Last Thursday, William Hinman, the Securities and Exchange Commission’s (“SEC”) figurehead on all things cryptocurrency, gave an informative speech at the Yahoo All Markets Summit: Crypto. The question on everyone’s mind, and discussed in previous posts (here, here, and here), is whether and to what extent cryptocurrencies such as Bitcoin and Ethereum are securities subject to SEC and state securities regulations.
Now we have an answer—albeit an unofficial one. According to Hinman, Bitcoin and Ethereum are not securities (cue Crypto Valley celebratory parade). That was easy.
But before you go looking to hitch a ride on the next big initial coin offering (“ICO”), you should note that not all cryptocurrencies are created equal. Bitcoin and Ethereum are unique currencies, even by blockchain standards, because of the nature of their creation, the manner in which they were introduced to the market, and ongoing lack of centralized oversight of the currencies. In other words, centralization—or the lack thereof—is the key criterion in determining whether a certain asset crosses into the realm of securities.
"Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers," Hinman explained. For example, although residential units are not securities in most circumstances, if such units are offered to third parties by a single entity promising management of the assets and a return on investment with little to no involvement on the part of the purchaser, then they can be considered securities under current SEC regulations. By contrast, assets which are sold to the general public for personal use are not securities. According to Hinman, the SEC will take a similar approach to ICOs on a case-by-case basis. (Hinman promised more “formal interpretive or no-action guidance” in the future.)
Bitcoin and Ethereum survived the SEC gauntlet in large part because both lack a centralized third party responsible for making key decisions and driving the value of the currencies upward. To the extent there is central oversight, it is in a strictly operational capacity. Bitcoin and Ethereum are in stark contrast to Tezos, a cryptocurrency holding the record for the largest ICO to date (a whopping $232 million in July 2017), which is managed by the Tezos Foundation and Dynamic Ledger Solutions, Inc. The U.S. District Court for the Northern District of California certified a securities fraud class action against the Tezos entities in March of this year. (Though, whether the class will succeed on the merits has yet to be seen.) At least Tezos ICO participants received tote bags for their investments, or rather, their “donations.”
Even if a specific cryptocurrency is subject to SEC regulations at the time of its ICO, there may come a day when the currency graduates from security to, well, just another currency. According to Hinman, such evolution can occur where, you guessed it, the network decentralizes to a point where the efforts of a single third party “are no longer a key factor for determining the enterprise’s success.” And though not discussed in Hinman’s speech, the converse could also be true. A cryptocurrency that is not a security today could become one tomorrow as a result of changes to the structure of the network or the nature of transactions.
Are you wondering whether your digital currency is or will be subject to federal and state securities regulations? If so, consider the following questions:
- Has a person or entity sponsored the creation and sale of the currency?
- Will the sponsor be responsible for managing and increasing the value of the currency?
- Will the sponsor retain a stake in the currency incentivizing the sponsor to increase the currency’s value?
- Will third parties participate in the ICO or purchase the currency on an exchange with the intent or belief that the currency will provide a return on investment?
- Has the sponsor raised funds in excess of what may be needed to establish a functional network, and, if so, for what purpose?
- Is the currency marketed to the general public as an investment, rather than to potential users of the currency?
- Are ICO participants relying on the management of others to increase the value of the currency such that disclosure of the manager’s plans and activities would be of importance to currency holders?
- Do other persons or entities exercise governance rights or meaningful influence?
If you answered “yes” to any or all of these questions, your cryptocurrency may be a security.
Hinman’s complete speech can be viewed here.