In a Sep. 28th, 2018 letter, North Carolina Republican congressman Ted Budd asked Securities Exchange Commission (SEC) chairman Jay Clayton questions around cryptocurrency and its securities treatment.
More specifically, he asked Clayton to clarify what criteria are used to determine when the offer and sale of a cryptocurrency should be considered “investment contracts,” and therefore securities.
"Current uncertainty surrounding the treatment of offers and sales of digital tokens is hindering innovation in the United States and will ultimately drive business elsewhere".
Budd also inquired whether Clayton agreed with the analysis previously conducted by director of the Division of Corporate Finance William Hinman in his speech delivered in June of 2018. Finally, Budd asked if a cryptocurrency sold as part of an investment contract can later be deemed a non-security if the circumstances change.
In Clayton’s response, the chairman reaffirms some of the analysis conducted by Hinman, notably around whether a cryptocurrency classified as a security can later be deemed a non-security:
"I agree that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument. A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition"
Furthermore, Clayton clarifies his stance on decentralization and its role in securities classification:
“I agree with Director Hinman’s explanation of how a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.”
Clayton’s statements are in response to Hinman’s speech, where Hinman says a cryptocurrency’s securities definition may change over time and that a digital asset may no longer represent a security offering if a network is “sufficiently decentralized.” In this speech, Hinman also suggests that Bitcoin and Ethereum are not securities. According to Hinman:
“If the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract.”
By extension, Clayton’s statements provide additional clarity on whether Bitcoin, Ethereum, and other cryptocurrencies, such as XRP, are securities.
For example, based on Clayton’s statement, if Ethereum’s ICO was initially an investment contract (and thus a security) then its coin, ether, can later be deemed a non-security. Securities definitions, according to Clayton, may change over time in line with Hinman’s speech.
Furthermore, Clayton also suggests that if investors “no longer reasonably expect” a group to carry out management, such as in a decentralized organization, then it’s conceivable that cryptocurrencies attached to those organizations do not fall under the securities definition of the Howey test.
More specifically in Ted Budd’s letter, he calls for more clearer criteria and “FAQ-type” examples to illustrate how different factors can be applied to cryptocurrencies and “aid market participants in better understanding how these factors should be applied.” Budd uses the SEC’s purported criteria for Bitcoin as a reference:
“An example of a digital token that is not considered to be a security is Bitcoin, whose value, functionality, and transferability is determined by a permissionless blockchain maintained by unaffiliated miners, code contributors, and spot-markets for trading.”
These criteria are in line with Hinman’s speech and Budd requested more examples like Bitcoin’s applied to other cryptocurrencies. Another concern Budd voiced regards the SEC “regulating through enforcement” rather than providing clear guidelines:
“We are concerned about the use of enforcement action alone to clarify policy and believe that formal guidance may be an appropriate approach to clearing up legal uncertainties which are causing the environment for the development of innovative technologies in the United States to be unnecessarily fraught.”
Clayton’s response, in more detail, asserts that the securities definitions of a cryptocurrency greatly depend on the “facts and circumstances of the transaction” and that the definitions used for crypto do not differ from traditional securities:
“Regardless of the terminology used to identify the digital asset—will depend on the facts and circumstances, including the economic realities of the transaction.”
He also iterates that one of the key factors around whether a token is considered a security is the expectation of profit from the effort of others:
“The ‘touchstone’ of an investment contract ‘is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’”
To illustrate his position, Clayton references the DAO Report, which according to him includes “detailed legal analysis applying Howey to the facts and circumstances specific to the DAO tokens.”
Another important factor to consider, Clayton asserts, is the SEC’s role in protecting investors. Although some in the blockchain sector are willing to engage with the Commission in good faith, others are still looking to “prey on investors.” To reduce fraud, Clayton is looking to exercise diligence when policing the cryptocurrency markets:
“I have asked the Division’s leadership to continue to police these markets vigorously and recommend enforcement actions against those who conduct ICOs or engage in other actions relating to digital assets in violation of the federal securities laws.”
The SEC’s actions are consistent with Clayton’s statement. Since 2016 enforcement actions have increased year after year, with major cases including the founder of EtherDelta, ICOs Paragon and Airfox, and DJ Khaled and Floyd Mayweather. As a result, those who do not comply with regulations in the US should be wary:
“The Commission acted swiftly to crack down on allegedly fraudulent activity in this space, particularly where the misconduct has targeted Main Street investors. Regardless of the promise of distributed ledger technology, those who invest their hard-earned money in opportunities that fall within the scope of the federal securities laws deserve the full protections afforded under those laws.”
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