Is Crypto a Security? (EN)
If $XRP is considered a security, then your cat could also be considered a security
The issue of whether cryptocurrency is a security has been a cause for concern for a long time, with several high-profile cases, including SEC v. Ripple Labs and investigations into staking services of crypto exchange Kraken and Paxos, the issuer of the BUSD stablecoin. However, the determination of whether a cryptocurrency is a security still remains vague as it is not yet written into securities laws, leading to confusion for investors. With that in mind, this article aims to explain what a security is, how it is judged, and what investors may be missing from the most recent ruling in SEC v. LBRY.
What is a security?
In the United States, the term ‘security’ is defined in Section 2(a)(1) of the Securities Act of 1933.
Unlike stocks and bonds, cryptocurrency is a newer asset and is not precisely defined by securities laws. Therefore, the question of whether cryptocurrency is a security is mostly about whether it qualifies as an “investment contract,” which is determined by the Howey Test.
The Howey Test
The Howey Test is a legal test used in the United States to determine whether a particular transaction constitutes an investment contract under the securities laws. It originated in the 1946 U.S. Supreme Court case SEC v. W.J. Howey Co. and states that if all four criteria below are met, the transaction is considered an investment contract and therefore subject to securities regulation under U.S. law:
1. It is an investment of money.
2. There is an expectation of profits from the investment.
3. The investment of money is in a common enterprise.
4. Any profit comes from the efforts of a promoter or third party.
While the SEC’s guidelines state that a token must be decentralized or have no specific operating entity, not be for speculative purposes, have a stable value, have functionality that outweighs the value of the token, and be immediately redeemable within the token’s platform to not qualify as a security, there remains ambiguity around these guidelines.
SEC v. LBRY
LBRY is a blockchain-based content sharing platform like Amazon and YouTube, which allows users to access a wide variety of content using the LBRY blockchain. In July 2016, LBRY issued 1 billion $LBC to reward users for sharing information, initially allocating 400 million to themselves for “usage and adoption,” and 53.9 million $LBC to sell directly through an app created by LBRY or through other third-party trading platforms.
However, on March 29, 2021, the SEC filed a lawsuit against LBRY for violating Section 5 of the Securities Act of 1933 by selling $11 million worth of unregistered securities. The case centered on Howey Test questions 2 and 4, “with the expectation of profits to be derived solely from the efforts of the promoter or a third party,” to which LBRY countered that 1) $LBC is not a security and 2) LBRY did not receive a fair notice.
On November 7, 2022, the court found that LBRY violated the securities laws for the following reasons:
- Through its various communication channels, LBRY has created a reasonable expectation that the value of $LBC will increase as LBRY grows.
2. Even if not directly stated, LBRY’s business model, with its economic incentives, suggests that the value of LBRY and $LBC are linked.
3. The mere fact that a crypto has a utility aspect does not make it a non-security.
Tokens themselves are not securities
It is worth noting the outcome of the SEC v. LBRY case as many investors mistakenly believed that $LBC itself is deemed a security. However, following the court’s ruling on January 30, 2023, it became clear that the previous securities law violation only applied to primary market sales of $LBC and not secondary market sales. Although the SEC sought a permanent injunction against $LBC by arguing that $LBC itself is a security and thus any subsequent token sales is in violation of securities laws, the court clarified that it was the contractual process of initial sale of $LBC that was considered an investment contract.
Using the Howey Test as an example, an entity that owns an orange farm and offers it for sale in a way that allows it to be subleased back to the recipients of the sale, guaranteeing rental income and a return on cultivation, constitutes an investment contract. However, it makes no sense for the orange farm itself to be a security, and if the same orange farm is subsequently purchased for actual cultivation, it is not an investment contract either. In other words, even in SEC v. LBRY, while the act of buying with the expectation of profit in the primary market is an investment contract and, therefore, a violation of the securities laws, the ruling does not imply that the $LBC itself is a security. Moreover, if an individual subsequently purchases the $LBC for purely utility purposes, they cannot be held to have violated the securities laws for that act.
In fact, two of the most prominent cases in the crypto space, SEC v. Telegram and SEC v. Kik Interactive, also found that the contracts in the ICO process were investment contracts, but not that the crypto itself is a security. Furthermore, in his report titled “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets are Not Securities,” attorney Lewis Cohen analyzed all 266 cases involving securities and argued that none of the cases found that the assets themselves were investment contracts.
What about XRP?
The SEC v. Ripple Labs case bears many similarities to SEC v. LBRY. Like LBRY, Ripple Labs is accused of raising approximately $13.8 million in cash in the primary market, and the Howey Test “with the expectation of profits to be derived solely from the efforts of the promoter or a third party” is a key issue of contention.
If the ruling in SEC v. LBRY were applied to the Ripple case, it is possible that the argument in which Ripple Labs allegedly raised cash by selling approximately $13.8 million worth of XRP on the primary market could be viewed as an investment contract. However, while it is possible that Ripple Labs could be fined for this sale, it is unlikely that the SEC’s argument that “XRP itself is a token” will be accepted, based on the ruling in SEC v. LBRY. Therefore, it can be predicted that XRP in subsequent sales will not be subject to the SEC’s jurisdiction.
Conclusion
- A token sale on an issuance market is very likely to be considered a security. Most projects are issued by a common enterprise, promoting their tokens and trying to get investors to invest in them. This meets all the criteria of the aforementioned Howey Test, especially the always controversial “expectation of profit from the efforts of a third party” part. In the future, it is necessary to have clear guidelines on how projects can sell and promote their tokens in compliance with securities regulations.
- It will be interesting to see if the SEC’s embodiment theory is accepted. As mentioned earlier, contracts in the issuance market are likely to be considered investment contracts, but it remains to be seen if the courts will recognize the SEC’s jurisdiction in the secondary market or whether they will recognize crypto itself as a security. If the court decides to recognize crypto as a security, it could have a significant impact on the crypto industry.
- With a market capitalization of over $1 trillion and a conservative estimate of around 15,000 projects in the crypto market, there is an urgent need for a well-defined plan of action. Alongside establishing clear criteria for judging whether a token is a security or not, it is imperative to provide more detailed guidelines on how to manage and review existing tokens, as well as new projects in the future.
Disclaimer
All content in this article is intended to communicate and provide information and is not intended as the basis for investment decisions or for recommendations or advice for investment. The contents of the text are not responsible in any shape or form including matters that pertain to investment, law, or tax matters
