By: Steve Masur
SEC Chairman Jay Clayton recently confirmed in a letter that Ethereum and similar cryptocurrencies are not securities. This letter was in response to Representative Ted Budd’s letter asking the SEC to clarify the criteria used in determining whether a digital token offered or sold is an investment contract and thus is an offer or sale of a security. Ever since SEC Director William Hinman’s June 2018 speech, where he announced Ethereum and other similar cryptocurrencies are not securities, the crypto community has been wondering whether these remarks, in fact, reflect the beliefs and policies of the SEC – despite his disclaimer that his statements reflect his own opinions only. Generally, his speech concerns when a digital asset is offered as an investment contract and is thus a security.
There were several key takeaways from Director Hinman’s speech:
1. A token itself is not a security, but the transactions pursuant to which a token is distributed may be a securities transaction.
2. The Bitcoin and Ethereum networks are currently decentralized enough that the disclosure rules in federal securities laws would add little value. Further, other networks could become decentralized enough such that the tokens that are on these networks do not need to be regulated as securities.
3. Drawing on the well-known Howey Test, the form of a transaction is less important than the economic reality of it. The sale of tokens may qualify as a securities transaction where the tokens are sold in efforts to fund an enterprise, and where the token purchasers rely on the efforts of a third party to see a profit.
4. Lists of relevant factors in assessing whether a third party is driving the expectation of a return on a digital asset, and in determining when the sale of tokens may be a securities transaction.
5. The way that securities laws are applied to token distributions may impact the securities treatment of the token or sale in secondary transactions.
Chairman Clayton reiterated that whether a digital asset is an investment contract, and thus a security, depends on the application of the Howey Test and its progeny, including the Forman Test. While he didn’t specifically mention the consumption/consumer use test from Forman – finding that when a purchaser is motivated by a desire to use or consume the item purchased – it is assumed that this test applies. Chairman Clayton agreed with Director Hinman that the analysis of whether a digital asset is offered or sold as a security can change over time – that a digital asset may be initially offered or sold as a security, but that this designation as a security can change if the digital asset is offered or sold in a way that no longer meets the definition of an investment contract. He further agreed with Director Hinman that a digital asset transaction may no longer qualify as an investment contract if a purchaser no longer reasonably expects a third party to generate a return.
Chairman Clayton said that networks such as Ethereum and similar coins are sufficiently decentralized such that they are not investment contracts, and thus not securities. Although he didn’t specifically say it in his letter, he has mentioned in the past that Bitcoin is not a security. It is clear that a coin, alone, is not a security. It’s about the method in which the coin is offered or sold that makes it a security. If a coin is sold to fund an enterprise and the purchasers of the coin are relying on the efforts of a third party to make a profit, the coin is likely to be deemed a security. While this increased clarity is helpful in providing some general rules of thumb to consider in determining whether a digital asset could be considered a security by the SEC, it has also left open many questions that would need to be answered for this to achieve the level of real guidance.
What is the meaning of sufficiently decentralized, and at what point does a network become sufficiently decentralized? Networks will want to know more from the SEC on what this looks like, so they know what to expect. What does the SEC consider to be a similar coin, and what factors do they use to determine this? This is still an open question, and it may be wise to wait and see what coins the SEC deems to be similar to Ethereum, before assuming that a coin is not a security. The main takeaway from the letter is that the SEC is going to move slowly and carefully in providing guidance. So for the time being, it is safest to presume a new digital asset might be considered to be a security in the US unless you are confident you can prove otherwise if tested in a court of law.
If you have further questions about a digital asset you plan to create, we can help you develop a good legal strategy for how to remain compliant when releasing it, both in the US and abroad.
We would like to thank Rachel Behar for her contribution to this article.