Since the arrival of Bitcoin in 2009, the world’s first decentralized cryptocurrency, securities attorneys, officials at the U.S. Securities and Exchange Commission, and others have wrestled with the question of whether any particular encrypted cash system should technically qualify as currency or a security. Recent SEC enforcement actions and a ruling by a federal judge in the Eastern District of New York have continued to fuel that discussion.
“That’s what this is all about,” said Rikard Lundberg, shareholder at Brownstein Hyatt Farber Schreck. “There’s been a fair amount of pronouncement by the Securities and Exchange Commission since July of 2017 that anyone involved in this space will need to evaluate whether their token is a security.”
On Sept. 11, the SEC settled charges in a case against the company Crypto Asset Management LP, which had allegedly violated securities law by making a public offering of a security without first registering it. Companies dealing in securities (as opposed to with a currency) are subject to certain federal regulations, including registering the security in the applicable states or pursuing an exemption from that obligation.
Those types of securities disclosures are required pursuant to the Securities Act of 1933. The case against Crypto Asset Management is the first time the SEC pursued a violation against an investment company for failing to register a security as the act requires. On the same day, though, the SEC also settled a case against TokenLot LLC, which bills itself as an ICO, or initial coin offering, superstore for “over 200 digital tokens.” In the settled case, TokenLot had not registered the securities it sold. As part of the agreement, the company agreed to relinquish $471,000 and pay $7,929 in interest.
Taken together, the settlements were viewed by some as a warning sign sent by the SEC to those dealing with cryptocurrencies. “If you just read these enforcements,” Lundberg said, “you get the sense that all this stuff is securities.”
The market that started with Bitcoin several years ago has since grown considerably; there are now more than 1,500 cryptocurrencies.
The test used to define what constitutes a security, or an “investment contract,” was developed in a 1946 decision by the U.S Supreme Court in the case SEC v. Howey and is now referred to as the Howey test. The test has four components: Is it an investment of money; is there an expectation of profits from the investment; is the investment of money in a common enterprise; and will a promoter or third-party make any profit from the exchange.
That, Lundberg said, will continue to be the test.
“They’re going to continue to apply this Howey test,” he said. “The court said you have an investment contract anytime someone invests money in a venture and you have the reasonable expectation of profit.” Lundberg added. “They’ll continue in most instances to conclude that these are securities. I’m not aware of any meaningful legislation in Congress that would change this. There could be change in Congress if people are convinced that the blockchain technology fills a meaningful function; it’s possible that Congress could step in and regulate this.”
The day after the two SEC actions, in a rare criminal case dealing with this technical cryptocurrency issue, a federal district court judge in the Eastern District of New York ruled that criminal charges pertaining to an allegedly fraudulent initial coin offering was indeed subject to securities law. Lundberg explained that Judge Raymond Dearie’s ruling amounted to an estimation that a jury could indeed find that a cryptocurrency was a security.
Lundberg said there will likely be more activity in the courts on this question. “The next frontier here is now the courts will start stepping in,” he said. “And then also we’ll probably see an increase in civil litigation where individual buyers are suing these crypto operators. You will have courts starting to interpret the Howey test in the crypto space — and they may or may not come out the same way as the SEC.”
But, Lundberg added, so far as he knows, a good case with a good set of facts to decide this issue has yet to make its way into a courtroom. “You need a good case that has some good features,” he said.
He added, “The good news is for anyone in the market they’re not opining on whether it’s a good or bad investment, they’re just enforcing the issuers’ requirement to disclose.”
— Chris Outcalt