Whether you’re a stock market participant, a cryptocurrency token issuer, or an investment banker, you’re probably familiar with securities law. However, compliance can be difficult to navigate if you aren’t well versed in the requirements and provisions set in place by both federal and state regulation. For those who aren’t heavily involved in the financial industry, securities law may even be a foreign concept all together.
So what is securities law, and why do we need it? This article will analyze securities law from the perspective of an experienced attorney who specializes in digital assets and offer the history and purpose behind securities law, explore the subtle variations of the definition of “security” and outline the requirements, liability provisions and exemptions mandated by the primary securities laws in the United States.
In relation to digital assets, the emergence of cryptocurrencies and their explosive adoption opened a door to legal uncertainty as the government has attempted to navigate their regulation. Currently, securities laws may come into play with respect to various digital assets and token issuances (depending on the issuance). In this article, the relationship between digital assets and securities law is explored to offer a better understanding of how these laws affect the virtual currency market.
Securities law consists of both federal and state statutes that regulate capital markets, capital formation activities, and related transactions.1 Congress enacted the federal securities regulatory framework in the 1930s to address the fraudulent abuse and manipulation of the unregulated market, recognizing the “the virtually limitless scope of human ingenuity, especially in the creation of countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”2
Securities Act Section 2(a)(1) defines the term security as:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”3
The term ‘security’ was purposely defined in broad and general terms to cover the various types of instruments in the commercial market that may be sold as an investment.4 The primary laws governing the market for common stocks are the Securities Act of 1933, as amended (the ”Securities Act”), the Securities Exchange Act of 19345 (the ”Securities Exchange Act”) and state securities laws known as Blue Sky Laws.6 These laws are administered by two principal regulatory bodies: the Securities and Exchange Commission (”SEC”), and the Financial Industry Regulatory Authority (”FINRA”).7
Preceding the crash of the stock market in 1929, companies were issuing stocks that were marketed through promotion of the company’s value and sold based on large profit promises. The lack of regulation allowed for these transactions to take place with little to no disclosures provided to investors regarding important information about the company selling the securities. Many of these promises ended up being insubstantial or completely fraudulent.8
As a result, President Franklin D. Roosevelt sent a message to Congress on March 29, 1933 urging them to enact legislation for “federal supervision of traffic in investment securities in interstate commerce.”9 This series of events was the precursor to the development of the Securities Act and Securities Exchange Act.
In deciding when a financial instrument or transaction constitutes a security, the SEC relies on the 1946 case ruling of the Securities and Exchange Commission v. W. J. Howey Co.,10 which established a test to determine if an investment is a security, coined the “Howey test.”11
William John Howey owned a large amount of land containing citrus groves in Florida; he sold half of this land to outside investors, who in turn realized they lacked the means to upkeep their newly inherited citrus trees. Thus, the investors entered into service contracts with the Howey Company allowing him to work the land and market the produce, and the purchasers shared in the profits. The foundation of the case was whether or not the service contract was an “investment contract” under Securities Act Section 2(a)(1),12 and the Court ruled in favor of the SEC declaring the contracts to be investment contracts, meaning the interests in the groves were securities.13
Through the Howey test, an investment contract was defined as “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”14
The Howey test is crucial framework for securities laws and regulation.
The offer and sale of securities are regulated through the Securities Act and focuses on registration requirements and disclosure requirements that mandate companies to provide information regarding the company itself, their financial condition and the result of their operations.15
The Securities Act requires the registration of any offer and sale of securities that do not qualify for an exemption. Prior to any offer, the issuer must file a registration statement16 containing disclosures required by the SEC that they will present to investors, and that statement must become effective before any sale of the security.
Sections 11 and 12 of the Securities Act provide liability for violations of the disclosure requirements; right of action for damages is granted to investors and purchasers if an issuer’s effective registration statement contains misleading, untrue, or omitted statements and potential liability is imposed on the seller for misleading, untrue, or omitted information in the prospectus or any verbal discussion related to the offer and sale of their securities.17
Certain securities and transactions are exempt from registration under the Securities Act including the issuer private placement exemption and the investor private resales exemption and Regulation S.18
- Issuer private placement exemption: Transactions by issuers that do not involve a public offering are exempt under Section 4(a)(2), and Regulation D provides safe harbors for issuers participating in unregistered offerings.
- Investor private resales exemption: Rule 144A provides safe harbors for securities resales to qualified institutional buyers, and the “4(1/2) exemption allows limited resale among “sophisticated” investors.
- Regulation S: Safe Harbors for offerings and resales outside the US.
You can find the complete list of exemptions and full text of the Securities Act here.
The Securities Exchange Act established the SEC and mandates reporting requirements for public companies as well as regulates securities exchange trading.19
The Exchange Act contains liability provisions prohibiting false statements or omission of important statements and is intended to prevent fraud or manipulation in securities transactions, as to not repeat the events of the 1920s. Trading of securities on national exchanges are prohibited in the absence of registration and those registration requirements, as well as reporting requirements, are outlined in the Exchange Act.
The Act also regulates brokers and dealers, mandating their registration and the registration of securities exchanges.
The full text of the Exchange Act can be found here.
Blue Sky Laws are the state rules and regulations that govern the offers and sales of securities which impose registration requirements varying by state.20
The SEC was created to enforce securities law to ensure investor protection, regulate the securities markets, and assist in the formation of capital.21 The SEC has the authority to bring forth administrative proceedings, draft regulation and pursue enforcement action against securities laws violation. The first appointments to the SEC were made on June 30, 1934, and Joseph P. Kennedy, father of John F. Kennedy, was the first named chairman.22 This choice upset many people; “New Deal liberal” Jerome Frank was quoted saying it was “setting a wolf to guard a flock of sheep,” however, Kennedy believed in the mission of the SEC. “Kennedy’s vision for the SEC centered around a simple objective–he would have to prove to businessmen, traders, exchange officials, and the public that the markets were better off with the SEC than without it.”23
FINRA is the largest non-governmental regulatory body for US securities firms and operate under the SEC. The responsibilities of FINRA include firm registration and regulation, disciplinary action and ensures fair underwriting arrangements.24
What do a financial advisor and a celebrity homemaker have in common? Securities law violation. Two of the most notable cases of securities laws violations include those of Martha Stewart, America’s homemaker, and Bernie Madoff, an investment advisor.
Bernie Madoff is the founder of the Wall Street firm Bernard L Madoff Investment Securities, under which he facilitated one of the largest Ponzi schemes in history. Madoff was charged with securities fraud in 2008 and sentenced to 150 years in prison.25
Martha Stewart was charged with insider trading after being accused of receiving confidential information regarding the company she held stock in, after which she sold all of her shares before the companies stock prices fell 16%.26
Following the collapse of The DAO, an Ethereum-based Decentralized Autonomous Organization that collapsed in 2016 after being hacked through a loophole in their code, the SEC began an investigation into the DAO tokens and ruled they had been offering unlawful securities contracts to its investors. This led the SEC to release a Press Release entitled “SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities” (”The DAO Report”)27 officially declaring that offers and sales of digital assets are subject to the requirements of the federal securities laws. This case set a foundational precedent for the legal treatment of cryptocurrencies and digital assets.
The Howey test has since been used by the SEC to regulate various token issuers and decentralized finance industry participants; the SEC claims that the exchange aspect of digital assets satisfies the “investment of money” and “common enterprise” sections of the test.28 Many have questioned the application of the existing securities laws to the new age digital asset space and are calling for new legislation.29
It is recommended that any issuer of cryptocurrency token confer with a securities attorney for securities compliance. Attorneys and firms who specialize in securities law, such as Montague Law, can assist you in assuring all aspects of your business are compliance with both federal and state regulation.
Securities laws are complex and can be difficult to navigate, but they are vital to ensure investment protection and safe and fair securities transactions. It is often said that history repeats itself, however the establishment of securities laws and the SEC seek to ensure that the fraudulent market proceedings seen in the 1920s will not have the opportunity to emerge again.
1 Practical Law Corporate & Securities, US Securities Laws: Overview, Thomson Reuters Practical Law (last visited Sep. 30, 2022), WL 3-383-6798.
2 SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).
3 The Securities Act of 1933, as amended, 15 USCS § 77a et seq.
4 Practical Law Corporate & Securities, Security Defined, Thomson Reuters Practical Law (last visited Sep. 30, 2022), WL 0-578-9965.
5 Securities Exchange Act of 1934, 15 U.S.C. § 78c-qq (1934).
6 Supra note 4.
7 Supra note 1.
8 Legal Information Institute, Securities Law History, Cornell Law School (last visited Sep. 30, 2022), https://www.law.cornell.edu/wex/securities_law_history.
9 H.R. Rep. No. 85, 73RD Cong., 1ST Sess. 1933, 1933 WL 983 (Leg.Hist.)
10 See 328 U.S. 293 (1946)
11 Supra note 4.
12 15 USCS § 77a
13 Supra note 4.
14 Supra note 2.
15 Supra note 1.
16 Practical Law, Registration Statement, Glossary (last accessed Sep. 30, 2022), WL 4-382-3743. “In connection with a public offering of securities, an issuer must prepare a registration statement to give potential investors a reasonable basis upon which to make an investment decision. Rule 404(a) of the Securities Act states that a registration statement consists of the following: (i) the facing sheet of the applicable SEC form, (ii) a prospectus containing information required by Part I of the form, (iii) the information, list of exhibits, undertakings and signatures required by Part II of the form, (iv) required financial statements and schedules, (v) the required exhibits, (vi) other information or documents filed as part of the registration statement, (vii) documents or information incorporated by reference in the foregoing (whether or not required to be filed).”
17 Supra note 1.
20 Practical Law, Blue Sky Laws, Glossary (last accessed Sep. 30, 2022), WL 7-382-3275.
21 Darla M. Fera, 121 Securities and Exchange Commision, Money Manager’s Compliance Guide (June 2018),¶ 1000 EXECUTIVE SUMMARY, MNYMGUIDE ¶ 1000.
22 431 Days: Joseph P. Kennedy and the Creation of the SEC (1934-35), Securities and Exchange Commission Historical Society (last accessed Sep. 30, 2022), https://www.sechistorical.org/museum/galleries/kennedy/building_a.php.
24 Supra note 1.
25 Melbourne FL Attorney, Famous Securities Law Cases, Legal Team USA (April 30, 2015), https://www.legalteamusa.net/famous-securities-law-cases/.
27 Press Release, Securities & Exchange Commission, SEC Issue Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities (July 25, 2017), https://www.sec.gov/news/press-release/2017-131.
28 Nathan Reiff, Howey Test Definition: What It Means and Implications for Cryptocurrency, Investopedia (August 11, 2022) https://www.investopedia.com/terms/h/howey-test.asp.
29 See 17 C.F.R. 201.192(a); see also Press Release, Lummis, Gillibrand Introduce Landmark Legis. To Create Regul. Framework For Digital Assets (June 07, 2022) https://www.gillibrand.senate.gov/news/press/release/-lummis-gillibrand-introduce-landmark-legislation-to-create-regulatory-framework-for-digital-assets.