Cryptoassets did not exist before 2009, the year that the Bitcoin blockchain was released and the first Bitcoins were mined. This new “asset” had no governmental backing and no tangible existence whatsoever, and was embodied only as a digitized code hosted on a computer network owned and controlled by private citizens. Yet, the original goal was to have this new technology either replace or substantially supplement conventional, government-issued currencies. To the surprise of many and the glee of others, the idea took off. Arising out of single pseudonymous “white paper” promoting the idea, on February 21, 2021, Bitcoin reached a total market capitalization in excess of a trillion U.S. dollars, with each Bitcoin being “valued” at a high of just over $58,000. Bitcoin is not the only cryptoasset; today there are thousands of other forms of crypto available on various exchanges. The total market capitalization of all crypto reached a high on February 20, 2021, of nearly $1.8 trillion.
Illegality and Regulation
Not surprisingly, as has been the case wherever innovation has led to the rapid influx of money, those willing to take advantage of the inevitable lag in regulation soon appeared. Regulators took note of the lack of oversight, and a regulatory response began to take place around the world and certainly in the United States.
Much has been made of the criminal element in the crypto world, including a recent report from the Department of Justice. The fear of criminal involvement explains why regulators have been so insistent in stepping in to oversee the functioning of this new class of assets. One of the most assertive regulators in the United States has been the Securities and Exchange Commission (SEC), whose mission is to protect both the capital markets and investors. The SEC oversees enforcement of the Securities Act of 1933 (’33 Act), which includes in Section 5 a requirement that every offer or sale of any “security” must be registered or exempt from registration. The SEC also acts to investigate and punish fraud in connection with the sale of any security.
The SEC’s Approach
As expected, this legislation, adopted in 1933, does not mention cryptoassets. However, the definition of security in Section 2 of the ’33 Act does include “investment contracts,” which the Supreme Court defined in 1946 in SEC v. W.J. Howey Co. Howey stands for the principle that that an investment contract exists whenever purchasers pay money in order to join a common enterprise in which they expect profits solely from the efforts of others. Over time, various courts have clarified the test, now widely known as the “Howey test.” Not surprisingly, contributions of money or anything else of value will suffice,1 and a 1973 case from the Ninth Circuit, SEC v. Glenn W. Turner Enterprises, has come to be the leading case indicating that the managerial efforts do not need to be “solely” those of others so long as they are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”2
When the SEC first publicly concluded that the sale of a cryptoassets involved the illegal sale of securities in late 2017, it did so in reliance on this approach. Known widely as the DAO Report, the SEC found that the sale of the DAO Tokens involved the investment of something of value in a common enterprise where the efforts of the developer, promoter, or others associated with the launch of the asset were essential in determining profitability of the venture. That particular venture had already shut down because of a deficiency in the programming that had led to an infamous hacking incident, but the SEC certainly put entrepreneurs on notice that future crypto sales could be subject to SEC oversight.
In fact, following the release of the DAO Report, early indications from the SEC were that all cryptoassets were likely securities under the Howey test. Then SEC Chairman Jay Clayton publicly opined that he had not seen a crypto offering that did not involve the sale of securities. While the Commission, initially through statements by then-Director of the Division of Corporate Finance Bill Hinman, backed off of this position for two of the most popular cryptoassets, Bitcoin and Ether, the Commission continues to be active in treating most sales of cryptoassets as involving securities.
Application of the Howey Test to Crypto
Application of the Howey test to crypto is not always easy or intuitive. In an effort to clarify how a cryptoasset might avoid application of the test, the SEC promulgated a framework containing more than three dozen distinct subparts. Ostensibly, the purpose of this document was to help entrepreneurs understand the securities laws as they apply to crypto. Unfortunately, as even SEC Commissioner Hester Peirce has noted, this effort is likely to make the application of the securities laws to crypto sales harder to understand rather than simplifying the regulatory landscape.
The SEC has done more than spend untold man-hours in trying to explain to the public how crypto can fit within the pre-existing securities regulation framework. The Commission has also been willing to devote considerable resources to arguing its position in court. This has been a primary focus of the SEC’s complaints in high-profile cases in the Southern District of New York such as SEC v. Telegram Group, Inc. and SEC v. Kik Interactive Inc. It is currently being litigated (again) in SEC v. Ripple Labs, Inc.
As a result of the need to defend its interpretation of existing law, the SEC has far fewer resources to spend on developing regulations and exemptions more targeted towards cryptoassets. This pattern of regulation by enforcement also creates significant uncertainty and confusion among entrepreneurs.
Complicated Regulatory Landscape
The difficulty of developing legitimate cryptoasset-based technology in the United States is further complicated by overlapping regulation from other federal agencies. Moreover, these agencies disagree on the appropriate characterization of crypto. The Commodities Futures Trading Commission (CFTC) released a Backgrounder in 2018 opining that cryptoassets were commodities. The Financial Crimes Enforcement Network (FinCEN) reaffirmed its longstanding position that cryptoassets that can be converted into fiat currencies (directly or indirectly) should be regulated as virtual currencies. The Internal Revenue Service (IRS) gave notice in 2014 that it would treat and tax crypto as property. In addition, there are conflicting and overlapping state laws and regulations for crypto as well, making it incredibly difficult to be a legally compliant crypto entrepreneur in the United States. Various resources trying to keep track of state crypto laws have to be updated regularly. It is so difficult that commentators have noted that the U.S. is the country most likely to be excluded from crypto offerings, followed by North Korea, Iran, and Syria.
This is not a desirable situation. Not only does the current approach exclude the U.S. from benefiting from the full potential offered by the development of new technology as entrepreneurs rush overseas, it also restricts the ability of entrepreneurs who remain to raise needed capital, and it excludes U.S. investors from the opportunity to participate in potentially valuable ventures. To combat this, a change is called for.
A Suggested Change
Ideally, authority over crypto enforcement should be given to a single agency, which should be experienced in handling not only fraud, but also in promulgating regulations geared towards the needs of persons acting in the crypto ecosystem. While it is critical to combat fraud and the involvement of criminals in the crypto ecosystem, legitimate developments should be encouraged or at the very least permitted. The SEC, which already interacts with FinCEN to protect against the problems of money laundering and funding of criminal activities for securities brokers and exchanges, and has extensive anti-fraud experience, seems a logical choice.
If the SEC was given exclusive jurisdiction over crypto, inconsistent federal and state laws could be avoided or preempted. Freed from the need to argue about whether crypto is a security at all, the SEC could spend resources to craft exemptions from registration targeted to crypto offerings. Informational disclosures relevant to these deals rather than those focused on different kinds of offerings could be mandated.
Admittedly, it will take an act of Congress to give the SEC exclusive federal jurisdiction over cryptoassets and to preempt inconsistent state regulation. Moreover, Congress may well have to direct the SEC to take a more encouraging stance towards legitimate, non-fraudulent offerings. Given that we are still in the midst of a pandemic, and the fact that there are a number of critical issues facing our elected representatives, this might be an unrealistic hope. However, if we want to stop driving crypto entrepreneurs away and open legitimate investment opportunities for U.S. citizens, such a change is badly needed.
Carol Goforth is a University Professor and the Clayton N. Little Professor of Law at the University of Arkansas (Fayetteville). She has written a number of legal articles focusing on cryptoassets, acts as a regular expert commentator on CoinTelegraph.com, serves on the board of advisors for HoneyComb Digital Investments, and is the author of West Academic’s Regulation of Cryptotransactions (2020).
This post is derived from Cinderalla’s Slipper: A Better Approach to Regulating Cryptoassets as Securities, forthcoming in 17 Hastings Business Law Journal (2021), and available on SSRN at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3744254.