In a completely unsurprising statement, a high-ranking official at the Securities and Exchange Commission said that Bitcoins are not securities. William Hinman, Director, Division of Corporation Finance at the SEC, gave detailed speech on cryptocurrency.
When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey. That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. … In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.
Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.
In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.
It seems clear that the SEC’s default position on Initial Coin Offerings is that they are securities offerings. The coin promoters are not offering oranges for sale, but interests in the orange grove.
I did find it interesting that Mr. Hinman indicated that even if the ICO was an illegal securities offering, eventually the cryptocurrency could evolve into not being a security. Eventually, you are not exchanging interests in the orange grove, but exchanging actual oranges. He went to the next biggest coin platform: Ether.
And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.
As for the rest of the coin and ICO universe, Mr. Hinman offered up six factors to consider:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
That is just for coins based on being able to buy some future service. If the digital coin includes some profits interest in the coin network, it’s always going to be a security.
The other factor to take into consideration is the trading platform for the digital coins. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. If the platform just handles Ether and Bitcoin, it’s okay based on the Hinman speech. Those two are not securities. Others are still suspect.
What is left out is the whether Bitcoin, Ether, or any of the other non-security digital coins are commodities or currency.
Sources:
- Digital Asset Transactions: When Howey Met Gary (Plastic)
Remarks at the Yahoo Finance All Markets Summit: Crypto by William Hinman Director, Division of Corporation Finance - Statement on Potentially Unlawful Online Platforms for Trading Digital Assets
- Cleary Gottlieb Discusses SEC’s Latest Take on Digital Assets as Securities By Michael H. Krimminger, Pamela L. Marcogliese, Matthew C. Solomon and Zachary L. Baum
- REST EASY, CRYPTOCURRENCY FANS: ETHER AND BITCOIN AREN’T SECURITIES by LOUISE MATSAKIS
