Why Fungible Crypto Assets Are Not Securities
With the SEC becoming more visible in how they enforce their interpretation of the Securities Act I thought it would be useful to consider again the draft proposal from the excellent team at DLx Law entitled The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities.
It’s a sizeable paper (180 pages) so I have plucked out what I think are the most pertinent statements and shared them below. If you do read one thing in the paper make it the Parable of the Strowrange Seeds on page 17 for a straightforward metaphor of web3 investment, token emission and public offerings.
Full disclosure: I was lucky enough to work alongside DLX Law’s Lewis Cohen in 2016 on the concept of enshrining law into smart contracts, a fascinating topic. Also, I’m not a lawyer.
TLDR
According to the current law regarding “investment contracts,” most fungible crypto assets transferred in secondary transactions should not be classified as “securities.” This is because these assets lack the necessary legal relationship between an identifiable entity and the owner of the crypto asset, which is crucial for something to be considered a security.
Investment Contract or Instrument?
Four prongs of the Howey test can be applied to fundraising sales of crypto assets, but not in the context of secondary transactions. According to the Howey Test a transaction is a security under US securities law if it satisfies all four criteria:
The inclusion of “investment contract” as a security in the Securities Act is basically a catch-all and is not typically used in the context of commercial arrangements. As a result it’s left to the courts to determine in hindsight whether or not a crypto asset is a security. This would be despite the fact that parties to the commercial arrangement did not label their arrangement that way.
A crypto asset that neither creates, nor is intended to represent, a legal relationship between an identifiable issuer and the persons who, from time to time, own that asset cannot be an “instrument” (or any other type of security, for that matter). This is regardless of whether the transaction in which the asset is sold is an investment contract transaction. That is, there is usually nothing in the smart contract code that creates a token or in any associated metadata that enables any set of legal rights or duties on the part of any person or entity.
Issuer Independent Assets
When you own a token, it aligns your economic interests with other owners, but it doesn’t create any legal relationship between you and the entity that created or sold the token. This means that such a token would essentially be “issuer independent,” which is completely different from how federal securities law works.
According to the US securities law right now, there’s no such thing as a “issuer-independent security.” This means that there can’t be a security that exists without a specific entity being considered its “issuer” under the law. When it comes to assets like tokens, the people or companies who initially create them don’t have a necessary connection to the asset itself. As a result, these assets lose their “securityness” when they’re sold again by individuals who are not the original promoters.
SEC’s “Embodiment Theory” and “Morphing” Approach
The SEC’s “embodiment theory” should not be adopted for secondary markets because it is too unwieldy. The SEC has pursued litigation where it is not the crypto asset, but rather all the facts and circumstances surrounding the crypto asset and the manner in which a token was initially offered and sold, asserting the token “is the embodiment of those facts, circumstances, promises, and expectations and today represents that investment contract.” However, the purchaser of a crypto asset in a secondary market transaction (e.g., whether on a CEX or DEX) has no way of knowing or determining all of the “facts, circumstances, promises, and expectations” which might be deemed by a court in hindsight to be “embodied” in any given crypto asset, many of which may not be matters of the public record and capable of discovery by third parties.
A crypto asset can morph from something that evidences an investment contract to something that does not. However crypto asset market participants are without an objective and observable means of determining with any reasonable certainty when and under what circumstances such a morphing “out of” security status might occur.
Efforts of Others
Most commonly, tokens and the on-chain abilities they may facilitate, like governance or paying for transaction fees, do not in and of themselves provide the token holders with an rights or interests in the project’s founders or entities. Instead the activities of the project’s founders or entities are better understood as a positive externality, like an increase in house prices when a local school achieves outstanding results.
Conclusion
Crypto assets are not like traditional securities with written documents that explain the obligations of an issuer and the rights of a holder. They are essentially just strings of numbers that allow the person in control of the private key associated with the public blockchain address to interact with the blockchain. In general, crypto assets don’t grant specific legally enforceable rights to the holder, nor do they impose obligations on any identifiable issuer. Given these facts, there’s no legal or logical basis to automatically consider all crypto assets as securities. Instead, each transaction involving a crypto asset needs to be examined based on its specific facts and circumstances to determine if it should be treated as an investment contract and subject to compliance with securities laws.
