Until recently, digital assets were assumed to be outside the scope of traditional financial regulation. But a recent SEC ruling in the USA suggested that some ICO tokens, at least, are securities.
While rulings by the SEC are a matter for US citizens and don’t directly affect Hong Kong, common law is based on precedent, and judges in other common-law countries will be reading the rulings coming out of the US with interest. While Hong Kong’s SFC hasn’t made any definite statements about this, therefore, we can expect the SEC and federal judges’ rulings to have an impact.
Legal and regulatory authorities are in the process of catching up with new kinds of assets and figuring out which of them fall under laws meant to protect investors buying investment contracts and other forms of security.
Put simply, a security is any proof of ownership that has been assigned a value and may be sold. But does that mean digital assets like Bitcoin and Ether are securities?
How does the SEC decide whether something is a security or not?
SEC Division of Corporate Finance Director William Hinman went into more detail about exactly how the SEC will figure out if something is a token, emphasizing that “the economic substance of the transaction always determines the legal analysis, not the labels.”
For instance, he says, whisky definitely isn’t a security. But in the 1960s, the SEC examined a case in which warehouse whisky receipts were sold to finance the aging and blending of Scotch whisky.The difference is clear: whisky is a consumable, not an investment. But the receipts were an investment, and selling them was illegal securities trading.
If we exchange “whisky” for “coin” or “token,” we can see that if a coin is sold to be used as a coin, it isn’t a security: it’s being sold for utility. If something — coin, token, or whisky receipt — is sold in the expectation of a return, primarily from others’ efforts, it’s a security, at least as far as the SEC is concerned.
As SEC Chairman Jay Clayton explains, “there are tokens, which are used to finance projects. I’ve been on the record saying there are very few, there’s none that I’ve seen, tokens that aren’t securities. To the extent something is a security, we should regulate it as a security, and our securities regulations are disclosure-based, and people should follow those and provide the information that we require.”
The Howey test
The most famous test case for securities law is the Howey case, officially Securities and Exchange Commission v. W. J. Howey Co., May 1946. In this case, the Supreme Court hear that Howey and company had sold citrus-growing land to buyers, then offered those buyers the chance to lease the land back to Howey; Howey would then harvest, pool and market the fruit, and pay the landowners from the proceeds. The Supreme Court decided that Howey was in fact selling securities and established a test, now known as the “Howey test,” to determine whether something is a security or not.
According to the Howey test, a transaction is an investment contract, and therefore a security, if it:
- Is an investment of money
- Involves an expectation of profit from the investment
- The investment of money is in a common enterprise
- Profit is expected to come from the efforts of a promoter or third party
Judge Dearie says ICOs may be securities
That strongly suggests that a lot of token sales are securities sales, a point of view given credence by the September 11 ruling from Eastern New York district judge Raymond Dearie, in the trial of Maksim Zaslavskiy. Zaslavskiy was accused of defrauding investors in two ICOs, offering tokens — REcoin and Diamonds — whose value was based on diamonds and real estate, respectively. (Zaslavskiy has since pled guilty and faces jail time.)
The judge’s decision was widely reported as indicating that Zaslavskiy’s tokens were securities, and thus, all ICO tokens and even all digital assets were also securities.
However, a closer look shows that in fact, Judge Dearie merely said that Zaslavskiy’s case had to go to trial. He said Zaslavskiy’s lawyers hadn’t proved they weren’t subject to securities law, not that all ICOs were securities. He certainly didn’t say that all cryptoassets are securities.
What makes a security?
Where digital assets aren’t securities, it’s either because utility is being sold directly or because of “sufficient decentralization.” Those two considerations come together in the case of Ether and Bitcoin.
The SEC has clearly stated that Bitcoin is not a security. On April 26 this year, SEC chairman Jay Clayton told the House Appropriations Committee that “…there are different types of cryptoassets. Let me try and divide them into two areas. A pure medium of exchange, the one that’s most often cited, is Bitcoin. As a replacement for currency, that has been determined by most people to not be a security.”
That’s the same approach taken earlier in the year when the SEC’s Division of Corporate Finance, William Hinman, said “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”
“Combine prior research with Hinman’s suggestion that Bitcoin and Ethereum have sufficiently decentralized networks,” says Josh Garcia, principal at Ketsal Consulting, legal consulting arm of blockchain law firm Blakemore Fallon.
Garcia proposes that:
- Any network with node participation and geographic distribution at least as distributed as the Bitcoin network should be considered sufficiently decentralized.
- Reward volatility may vary for small miners without making the network insufficiently decentralized.
- The presence of centralized mining power (even up to 61% of weekly mining power split between three miners) does not make a network insufficiently decentralized.
- The presence of powerful core developers or an influential foundation does not make a network insufficiently decentralized.
- An open-source, proof-of-work network may be sufficiently decentralized at inception.
At the moment, exactly where a network and its token fall isn’t totally clear. But we do know for sure that the SEC thinks many, if not all, token sales are securities, and that it’s equally decisive about Bitcoin and Ethereum. Thanks primarily to their decentralization, both networks and their currencies are in the clear.
The implications outside the US are less clear-cut, but in common-law countries, including Hong Kong, judges will be considering the precedents set by US judges and regulators when they come to make their own decisions. That means the decisions made in US courts, while obviously not binding elsewhere, are a good indication of the direction of development in the common law countries.