SEC v. Cryptocurrencies: Why a 1946 Securities Law may not be able to Regulate Cryptocurrencies


In 1946 the Supreme Court made a decision about the legal status of an agreement that allowed buyers to purchase land in a Florida orange grove and then lease the land back to experienced growers to tend and manage the land. In the 1940s, the Florida orange industry was a hot market, and at the time this type of investment was as exciting as many ICOs were in 2017.

The Supreme Court ruled that in this case, SEC v. Howey, that the substance of an investment contract is more important than its form. The court ruled that even though on the surface this investment appeared different than a standard sale of securities, it would still be treated as a securities offering and an unregistered one at that. The Supreme Court decided that there were 4 main factors that determined if something was a security, regardless of how the investment agreement looked.

A test was developed as part of the ruling that is known as the Howey Test and is still being used to this day to evaluate whether something is a security.

The Howey Test has most recently been applied to a new method for raising capital, an Initial Coin Offering (ICO), which relies on recent advances in the fields of cryptography, computer science, hardware manufacturing, distributed networks, and blockchain.

The question of whether ICO’s and Cryptocurrencies are securities has loomed like a dark specter over the 2018 ICO market and has ground the majority of activity to a halt as the entire sector awaits a concrete decision as to the circumstances under which ICOs are securities. A securities designation would impose significant costs and regulations for raising capital and for exchanges that offer the trading of coins on a secondary market.

The SEC has mainly made its intentions known through a few enforcement actions targeting low-hanging fruit (outright scams, blatant violations), although it has recently started to expand and has now targeted ICOs which raised capital after the SEC made unofficial comments on their status as securities. The most well-known of these comments is a statement by the Chief of the SEC, Jay Clayton, who famously said: “I believe every ICO I have seen is a security”.

However, it seems the legal team over at Coinbase, a top regulated cryptocurrency exchange, believes the SEC has a broader definition than the comments by Clayton would suggest. The cryptocurrency exchange has added a large range of coins which previously conducted ICOs, and executives for Coinbase stated in an interview that they feel confident they are not listing any unregistered securities.

Regardless, the uncertainty around the SEC’s intentions has left the once booming ICO market lifeless and done almost the same for the broader cryptocurrency market.

Yet, the entire process is based on an assumption which has not been properly discussed:

Can a 1946 ruling about leasebacks for Florida orange groves still apply to raising capital by issuing digital assets on decentralized blockchains?

By taking action, the SEC assumes that the Howey Test applies to ICOs as much as it has applied to leasebacks, equity offerings, and any other securities that have been offered between 1946 and now.

At its heart the Howey Test states the substance of an investment agreement is what matters, not the form, and so while an ICO is entirely different than a citrus grove leaseback it still results in a group of individuals investing in a project they are not a part of and expecting a profit. Given this view, the SEC can argue the Howey Test applies.

On the other hand, cryptocurrencies, cryptoassets, and ICOs have a number of qualities that suggest different rules might be warranted to properly regulate this new digital frontier. It is impossible to lump all cryptoassets into a single category as they all have different structures.

Bitcoin was never issued in a token sale by a founding team (like many ICOs), and Ethereum, which was, is no longer controlled by that team. In fact, the SEC has even ruled that Ethereum, despite once being a security, is no longer a security. Some coins are more similar to commodities, some are like airline miles, and others can even represent digital ownership of art or property.

The sense that the entire landscape of digital assets, one that is being born as we speak, requires a different regulatory approach is so strong that even Congress is fighting to ensure digital assets receive their own framework.

The “Token Taxonomy Act” was recently introduced by Warren Davidson and David Soto, and seeks to provide a more appropriate framework for crypto asset regulation. The bill seeks to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to create a new category for digital tokens. Many of the distinctions in the bill revolve around the level to which a single party controls the token, which corresponds to the exemption given to Ethereum by the SEC. One possible outcome of the act, if it were to be adopted, is that meaningfully decentralized tokens would be exempt from a securities designation.

The bill has been months in the making as Davidson hosted a large discussion featuring many industry players (Fidelity, Nasdaq, Andreessen Horowitz) and members of the U.S Chamber of Commerce. One of the clear goals of this discussion is to prevent driving digital assets innovation overseas, something which has already been occurring.

The biggest takeaway is that a diverse and bi-partisan group is taking initial steps to change the discussion around digital assets as they have recognized how the current regulatory limitations are pushing blockchain and cryptocurrency companies out of the United States.

To quote Davidson,

In the early days of the internet, Congress passed legislation that provided certainty and resisted the temptation to over-regulate the market. Our intent is to achieve a similar win for America’s economy and for American leadership in this innovative space.

This is ultimately the point that is truly worth discussing.

Digital assets are not a single homogenous thing, far enough in its developmental lifecycle to be able to be neatly regulated. They are a diverse blend of different concepts, none of which have ever existed before. They are developing rapidly, and what exists today by no means represents what digital assets may look like in 10 years.

How do you regulate such an uncharted and rapidly evolving arena of innovation?

How can any regulator truly answer with confidence that they understand the needs of the digital asset sector enough to pass decisive regulation?

A strict regulatory approach is likely to be a shot in the dark. While this may save some short-term abuses, it also threatens to rob society of a crucial innovation down the road.

Firm regulation may do much more harm than good.

It is not the job of a regulatory body to decide which technologies get to evolve and mature by crippling the field when it is young. It is the job of a regulatory body to apply knowledge and wisdom in dual measure to limit abuses and harm.

As Rep. Davidson stated, the way Congress regulated the internet in its early days is a model to aspire to. Where would we be as a society if we had crippled the internet when it was young and made it prohibitively restrictive for new companies to try new ideas. We might have robbed ourselves of one of the greatest tools that humanity has developed, a free and open exchange of information.

While the internet and tech landscape of today does not quite match that lofty ideal, it is perhaps the approach being spearheaded by blockchain technology and cryptocurrencies that may bring our remedy to tech overgrowth and overreach.

Blockchain is an experiment with a new form of organization and a new type of network. It is reaching for a system that is resistant to control and manipulation, and, if it is able to achieve this, could help the internet embody its early ideals.

As with any new endeavor, we cannot know ahead of time what it will bring, but we will never know what it could have brought if we blockade its progress with regulations focused more on preserving an old order than facilitating the discovery of new possibilities yet to come.

The regulatory approach that must be taken here is to do no harm, as not to kill something we do not yet truly understand.

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