Digital Assets—Investment Contracts or Howey Test Unicorns? (Part 1 of 6)
In this first segment of a six-part series, Professor Ari Gabinet begins to outline how digital assets such as cryptocurrencies and NFTs conform—or fail to conform—with the SEC’s current regulator framework. Professor Gabinet is an expert in securities law, drawing from experience as a private practice litigator, a private sector in-house counsel, and as a district administrator of the SEC. Submitted March 2021.
The regulation of cryptocurrency and digital asset offerings has become a hot topic in finance. Beginning in 2013 with the issuance of Mastercoin and Ethereum’s offering in 2014, initial coin offerings exploded in popularity; as of this writing, coinmarketcap.com identifies more than 8,700 cryptocurrencies with a market capitalization of more than $1.5 trillion. The idea of a digital currency or token began with Bitcoin, a digital currency created through the autonomous operation of a supposedly immutable software engine running on a ledger distributed across numerous independent and anonymous servers. The novelty and attraction of a new, entirely digital, asset class captured imaginations. For a while it seemed like the best way to attract startup capital was to offer people a “coin”—regardless of whether it was actually a currency or operated on and by a blockchain or other distributed network.
The Securities and Exchange Commission’s role is to ensure that entrepreneurs who solicit capital from the public comply with securities laws. If a business opportunity falls under the SEC’s jurisdiction, the Commission and its staff are rightfully vigilant to ensure that investors receive adequate information and that market participants comply with applicable law and regulations. Given the explosion of digital asset offerings, their arcane nature and the frenzy for them among retail investors, the SEC is rightly concerned. But the technical complexities of the digital asset world, where computer science meets finance and virtual reality meets concrete transactions, complicate effective regulation.
Distributed autonomous systems like blockchains challenge conventional modes of securities regulation. Blockchains are not proprietorships, partnerships, corporations or LLCs—although they may be created by them. Blockchains can create value without the ongoing intervention of human agents. Once initiated, they can operate autonomously, executing transactions, purveying goods and services, completing payments and maintaining the records all on their own. SEC enforcement actions in the blockchain area have run the gamut from promoters who were alleged to have simply taken investors’ money and used it for personal purposes without having a real business at all (SEC v. Krstic et al. 21 Civ. 0529 (E.D.N.Y. filed 2/1/21)) to those involving promoters alleged to have misrepresented the status and readiness of their proposed business (In Re Boon, Sec. Act Rel. 10817, Exchg. Act Rel 89548, Ad. Proc. No. 3-19913 (8/13/2020)), to cases alleging violations of the registration requirements of the Securities Act of 1933. Some of these cases are simple securities frauds; others, though, involve difficult questions of how and where the SEC’s jurisdiction intersects blockchains and the digital assets related to them.
The fundamental issue that defines the SEC’s jurisdiction is whether the digital asset in any particular setting is in fact a security within the SEC’s purview. The SEC has not yet offered definitive guidance and crypto entrepreneurs—the fraudsters and the good faith business digital businesses alike—are left to interpret a patchwork of staff guidance and enforcement actions that have themselves been the target of criticism from the Commissioners. For example, the SEC’s division of corporation finance has promulgated a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn11 (the “Corp. Fin. Framework”). In the staff’s own words, the Corp. Fin. Framework represents the views of the Strategic Hub for Innovation and Financial Technology ("FinHub," the "Staff," or "we") of the Securities and Exchange Commission (the "Commission"). It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content.
Corp. Fin. Framework fn.1. SEC commissioner Hester Peirce has publicly criticized the Corp. Fin. Framework, dissented from cryptocurrency-related enforcement actions, and denigrated Division of Corporation Finance no-action relief which, in her view, improperly imposed conditions on digital assets in order to ensure that they were not construed as securities requiring SEC registration. See, e.g., Pierce, H., “How We Howey,” speech at Securities Enforcement Forum, East Palo Alto, CA, https://www.sec.gov/news/speech/peirce-how-we-howey-050919; Peirce, H., Statement on SEC Settlement Charging Token Issuer with Violations of Registration Provisions of the Securities Act of 1933, https://www.sec.gov/news/public-statement/peirce-statement-settlement-charging-token-issuer.
The regulatory task is further complicated by the heterogeneity of digital assets and the way they are created and issued. There is no single type of digital asset, coin, token or cryptocurrency. Generally defined as electronic records represented on decentralized electronic ledgers (commonly blockchains), they may be simple currencies (stores of value), they may be means of payment for goods and services, means to access applications running on blockchains, claims on the assets or income streams of users, loyalty programs for digital platforms, governance mechanisms, representative ownership of some other (physical or digital) asset, digital currencies tied to fiat currencies (stablecoins), centralized and/or decentralized financial abstractions or digital collectibles (nonfungible tokens, also known as “NFTs”); they may be sold directly to the public in exchange for fiat currency or other digital assets; they may be issued pursuant to the self-executing operation of an algorithm as a reward for participation in a blockchain ledger; or they may be issued free for use of an application running on a blockchain. They may be sold in order to raise the capital necessary to create a blockchain or a blockchain application, to create a marketplace in which they can be used to purchase goods or services that comprise the blockchain or applications in the blockchain environment, or to generate activity in a blockchain application or environment.
So, which ones are securities? The first place to look for an answer is the law itself. The ’33 Act does provide a definition of “security,” but unfortunately, it is not particularly instructive. Section 2(a)(1) defines security by giving a long list of items that are securities. That list, which includes the obvious stocks, bonds and derivatives, does not include “currency” or “cryptocurrency” or “digital token” or “digital asset.” Nor does it include any general statement of characteristics or organizing principles from which one might deduce a “test” for whether something is a security.
It does include “investment contract”; this simple term has become the catch-all under which new and unconventional ventures are assessed to determine if they fall under the ‘33 Act.
Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review is grateful for his support as our Faculty Advisor.