As New York Times columnist Paul Krugman noted in a recent column, blockchain is now a bit long -in-the-tooth as far as internet technologies go. Bitcoin was launched in 2009, and over the past decade-plus, countless alt-coins have hit the market. However, as tokens have become more mainstream, as well as an increased tool for ne’er-do-wells, cries to regulate the cryptospace have grown substantially. Not only are we seeing this nationally, through such events as the SEC’s suit against the creators of Ripple, we are seeing this internationally as well, as the Chinese government has cracked down on the crypto-mining industry in that country. While the international regulation is certainly interesting, and well worth watching for both investors and crypto-industry professionals, now is a good time to take stock of what the regulatory environment has been in the United States for the past decade and where it may be heading.
Crypto Regulation to Date
The big question on everyone in the crypto industry’s minds is whether the SEC will begin to regulate crypto. Billions of dollars worth of coins are being traded on a daily basis, and it’s quite rare for trading activity of that volume to escape the federal government’s attention. However, there is one big obstacle to that regulation, and that obstacle has to do with oranges.
The SEC was created to regulate the sale of “investment contracts,” and the question arose quite quickly as to what constituted an ‘investment contract,” or a “security.” The Supreme Court case that delivered the first definitive answer on this was SEC v. W.J. Howey. That matter involved the sale of contracts that would provide the purchaser with a share of the proceeds in the profits of orange groves in Florida. The Supreme Court held that these contracts were securities and announced a three-part test regarding what would be considered a “security.” A security is (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit to be derived from the effort of others. In other words, the orange trees themselves were not securities, but investment contracts that purported to provide investors with a share of the profits from the orange growers’ activities were.
Returning to the realm of crypto, the tokens themselves would appear to fall outside the ambit of the Howey test. If I purchase a token, it is not an investment in a common enterprise with expectation of profit to be derived from the effort of others. It is more akin to buying the orange tree itself than shares in the orange juice company.
But the crypto business has developed well beyond the simple buying a selling of tokens. Investors now have all sorts of ways to make (and lose money) in the crypto space, some of which certainly fall within the definition of a security. For example, crypto-mining companies and crypto-trading firms may offer shares in their business to investors; those would almost certainly be securities. If you are starting a crypto business, you need to ask yourself, are you selling the orange trees or the orange juice company?
The SEC’s Approach
Historically, the SEC has taken the approach to date has been that tokens are not securities, just as the orange groves in Howey were not. However, recently the SEC has begun to turn a more critical eye to token issuers. The most significant recent development is the SEC’s action filed last year against Ripple Labs Inc., which seeks to charge that company and its executives with unlicensed sale of securities. Why the change in approach? It seems the core issue is that the token sales were being used to finance company operations. In other words, the token was functioning in a way more akin to a security, asking purchasers to invest money in Ripple with the increase in the value of the token to come from the efforts of Ripple Labs. The SEC has argued that given this structure, Ripple Labs was required to provide investors with the disclosures that ordinarily accompanies a public securities offering, something the SEC alleges that Ripple Labs failed to do. The outcome of this case, and new SEC rulemaking on token issuances merit further monitoring.
The crypto industry is ever changing, as is the government’s regulation of the industry. If you are operating within the industry and are seeking legal advice please contact us for a free consultation at 848.202.9323 or email us at firstname.lastname@example.org. Please note that any legal question requires consideration of individual facts and this article is not intended as legal advice to any particular individual or business and should not be relied upon as such.