Is My Cryptocurrency a Security?
When James Henley first heard about Gladius Network’s business model, he was surprised that no one had come up with the idea earlier.
Gladius Network, a Washington D.C.-based cybersecurity startup was planning to rent backup internet bandwidth and storage space to firms experiencing cyberattacks that would otherwise paralyze a target’s internal systems and website.
As a systems administrator for a medium-sized company in the New York City area, Henley knows first hand what it’s like to be on the receiving end of a DDOS (Distributed Denial-Of-Service) attack, when his company’s website was attacked by unknown hackers demanding a ransom (in Bitcoin no less).
So when Henley heard of Gladius Network’s business idea through a friend, he was immediately drawn to the opportunity to invest in the project,
“It just made a lot of sense. Because that is precisely the service I would have hoped was available when it happened to us.”
Gladius Network went on to raise US$12.7 million by selling digital tokens to about 1,700 investors, including Henley.
But last month, Gladius Network agreed to offer refunds to all investors after the company self-reported potential violations to the Securities and Exchange Commission (SEC) in August.
According to Gladius Network’s CEO, Max Niebylski,
“We are pleased with the outcome of our collaboration and agreement with the SEC.”
“We approached the SEC in the summer of 2018 to self-report concerns related to our initial coin offering. We are proud to be the first blockchain company to do this and we hope our experience helps amplify the importance of these procedures for startup companies.”
The move by Gladius Network is to be welcome.
In a space mired by fraud, Gladius Network’s voluntary co-operation with financial regulators and its transparency in its dealings stands in stark contrast to legions of other initial coin offerings (ICOs), where investors have been left on the hook for billions of dollars in losses.
And because Gladius Network self-reported the violations, it avoided any punitive fines from the SEC.
Now Gladius Network’s settlement will require it to comply with expensive and complicated federal regulations that have frustrated many cryptocurrency startups hoping to avoid traditional Wall Street models of fund raising.
To be sure, the fundraising party that was ICOs was bound to end sooner or later.
ICOs were a novel way of startup financing through the issuance of digital tokens which could later be exchanged for the goods or services that the startup was offering.
Think of it as crowdfunding meets the blockchain — ICOs became huge tools of speculation from 2016 into the first half of 2018 — with startups raising billions of dollars, in some cases on the back of nothing more than a whitepaper and some slick marketing.
Against this backdrop of “irrational exuberance,” investors plowed billions of dollars, pumping up the perceived value of both ICO tokens as well as the base cryptocurrencies which underpinned them, including Bitcoin and Ethereum, which soared to record levels never seen since.
But from the beginning, the SEC and its chairman, Jay Clayton warned that ICOs were treading on thin ice when it came to their fundraising strategies, arguing that many digital tokens acted and behaved for all intents and purposes like securities, which would subject them to SEC oversight.
If it looks like a duck, swims like a duck and quacks like a duck…
Often referred to by lawyers as the “Howey Test,” the SEC cites a 1946 U.S. Supreme Court decision which defined an investment contract as creating a “security” and therefore subjecting the company issuing these investment contracts to SEC oversight.
According to Robert Cohen, head of the SEC’s enforcement unit,
“The SEC has been clear that companies must comply with the securities laws when issuing digital tokens that are securities.”
“Today’s (Gladius Network) case shows the benefit of self-reporting and taking proactive steps to remediate unregistered offerings.”
But even within the SEC, there are disagreements as to what constitutes a security offering and the limits to the SEC’s jurisdiction.
In a speech on February 8, SEC Commissioner Hester Peirce, long hailed by the cryptocurrency community for her “light touch” approach to regulating ICOs,
“My antennae will go up when apparently legitimate projects cannot proceed because our securities laws make them unworkable.”
According to SEC records, Peirce has voted against aspects of many SEC enforcement cases involving the sale of digital tokens, arguing in many cases that the SEC had overstepped the boundaries of its jurisdiction.
But Peirce’s approach is hardly that of the majority of SEC commissioners.
In Washington, jurisdiction is power and power is money. For the SEC, there is an inherent interest in claiming jurisdiction over digital token offerings, because by doing so, it can claim a larger budget allocation for overseeing new technological frontiers in fundraising.
The SEC would also subvert any oversight of digital token offerings from the Commodities and Futures Trading Commission (CFTC), which at one point argued that cryptocurrencies should be governed as commodities.
For the myriad cryptocurrencies that continue to be traded on a variety of cryptocurrency exchanges, the lack of clarity over the legal status of a cryptocurrency presents a legal risk when trading in such digital assets.
One of the things that investors ought to consider when investing in any cryptocurrency is their legal status — whether it is a security offering or otherwise.
For that purpose, it is helpful to recall the “Howey Test.”
In 1946, the U.S. Supreme Court in the case of SEC v. Howey found that a leaseback agreement was legally an investment contract of the type of investments listed as a “security” for the purpose of the Securities Act.
In the case, two Florida-based corporate defendants offered real estate contracts for tracts of land with citrus groves. The defendants offered buyers the option of leasing any purchased land back to the defendants who would then tend to the land and harvest, pool and market the citrus produce.
As most of the buyers were not farmers and did not have any agricultural experience, they were happy to lease the land back to the defendants.
The SEC sued the defendants over these transactions, arguing that the defendants had broken the law by not filing a securities registration statement.
The U.S. Supreme Court subsequently found that the defendants’ leaseback agreement was a form of security and developed the landmark test for determining whether or not certain transactions are investment contracts and thus subject to securities registration requirements.
According to the “Howey Test,” a transaction is an investment contract and therefore a security, if:
- It is an investment of money;
- There is an expectation of profit from the investment;
- The investment of money is in a common enterprise; and
- Any profit comes from the efforts of a promoter or third party.
But Cryptocurrency is Not Money Right?
The short answer is “it depends.”
Although the Supreme Court in the “Howey Test” used the term “money” in its ruling, later cases have expanded that definition to also include investments of assets other than money.
And because the SEC’s Jay Clayton had said previously that in his opinion, both Bitcoin and Ethereum were not likely to be “securities,” that leaves open to interpretation whether or not Bitcoin or Ethereum could be classified as assets other than money — in particular Ethereum which was the gateway drug for ICOs.
So when evaluating whether or not a particular ICO may ever fall foul of the SEC — do consider to begin with, what was the entry cryptocurrency to invest in the ICO? In many cases it would have been Ethereum and since Ethereum is not likely to be held by the SEC to be a security, could the ICO’s digital token that was purchased with Ethereum be a security instead?
Nobody Really Expects to Make Money from an ICO, do they?
During the most heady days of ICOs, there were more than a few ICOs which blatantly touted that their digital tokens were “going to the moon” or they would increase in price or value.
Such ICOs naturally were censured by the SEC, where the SEC had jurisdiction over them.
Other ICOs, registered in more lax jurisdictions got away with the boldfaced claims of profit for investors.
But regardless, whether explicit or otherwise, there were many ICOs which created the expectation of profits for investors — a definite no-no for the “Howey Test.”
Those ICOs that were a lot less likely to fall afoul of the “Howey Test” tended to be protocol-based — where the utility of the digital token was in the privilege of use the protocol to begin with.
For such ICOs, a far stronger argument could be made that the issued digital tokens were never intended to create an expectation of profit.
Who wants to take a dive into an ICO pool?
The term “common enterprise” in the “Howey Test” isn’t precisely defined and lower courts have used various interpretations of the term, while most federal courts have defined a “common enterprise” as one where investors pool their money or assets together to invest in a project.
Depending on how the term “invest” in a project is defined, the various ICO pools that were so common could arguably be used as fodder for the SEC to claim that an ICO was indeed an investment in a common enterprise.
One of the key ways that lawyers (myself included) used to skirt around the SEC’s “Howey Test” was to narrowly define an ICO’s digital token as a “utility token.”
By doing so, any “investment” in an ICO’s tokens were not to be seen as an “investment” per se, but rather a pre-payment for “utility tokens” that could be exchanged for a firm’s goods or services at a later date.
Whether or not these legal defenses would withstand a legal challenge by the SEC at the Supreme Court remains to be seen — while there were some ICOs which clearly had tokens of utility value — Ethereum stands out as an obvious example given the use of the token as fuel for smart contracts — the vast majority of ICOs were as the SEC’s Clayton rightly points out “securities.”
What about profits?
The last leg of the “Howey Test” is perhaps also one of the trickiest. Almost all digital tokens don’t pay out “profits” in the traditional sense. There are no dividend payouts the way stocks payout dividends and ICO tokens are generally non-interest bearing.
But, many ICOs also issued additional tokens just for simply holding an ICO’s tokens — could that be interpreted as paying out profits? Arguably so.
While airdrops to existing ICO token holders are not the payout of profits, where an ICO does make actual profits and then rewards its token holders by either paying out in additional ICO tokens or indeed in some other cryptocurrency such as Ethereum or Bitcoin — arguably, they could be classified as “securities” under the Securities Act.
Almost all ICOs are currently unprofitable, so this issue has not yet come to the fore, but if and when it does, how an ICO, especially one that is profit-generating decides to “reward” its digital token holders must be managed carefully.
While it would be admirable if an ICO chooses to reward its most staunch and loyal supporters with payouts, if the ICO is not prepared to subject itself to the relatively heavy regulatory burdens under the Securities Act, it may want to reconsider the manner and vehicle in which to reward “hodlers” of its digital tokens.
Tread Carefully Trade Carefully
Cryptocurrency trading is already challenging in and of itself, with myriad risks which are complex to navigate, but far too often, traders also discount the legal risks associated with trading ICOs.
Many of the most heavily traded cryptocurrencies are of course protocols — issued on their own blockchains, as opposed to the myriad ICOs which were issued on the back of the Ethereum blockchain.
But just simply because a cryptocurrency is based off its own protocol does not necessarily negate any legal risks that it would fall afoul of the “Howey Test” or that the SEC would never prosecute its issuers.
When trading cryptocurrencies, far too often traders may neglect the legal risks involved in the underlying digital assets which they are actively trading. At the very least, traders are well-advised to examine the purported legal nature of the digital assets which they trade in, to hedge and to implement risk management rules regarding the trading of such cryptocurrencies accordingly.
While the pronouncements by the SEC’s Clayton strongly suggests that the Bitcoin and Ethereum are well in the clear — that in and of itself has implications for ICOs which were issued in exchange for both these cryptocurrencies.
Until the SEC or Congress makes clear the legal classification of cryptocurrencies or attempts to create a comprehensive definition of the digital asset class, the legally ambiguous status of most cryptocurrencies will continue to constitute a risk that all cryptocurrency traders must be cognizant of and manage accordingly.