Cryptoasset Regulatory Environment in US

Published in

Albaron Ventures

17 min readAug 2, 2018

by Phillip Klimke, Vlad Andrei, Julian Gropp

Disclaimer: none of the content in this article should be considered legal advice. This is purely a personal opinion. The point of this article is not to influence buyers/investors of tokens in regards to specific ICOs. It is to depict a general landscape and offer general insights for everyone to use personally.

1. Overview

Overall, the US cryptoasset regulatory environment is lacking a clear framework that is agreed upon by the SEC, CFTC and IRS. However, throughout 2017 and 2018, multiple advancements have been made to provide more clarity in regards Initial Coin Offerings (ICOs), taxation, and classification of Bitcoin and Ether as non-securities.

SEC

To date, the SEC has not approved any exchange traded products (ETFs) holding cryptocurrencies, cryptocurrency related assets or derivatives. In addition, no ICOs have been registered with the SEC so far. Finally, the SEC has stated in several occasions that most ICOs would be regarded as securities, but is not excluding the possibility of non-security ICOs, as long as the Howey Test fails.

The SEC has been extremely active in the space, providing gradual guidance (DAO, ICOs, Ether), issuing hundreds of subpoenas to cryptocurrency related businesses (ICOs, cryptoasset funds, exchanges), and taking corrective action mainly on those which showed fraudulent behavior in addition to unregistered sale or dealing of securities.

CFTC

The CFTC is categorizing cryptocurrencies as commodities, and therefore exchanges generally need to obtain money transmitter licenses and abide by the FinCEN reporting requirements.

IRS

The IRS categorizes cryptoassets as property, and not currency, resulting in short term or long term capital gains or losses. Starting in 2018, the IRS has disallowed 1031 exchanges (in-kind exchanges) between cryptoassets, thus requiring every transaction to/from cryptoassets to be categorized as a taxation event.

2. Cryptocurrencies and Citrus Groves — The Howey Test

The increased regulatory scrutiny of cryptocurrencies in the United States may culminate in an unusual question: how do digital tokens — given out by blockchain-based ventures in exchange for funding — compare to a 1946 Floridian citrus grove?

The test devised by the U.S. Supreme Court to define an “investment contract” in the context of the Securities Act of 1933 hinges on this analogy. With it, courts may one day decide whether the jurisdiction of the Security and Exchange Commission (SEC) extends to cryptocurrencies and initial coin offerings. Whether the SEC’s jurisdiction does indeed apply to the sale of digital tokens is of critical importance to issuers, investors, and the professionals who facilitate the investments — it establishes an onerous set of regulation and disclosure requirements for the sale of securities and exposes these stakeholders to potential civil and criminal liability.

In its 1946 decision SEC v. Howey, the Supreme Court found that an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor, was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933. The Howey Company owned large tracts of citrus acreage in Lake County, Florida. It offered half of its acreage to the public “to help [the company] finance additional development.” Through a service company, it also offered to cultivate and develop many of these groves, including the harvesting and marketing of the crops. The purchasers were predominantly business and professional people who lacked the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees but were attracted by the expectation of substantial profits.

Based on these facts, the Court developed a four-prong inquiry that examines whether an investment contract is:

An investment of money
in a common enterprise
with a reasonable expectation of profits
to come solely from the entrepreneurial and managerial efforts of others

If all four requirements are fulfilled, the investment contract is a security and falls under the authority of the SEC. In the case of Howey, the Court found that the citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor, was an offering of an “investment contract.”

3. Elements of the Howey Test

Each of the elements of the Howey test has led to a plethora of decisions by lower courts that together form the modern framework to evaluate whether certain contractual arrangements constitute securities. Below is a brief description of each:

(1) Investment of money. The requirement of an investment of money is designed to capture only those investors who have undertaken some degree of economic risk. Courts have clarified that the term “money” is meant to be expansive and not limited to cash. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”). Uselton, 940 F.2d at 574 (“[T]he ‘investment’ may take the form of ‘goods and services,’ or some other ‘exchange of value’.”)

There is little doubt that the first prong of the Howey test applies in the context of cryptocurrencies. See SEC v. Shavers, №4:13-CV-416, 2014 WL 4652121, at *1 (E.D. Tex. Sept. 18, 2014) (holding that an investment of Bitcoin constituted an investment of money).

(2) Common enterprise. The common enterprise requirement was likely devised to “exclude one-on-one contracts, bargained for at arm’s length.” But circuit courts are split on how to test for this element. Some courts look for horizontal relationships between an individual investor and the pool of other investors. Others hold that a vertical relationship between investors and promoters is sufficient to establish the common enterprise requirement. Below is a brief explanation of both approaches:

Horizontal commonality: The test for horizontal common enterprise was developed by the Sixth Circuit in a case involving commodities future trading accounts at Merrill Lynch. Customers alleged mismanagement of discretionary trading funds and claimed that the accompanying investment contract constituted a security. The court found that the common enterprise element of the Howey test necessitates “some relationship which ties the fortunes of each investor to the success of the overall venture.” Curran v. Merrill Lynch, 622 F.2d 216 (6th Cir. 1980). Because such a relationship did not apply in the case of the discretionary commodity account, the court concluded it was not a security. The Seventh Circuit likewise concluded “that a sharing or pooling of funds is required by Howey” in a similar case involving management of a discretionary futures trading account. (emphasis added)
Strict vertical commonality: Courts applying strict vertical commonality, do not find it necessary that the funds of investors are pooled. Instead they examine whether “the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment.” A common enterprise exists if a direct correlation has been established between success or failure of [the promoter’s] efforts and success or failure of the investment. SEC v. Eurobond (quoting Brodt v. Bache & Co., 595 F.2d 459, 460 (9th Cir.1978) (quoting Securities and Exchange Comm’n v. Glenn W. Turner Enter., 474 F.2d 476, 482 n. 7 (9th Cir.).
Broad vertical commonality: Like the strict vertical test, broad vertical commonality depends on the relationship between the investor and promoter. Unlike the narrow vertical approach, however, the broad vertical test is not concerned with the economic interdependence of the promoter and investor but instead examines the investor’s dependence on the promoter’s expertise. The seminal case is SEC v. Koscot Interplanetary, Inc., in which a multi-level marketing network of cosmetics salespeople was found to offer securities. The court found that the requisite commonality was evidenced “by the fact that the fortunes of all investors are inextricably tied to the efficacy of the Koscot meetings and guidelines on recruiting prospects and consummating a sale.”

(3) and (4) Profits “solely from the efforts of others.” Courts generally analyze the third and fourth factor together. “[P]rofits” include “dividends, other periodic payments, or the increased value of the investment.” Edwards, 540 U.S. at 394. As laid out by the Ninth Circuit in SEC v. Glenn Turner, the word “solely” is not meant literally. And adding “just a modicum of effort on the part of the buyer does not prevent finding that an arrangement constitutes and investment contract.” Id. In the case of Glenn Turner, for example, the court found that a multi-level marketing scheme called “Dare to be Great” constituted a security even though members had to expend some effort to identify new participants and bring them to the program’s meetings. The court adopted what it called a “realistic test,” to examine “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Because members of the Dare-to-be-great program shared in the proceeds of the program’s selling efforts generally, their own contribution was considered secondary to the essential efforts expended by Dare’s management.

4. Consequences of Classification as a Security

The consequences for classification as a security under the Howey test are substantial. All securities offered in the U.S. must be registered with the SEC or must qualify for an exemption from the registration requirements. The registration forms are accompanied by a set of mandatory disclosures through a prospectus during the IPO process and other necessary filings during the public life of the company. The initial disclosures are described on the SEC’s website as follows:

A description of the company’s properties and business
A description of the security to be offered for sale
Information about the management of the company
Financial statements certified by independent accountants

Companies incur significant costs both in the process of going public and to comply with the disclosure requirements of being a public company. On average, companies incur $3.7 million of costs directly attributable to their IPO. An additional $1.5 million of recurring costs result from incremental internal staffing costs (accounting, tax, investor relations, auditing etc.) and professional legal and accounting services fees. In addition to monetary costs, companies need to budget 1–2 years to plan for an IPO and prepare to spend significant management resources during that time.

Those who participate in an unregistered offer and sale of securities not subject to a valid exemption are liable for violating Section 5. Aside from the issuers themselves, liability can extend to third-party participants that solicit offers to buy the security for value. See, e.g. SEC v. Chinese Consol. Benevolent Ass’n., 120 F.2d 738, 740–41 (2d Cir. 1941) (finding a group of Chinese Americans liable for selling unregistered Chinese government bonds even though it was neither authorized to act on behalf of the Chinese government nor compensated for the undertaking).

5. Motivations of US Regulators

To predict the likely path of future regulatory action, it is instructive to examine the underlying motivation and historical context of securities regulation. The Securities Act of 1933 and the Securities Exchange Act of 1934 were passed in the aftermath of a period of excessive stock market valuations that culminated in the 1929 stock market crash. The Senate described its underlying rationale as follows (emphasis added):

The purpose of this bill is to protect the investing public and honest business. The basic policy is that of informing the investor of the facts concerning securities to be offered for sale in interstate and foreign commerce and providing protection against fraud and misrepresentation.

The aim is to prevent further exploitation of the public by the sale of unsound, fraudulent, and worthless securities through misrepresentation; to place adequate and true information before the investor; to protect honest enterprise, seeking capital by honest presentation, against the competition afforded by dishonest securities offered to the public through crooked promotion; to restore the confidence of the prospective investor in his ability to select sound securities; to bring into productive channels of industry and development capital which has grown timid to the point of hoarding; and to aid in providing employment and restoring buying and consuming power.

In addition to this legislative history, scholars have distilled three distinct goals underlying the mandatory disclosure framework for public companies:

Investor Protection: Mandatory disclosure rules further the goal of investor protection through two related mechanisms: market efficiency and market egalitarianism. For markets to operate efficiently, investors need to trust the integrity of the information on which they base their decisions. Lack of trust would lead investors to withdraw their funds and the market would collapse. Disclosure rules enhance market egalitarianism because they put sophisticated and unsophisticated investors on a level playing field by making information available to both equally.

Agency Cost Reduction: Much of modern corporate law is based on the idea of corporate officers acting as agents of shareholders to maximize shareholder value. Inherent in these agency relationships are monitoring and bonding costs to restrict manager behavior and align it with the goals of the venture. Mandatory disclosure rules help surface the information necessary to enable these monitoring and bonding mechanisms. Disclosure, for example, can help identify breaches of fiduciary duties by exposing the involvement of board members in other ventures. The mere process of collecting information for disclosure also has the effect of raising managers’ consciousness of their duties and enhance manager performance.

Price Accuracy Enhancement: Since the ability to price securities correctly hinges on the market’s assessment of all available information, mandatory disclosure enhances the accuracy of security prices. In turn, accurate prices improve corporate governance and allocative effectiveness. For example, they help to identify underperforming companies, lower volatility, and enable incentive compensation.

6. Application to ICOs and Cryptoassets — case studies

The regulatory direction of the SEC suggests that security categorization depends on the properties of the cryptoassets. While Bitcoin and Ether have clearly been categorized as “non securities”, most ICOs are viewed as security offerings, due mainly to

not offering utility when the sale is made, which increases the expectation of profits when the investment is made;
project work is centralized, which makes the expectation of profits be dependent on the managerial efforts of the centralized team

In June 2018, the SEC has stated that Ethereum is not a security. In the reasoning, the SEC has stated that it is possible for a security to evolve into a non-security. Based the Howey test, the Ethereum ICO could have been classified as a security offering. However, due to its decentralized nature and establishment of clear utility, Ether has migrated from a security to a non security.

In December 2016, in a joint initiative, Coinbase, Coin Center, Union Square Ventures and Consensys provided a detailed analysis of the Howey test and subsequent case law. Leveraging the work of the law firm Debevoise and Plimpton LLP, the analysis concluded “that appropriately designed Blockchain Tokens would not be deemed to meet the definition of security and, accordingly, that the federal securities laws would not apply to the initial distribution and subsequent trading of such Blockchain Tokens.” This conclusion was in large part based on the assertion that “nonsecurity Blockchain tokens” allow users to “utilize, contribute to or license the use of the system in various ways, none of which would be considered a passive investment” — Blockchain tokens, the authors suggest, should instead be characterized as simple contracts like license and franchise agreements.

While the SEC hasn’t yet pronounced itself on general cryptoassets or tokens, it has focused on the initial sale of these assets, categorizing most of them as securities. SEC chairman Jay Clayton said on during a U.S. Senate hearing in February 2018 “I believe every ICO I’ve seen is a security.” The Commission has acted accordingly and embarked on an increasing effort to rein in initial coin offerings across various types of business models. Below is an overview of the most significant SEC actions and statements to date:

DAO (July 2017)

The DAO, or Distributed Autonomous Organization, was a blockchain-based entity devised by German company Slocki.it with the intention to use smart contracts to solve governance issues described as inherent in traditional corporations. In 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether. The tokens would allow participants to vote and entitle the participant to “rewards” in a number of projects to be facilitated by the entity. Before any proposal was put to a vote by DAO Token holders, it was required to be reviewed by one or more of The DAO’s “Curators” chosen by Slock.it. DAO Token holders were to cast votes, which would be weighted by the number of tokens they controlled, for or against the funding of a specific proposal. DAO Token holders could sell their DAO Tokens in a variety of ways in the secondary market and thereby monetize their investment.

In July 2017, the SEC issued an investigative report finding that tokens offered by the DAO were securities and therefore subject to the federal securities laws. To arrive at this conclusion, the SEC highlighted the following characteristics of the token:

The use of ETH to make investments in exchange for DAO is the type of contribution of value that can create an investment contract under Howey
The DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment
The efforts of Slock.it, Slock.it’s co-founders, and The DAO’s curators were essential to the enterprise because
Slock.it created The DAO Website on which it published the white paper
Slock.it selected persons to serve as Curators based on their expertise and credentials
The creators of The DAO held themselves out to investors as experts in Ethereum, the blockchain protocol on which The DAO operated
The expertise of The DAO’s creators and Curators was critical in monitoring the operation of The DAO, safeguarding investor funds, and determining whether proposed contracts should be put for a vote
Proposals made by token holders were subject to control by the current Curators, including whitelisting and approval of the new token address
The pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control

Protostarr (August 2017)

U.S.-based Protostarr had raised $47,000 worth of ether for what its whitepaper described as “a new evolution for the world of digital media investing.” The company wanted to leverage blockchain-supported smart contracts to allow individuals to invest in an up-and-coming content creators and the opportunity to profit from their success. Fans would fund their favorite content creator while maintaining partial ownership of, and payment from, the revenue creating channel. After a predetermined amount of time, the contract would expire and the content creator would have full access to all of the income that they generate.

In August 2017, the SEC contacted Protostarr and the leadership team announced that “[a]fter consultation with multiple lawyers, [the company] decided to cease further operations and refund Ethereum collected in [the] crowdsale.”

While the communication between Protostarr and the SEC is not public, several characteristics likely contributed to the regulatory intervention:

The white paper explicitly characterized Protostarr as an “investment” platform
The business model promised “a portion of […] profits over time”
The platform was to be managed by a team of experts which would enforce community rules (such as limiting “Starrs” to one channel) and would investigate any issues

Munchee (December 2017)

Munchee, a California-based company, began developing a decentralized blockchain-based food review and social media platform in 2015. Through the use of blockchain technology, restaurant owners and Munchee users would be allowed to independently verify and trust the restaurant information and reviews published on the platform. In October and November 2017, Munchee conducted an initial coin offering of MUN tokens to raise about $15 million in capital to improve its app and recruit users to eventually buy advertisements, write reviews, sell food and conduct other transactions using MUN.

Unlike DAO and Protostarr, Munchee did not hold itself out to be an investment platform with dividend-like features. The token was instead described as a “utility token” to serve as a method of exchange inside of the Munchee ecosystem. There it would facilitate meaningful advertising and promotion for restaurant owners and rewarding content creators for their activity. To carry the token outside of the Munchee ecosystem, users would have to either purchase services from partner restaurants or exchange the token for other altcoins. The company’s white paper even referenced the SEC’s DAO report stating that it had done a “Howey analysis” and that “as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.”

The SEC disagreed with Munchee’s assessment and imposed a cease-and-desist order in December 2017. According to the order, MUN tokens were securities because they were investment contracts under Howey. The following characteristics led to the SEC findings:

Purchasers had a reasonable expectation that they would obtain a future profit from buying MUN tokens if Munchee were successful
Purchasers reasonably believed they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUN “ecosystem”
Munchee and its agents created the Munchee Website and the MUN white paper and then posted on message boards, social media and other outlets to prime investors
Munchee and its agents were to expend significant managerial efforts by revising the app, creating the “ecosystem” that would increase the value of MUN, and support secondary markets

With this order, the SEC highlighted that even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling — such as characterizing an ICO as involving a “utility token” — but instead requires an assessment of “the economic realities underlying a transaction.” Forman, 421 U.S. at 849.

Stream (March 2018)

Launched in October 2017, San Francisco-based Stream attempts to “level the playing field” for content creators by ending the “monopolistic dominance” of centralized social media platforms. Stream planned to use the Stream token, a blockchain-based cryptocurrency, to pay creators across platforms directly without any middleman taking a cut. The company raised $5 million in the pre-sale of the Stream token in and planned to conduct an initial coin offering in November 2017.

However, given increasing regulatory scrutiny, the team cancelled plans for a public coin offering and raised limited funds from accredited investors. It briefly considered distributing 500 million of 10 billion tokens with an airdrop to early adopters and interested potential users rather than offering them for sale. But in March 2018, they abandoned those plans as well “delaying them indefinitely . . . to make sure they can move forward in the most compliant way possible.”

Ethereum (June 2018)

At an event in San Francisco, the Director of Corporate Finance William Hinman has stated that Ethereum wouldn’t be considered as a security, in its form today. His explanation suggests that a cryptoasset can be categorized as a security in its early phases, and migrate towards a non-security after it becomes decentralized and exhibits clear utility.

7. Summary of SEC Actions

The trajectory of SEC interventions in initial coin offerings shows that the differentiation between investment and utility tokens can exist, once the respective projects become decentralized and their utility is established. While the SEC hasn’t negated the possibility of ICOs being non-securities (as long as they start off as decentralized and their utility is established), it has made it clear that most ICOs would be securities.

DAO and Protostarr were easy targets for SEC action given their explicit marketing of investment opportunities with dividend-like payment structures. Munchee and Stream, however, tried to characterize tokens as part of a broader ecosystem in which appreciation in value would accrue indirectly through use on the platform and exchange for other cryptocurrencies. Whether the SEC’s apparent view that (almost) all public digital token sales constitute security offerings will likely be decided in courts in the coming years.

In the meantime, the SEC has further increased its involvement by sending subpoeanas to over 200 companies and individuals. Quoting individuals who have seen the subpoeanas, the New York Times described that they were sent by SEC offices in multiple cities, including Boston, San Francisco and New York indicating the breadth of the investigation. Subpoeanas are not just sent to companies that sold or plan to sell virtual currencies but also to the “gatekeepers” that help them. This includes hedge funds in the space which have been asked for the following types of information:

Details on the methodology used to price digital tokens
Whether funds are complying with rules requiring firms to hold assets with qualified custodians, usually banks or brokerages, as a way to prevent misappropriation
Details on the relationships they might have with companies they’re investing in to spot potential conflicts of interest (e.g. personal stakes in ICOs)

The below tables tabulate the Howey test assessment as it was applied by the SEC to Debevois, DAO, Munchee, and Stream as well as its likely application to key Blockchain token archetypes.

Howey test assessment for recent publications and SEC actions: