherwise, then the item sold, regardless of its tangibility or concreteness, cannot be a security and cannot appear on the right side of the balance sheet. In short, all securities, no matter what their characterization, originate by means of financing transactions and must appear on the claims side of the balance sheet or they are not securities and are incapable of being registered as such.
DIGITAL TOKENS PROVIDE NO CLAIMS AGAINST ASSETS
Cryptocurrency tokens typically[6] cannot be included in the “claims against assets” portion of the balance sheet. In other words, they cannot “be” securities and cannot “be registered” as securities. This has to do with the terms of the sales transaction, which determines whether the item sold is a good (from inventory) or service, in which case the sale is an operating activity and the asset received characterized as revenue. Cryptocurrency tokens or coins generally are accounted for as assets on the token-producer's balance sheet because the cryptocurrency-producer sells the tokens from inventory and in operating transactions, not as financing instruments in financing transactions and because the token-sales contracts create no obligations for the token-producer and give no claims to token-purchasers against the producer’s assets. The fact that token-producers may use proceeds from token sales to create or build out their blockchain “infrastructures” or produce more tokens does not transform the token-producer’s operating transaction into a financing transaction that gives the token-purchaser or subsequent token-holders rights or claims against the token-producer.
Similarly, a token-purchaser’s decision to treat the token as an investment does not transform a digital token into a security. Not all investments are securities; for example, collectibles such as baseball cards or antique autos do not become securities because purchasers have decided to treat them as investments. Unlike a security, in which the issuer has continuing obligations to the purchaser and subsequent holders as a function of state corporation law, neither the painter of a painting, the manufacturer of a collectible automobile, nor the printer of baseball cards has ongoing obligations to the purchaser and subsequent owners of the item sold.[7] Neither the painter, manufacturer, nor printer has any obligation to pay the new owner of their product principal and interest, as if the product were a debt security, nor does the sale of the collectible item give the new owner any rights of ownership over the painter, manufacturer, or printer. The purchaser can use the investment-worthy object for its intended purpose or may realize a profit if, and only if, another collector is willing to pay more for that object than they originally paid to obtain it.
In contrast, the purchaser or holder of a security can realize profit directly from the creator of the security — the issuer — which is obligated to pay principal and interest on debt securities and, if dividends are declared, to pay out dividends to stockholders. If dividends are not declared, the stockholders own the increase in the net value of the company in the form of retained earnings, which can result in an increase of the overall value of the company and the stockholder’s ownership piece of that company.
“COMPLIANCE” REQUIRES A DIFFERENT SALES TRANSACTION
When the SEC’s Division of Corporation Finance reviews the financial statements, the Staff notes that cryptocurrency coins or tokens, which the SEC calls cryptocurrency “assets,” appear on the Assets side of the balance sheet, in compliance with GAAP, and not on the right side of the balance sheet as securities. The Staff must reject—as it no doubt has done non-publicly—any attempt to register the inventory, regardless of its intangibility, as securities.
In order to “comply” with the securities registration requirements of the Securities Act, the company must retrospectively grant the buyer claims against its assets and thereby recast closed transactions and re-characterize the sales transaction not as an operating sales transaction, which is what it was or is, but as a financing sales transaction. The effect is that the SEC has assumed the role of both the Congress and the President and enacted a law that prohibits sales of digital items that do not provide buyers with rights against the seller’s assets. This is not a securities law but a rule that outlaws the sale of non-security digital items.
A great example of this perversion of securities law involved the cryptocurrency company, Enigma MPC, Inc. (“Enigma”), which registered ENG Tokens[8] under section 12(g) of the Securities Exchange Act of 1934 (“Exchange Act”) as part of its February 2020 settlement of an SEC enforcement action.[9] Enigma had offered and sold its ENG Tokens in an initial coin offering without registering those particular tokens under the Securities Act, and agreed to register the class of tokens as “debt securities.” In order to do this, the SEC required that Enigma provide token-buyers with new, previously non-existent claims against Enigma’s assets. This effectively modified the terms of the contracts of sale and thereby forced Enigma to transform operating sales transactions into financing sales transactions, as evidenced by Enigma’s balance sheet and notes 1B and 6 to the financial statements:
In the claims-against-assets portion of Enigma’s balance sheet, we see that Enigma shows total liabilities of approximately $26.4 million, of which about $24.9 million are “ENG Token Liability.”[10] Note 1B accompanying this line item states that Enigma had “agreed to administer a claims process available to those who purchased ENG Tokens before and up to September 11, 2017.”
The process is perverse: the SEC claimed that the ENG Tokens were securities, even though they were sold like any other product—without the seller having any future performance obligations and without the buyer having any claims against Enigma’s assets—and in settlement and as required for registration, the SEC compelled Enigma to transform the ENG tokens from products that had been sold without ongoing obligations to the purchaser into new debt securities that appear in the claims-against assets portion of the balance sheet and require Enigma, now a “debtor,” to repay principal and interest less income received by the buyer.
In sum, with Enigma the SEC unilaterally outlawed a commercial product sale and compelled the product’s seller to ex post facto restructure the sales transaction as a financing transaction—a securities issuance—requiring new and different accounting to reflect this alternative, SEC-imposed, state of affairs. Only after changing the nature of the transaction could it then be submitted for registration as a security. This is an unprecedented and unlawful interference by the SEC into the substantive business of a non-regulated entity.
KRYPTEX: A HYPOTHETICAL COIN-PRODUCER
Let’s consider Kryptex Corporation, a company formed to become a cryptocurrency producer. It has one owner who capitalizes the company with $300,000 in cash, and one lender who loans the company $100,000. Kryptex’s balance sheet is as follows:
The company’s two financing transactions provide $400,000 of cash, which is reflected in the assets. Assume that Kryptex contracts with Mintcoin, Inc. to create a cryptocurrency called Kryptones (K1S) to be built on a blockchain. The blockchain will record all transfers of the coins, which are intangible, from one holder to another. Mintcoin agrees to develop a limited number of cryptocurrency coins for $200,000.
When Kryptex pays Mintcoin in cash, the $200,000 in production costs will be capitalized as shown below. This causes no net change to the total values on the balance sheet: the claims side of the balance sheet does not change at all, and the assets side changes only in the form or composition of the specific assets. Cash will be reduced by $200,000, replaced by digital tokens in Kryptex’s assets, valued at their production cost of $200,000.
The K1S form Kryptex’s inventory of digital tokens and are properly located on the Assets side of the balance sheet. Assuming that the public price (the price a willing buyer would pay) of each token exceeds the cost per token, a sale will generate a profit per token. The contracts by which tokens are sold are completed upon the purchaser’s payment for and Kryptex’s delivery of the tokens. As the inventory of tokens is sold, the sales price per token will more than offset the cost per token (cost of goods sold) and total Assets will increase. On the claims side of the balance sheet, the increase in assets is reflected as earnings — not new securities — under equity, which is owned by Kryptex’s stockholders, not the buyers of its products.
The sold tokens do not create debt obligations for Kryptex and do not increase Kryptex’s total liabilities. Unless otherwise set out in the offering document, these tokens also do not give purchasers any ownership rights in Krtyptex: the equity portion of the company’s balance sheet will increase only as a consequence of the net income (undistributed) that the token sales generate, and that increase will benefit Kryptex’s sole shareholder.
K1S CANNOT BE INVESTMENT CONTRACTS
Assume that the SEC’s Enforcement division learns of Kryptex’s Initial Coin Offering (ICO), investigates the Company, and brings a civil action alleging that: (1) KIS are securities (investment contracts) under the Securities Act; (2) K1S should have been registered with the SEC before being offered or sold; (3) Kryptex and its owner did not register the KIS; and (4) Kryptex and its owner therefore violated section 5 of the Securities Act.[11] Implicit in the second allegation that Kryptex should have registered K1S as securities is that K1S could have been registered as securities. If they could not have been registered as securities, then K1S cannot be securities, and if K1S are not securities, the SEC has no jurisdiction to file a civil enforcement action under the Securities Act.
Sales of K1S are not investment contracts but are solely sales contracts.[12] In a sales contract, the seller agrees to deliver a product (seller’s performance) and the buyer agrees to pay for the product (buyer’s performance). When the buyer pays and the seller delivers, the transaction closes. This is the case with the digital token sale and purchase: Krytpex sells the K1S token, and the buyer pays for it. Once the K1S is delivered into the buyer’s wallet, the transaction closes, and the relationship ceases. The purchaser buys the K1S, and that token is the only item with potential or actual value to the purchaser. That value, in turn, depends solely on the willingness of someone else to pay for K1S or accept it as payment, not on the financial position or performance of Kryptex’s business.
The sale of a security has two contracts: a sales contract, such as a subscription agreement, and the investment contract, which is the security. In the sales contract, a buyer pays for the security and the company issues and delivers the security to the buyer. When the sales contract closes, the investment contract begins and obligations under that contract continue until either the debt instrument (if the investment contract is a debt instrument) is paid off or the company (if the investment contract confers equity ownership rights) dissolves. A security imposes on the issuer continuing obligations to perform for the buyer-holder of the security and the company’s assets, against which the security-holder has claims, secure those obligations.
The purchaser of a bond or share of stock may receive a certificate evidencing ownership of the bond or stock, but the value of the bond or stock depends on the status and performance of the issuer, specifically, on its profitability and inclination to honor its financial obligations to its security holders and the value of the assets against which the security holder has claims. These claims are securities because, as claims against the assets, the assets secure them. None of this represents what happens in the typical cryptocurrency transaction.
CONCLUSION
The sales contract determines what rights and claims, if any, a token-purchaser has against the token-producer. Unless the producer promises to pay the purchase price back to the purchaser or give the purchaser an ownership interest in the producer’s enterprise, no investment contract or other type of security is created. States will charge the corporations they create for increases in the authorized number of shares of stock that can be issued, but cryptocurrency tokens — which are not shares of stock — do not require such payments, as the tokens do not provide ownership interests. If the SEC is going to impute terms into the contracts by which tokens are sold and characterize those contracts as “fund-raising” arrangements, then it is impossible to distinguish financing from operating transactions.[13]
The cryptocurrency token is no different from any other object of potential value, such as a painting, the value of which is not dependent on the painter’s financial position or operations: the painter’s financial statements will not show the receipt of payment on the claims-against-assets side of the painter’s balance sheet, and those financial statements are irrelevant to the value of the painting. So it is with cryptocurrencies, which would explain why they cannot be registered and why “non-compliance” by cryptocurrency producers has nothing to do with the SEC’s “enforcement” of registration requirements on non-securities.
[1] Section 6 of the Securities Act, codified at 15 U.S.C. § 77f, describes the registration process. Section 5 (15 U.S.C. § 77e) makes it unlawful to sell unregistered securities, while Section 4 (15 U.S.C. § 77d) provides certain exemptions from the need to register securities.
[2] The SEC’s Division of Corporation Finance administers the registration process. Registration refers to the specific units of the security to be offered and sold, not to the class of security, which can or must be registered under the Securities Exchange Act of 1934. There is one exception to this, which involved an enforcement action and which we discuss later in this article.
[3] If the company is a business corporation, the corporation owns the assets and the shareholders own the corporation. If the corporation is in bankruptcy or receivership or is dissolved, the claims against the assets are no longer intermediated by the corporation.
[4] When a company buys another company’s or governmental securities, they are not financing transactions and the securities appear as assets on the left side of the balance sheet.
[5] A transaction is a set of sequential interactions between two or more parties—those who or that are “part” of the transaction. Those interactions occur in phases. They are: (1) the opening, which includes the negotiations about the terms and conditions of a possible contract; (2) the parties’ separate executions (signing and delivery) of a single contract that creates performance obligations for each of the parties; (3) the parties’ performances under the contract, whether at once or over time, beginning immediately or in the future) and (4) the closing, when all performances have been completed. The number and timing of the parties’ performances need not be parallel or reciprocal. Retail sales of consumer goods, for instance, compress all four phases into a single event at the point of sale in the present: the buyer proffers payment, the seller accepts payment and “delivers” possession and title, that is, lets the buyer leave the premises with the item. The parties performance under forward contracts involves performance that are “forward” in time, that is, they begin in the future. In many transactions, for instance a lease, the buyer (of space or an object) performs fully upfront by paying while the seller performs (grants possession and use of the space or object) over a period of time.
[6] As we have noted elsewhere, a cryptocurrency producer could, in fact, create a digital token that functions as either a debt or equity security by granting the purchaser of the token the same rights as a bondholder or shareholder, transforming the transaction into a capital market (i.e., financing) transaction—but few cryptocurrency tokens are structured in this way.
[7] Of course, certain obligations can be imposed by a contract between the parties, such as when an auto manufacturer includes a warranty on an automobile’s systems or parts as part of the contract of sale.
[9] See Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933, Making Findings, and Imposing Penalties and a Cease-and-Desist Order, SEC v. Enigma MPC, Rel. No. 33-10755 (Feb. 19, 2020), https://www.sec.gov/litigation/admin/2020/33-10755.pdf; see also SEC, Press Release, ICO Issuer Settles SEC Registration Charges, Agrees to Return Funds and Register Tokens As Securities (Feb. 19, 2020), https://www.sec.gov/news/press-release/2020-37 (“The SEC’s order finds that ENG Tokens are securities and that Enigma did not register its ICO as a securities offering pursuant to the federal securities laws and its ICO did not qualify for an exemption from the registration requirements. . . . Enigma agreed to a claims process that would result in a return of funds to investors who purchased tokens in the ICO. The company also will register its ENG Tokens as securities and file periodic reports with the SEC.”).
[10] Enigma noted that the liability raised substantial doubt about its ability to continue as a going concern.
[11] Specifically, Sections 5(a) and (c) of the Securities Act of 1933, 15 U.S.C. §§ 77e(a) and 77e(c), as amended.
[13] Using proceeds properly characterized as revenue for the purpose of investing in long-term assets or creating new inventory is not a financing (or fund-raising) activity.
