Recently Coinbase stated that the Securities Exchange Commission stated all securities except Bitcoin should be considered Unregistered Securities.
This got me thinking it would be good to publish some information on indeed when certain crypto assets should be considered a security and when they should not.
Blockchain technology and crypto assets are in the limelight of financial conversations, particularly when it comes to understanding whether most fungible tokens should be classified as securities in the United States. This concern, shared by many, has been reinforced by Gary Gensler, Chair of the U.S. Securities and Exchange Commission, who has repeatedly indicated his belief that almost all tokens fall into the category of securities[1].
A case has added further fuel to this discussion. The U.S. District Court for the District of New Hampshire ruled in favor of the SEC in the case against LBRY Inc., regarding sales of LBC, a crypto asset disseminated by the blockchain-oriented decentralized media platform LBRY[2]. The court decreed that “LBRY offered LBC as a security”[3]. But it leaves us wondering: Is the LBC token itself a security or are the sales and offers of LBC tokens by the defendant the actual securities transactions?
This critical issue may resurface shortly in the higher-profile litigation in the U.S. District Court for the Southern District of New York, SEC v. Ripple Labs Inc. Legal advisors dealing with tokens need to address this question meticulously in every project or matter they handle. The current stance taken by the SEC should serve as guidance, but a deeper comprehension of these matters will prove beneficial to all parties involved in the crypto asset sphere and contribute to the policy conversation[4].
In a landmark ruling, U.S. District Judge Analisa Torres declared that Ripple Labs did not violate federal securities law by selling its XRP token on public exchanges, leading to a 75% surge in XRP value. This verdict is the first win for a crypto company in a case presented by the U.S. Securities and Exchange Commission (SEC). However, the SEC also achieved a partial victory, as the judge found Ripple violated federal securities law by selling XRP directly to sophisticated investors. Ripple CEO, Brad Garlinghouse, celebrated the ruling as a significant win for the broader crypto industry. Following the ruling, Coinbase announced it would resume XRP trading on its platform. Despite the victory, the crypto industry continues to call for legislative clarity regarding tokens’ status.[5]
When dissecting the nature of crypto assets, one must consider the Howey test, a principles-based test coined by the U.S. Supreme Court in a bid to capture Congress’s intent behind the term “investment contract” in the definition of “security”[6]. According to the Howey test, an investment contract involves an investment of money, in a common enterprise, with an expectation of profits derived from the efforts of the promoter or a third party.
We examined all pertinent appellate cases over the past 75 years that utilize the catch-all term “investment contract” under federal securities laws, starting with SEC v. W.J. Howey & Co., the 1946 case that provides the definition of “investment contract”[7].
Across these cases, an array of investment schemes were presented, often involving the sale of an item not intended for personal use, but marketed by a promoter who explicitly or implicitly promised to augment the item’s value through their efforts. Various objects used in these schemes ranged from orange groves to virtual shares[8]. None of these items are securities, yet they were part of fundraising initiatives identified by courts as investment contract transactions.
However, the landscape for crypto assets is distinct. Several crypto projects have been successful, with robust secondary markets evolving for the assets. Nonetheless, the presence of a secondary market does not automatically turn a nonsecurity asset into a security, as is evident in the secondary markets for luxury handbags or limited edition sneakers[9].
The SEC has almost always successfully argued that fundraising sales of crypto assets are securities transactions. Yet, the core question remains unanswered: Are crypto assets themselves securities?
This question holds paramount importance as crypto assets, like commodities, are technological tools enabling the use of decentralized systems. They must be readily available for users at a transparent market price, attained through open market trading. Just as with commodities, crypto assets are investable, assuming that increased demand for the technology in the future will allow for selling the asset at a higher price, outweighing the storage costs.
Reviewing the Howey cases showed that most involved some scheme, generally a sale of a nonsecurity asset coupled with a formal or informal commitment by the fundraising entity to enhance that asset’s value over time or produce income from the asset. While there are a few cases where a particular asset was deemed an investment contract, these typically involved a financial instrument offering specific legal rights against a discernable party.
The broader observation is that regulators and market players often confuse the transactions where tokens were sold with the nature of the tokens themselves. Most crypto assets do not provide legally enforceable rights against another party, the fundamental characteristic of a security. Indeed, this very notion is generally opposed to the fundamental principle of blockchain-based projects, which purports that the network or protocol will continue indefinitely, irrespective of any particular individual’s or entity’s participation.
That being said, even if crypto assets are not securities themselves, some argue that the general undertakings often accompanying the early sales of the asset effectively financialize the asset, causing it to encapsulate the original investment scheme indefinitely, even when the asset changes hands among persons unconnected to the original scheme. This concept, which we call the embodiment theory, appears to underpin the decision in SEC v. LBRY.
However, embracing the embodiment theory implies accepting the morphing concept — the notion that a crypto asset may initially embody the investment scheme under which it was sold and then cease to do so later on. This implies that the crypto asset would transform into a nonsecurity.
The morphing theory is useful for determining the current status of some tokens, but it largely fails when used as a general principle or extension of the Howey test. The embodiment theory could lead to significant challenges for market participants, making it virtually impossible to determine the exact moment a crypto asset morphs into a nonsecurity. Furthermore, after a crypto asset morphs into a nonsecurity, it is unclear whether it could subsequently remorph back into a security.
A more effective way forward involves addressing the legal loopholes relating to tokens. Tokens not classified as securities lack disclosure requirements from the project teams that raised funds through their sales. A legislative framework imposing ongoing disclosure obligations on those fundraising with nonsecurity crypto assets, coupled with federal oversight of secondary markets for these nonsecurity assets, could facilitate responsible U.S. leadership in this swiftly evolving space.
