The SEC has apparently determined that Bitcoin and Ether are not securities. In remarks to the Yahoo Finance All Markets Summit, its Director of the Division of Corporation Finance adopted a favorable tone towards cryptocurrency and blockchain technology, and specifically indicated that he does not view Bitcoin and Ethereum as securities. I’ve highlighted some excerpts below with commentary. For other insights on these issues, see our prior posts: Initial Coin Offerings (“ICO”) Regulation, SEC: Virtual Tokens Issued in Blockchain-Based ICO’s may be “Securities”, Cryptocurrency Regulation: Recent Developments.
The remarks began with a focus on secondary exchanges of digital assets:
To start, we should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold. To that end, a better line of inquiry is: “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.” In these cases, calling the transaction an initial coin offering, or “ICO,” or a sale of a “token,” will not take it out of the purview of the U.S. securities laws.
But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.”
Bitcoin and Ether
These remarks indicate that where a digital asset truly functions as a currency and does not simply manifest an interest in an underlying entity, enterprise or investment, the SEC will not take the position that the asset constitutes a security. The SEC went on to focus specifically on Bitcoin and Ether:
when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
The Securities Analysis is Not Static
The SEC underscored the fact that the inquiry into whether a digital asset constitutes a “security” is a moving target—a legal question that depends upon the circumstances and may change over time:
the analysis of whether something is a security is not static and does not strictly inhere to the instrument. Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security. If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.
Let me emphasize an earlier point: simply labeling a digital asset a “utility token” does not turn the asset into something that is not a security.
The Sec also discussed a number of factors to consider in assessing whether a digital asset is offered as an investment contract and is thus a security? Primarily, one should consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. The answer to that question depends upon the particular facts and circumstances, and a host of factors may be relevant, including (but not limited to):
Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
While these factors are important in analyzing the role of any third party, there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security. The SEC and courts look to the economic substance of any transactions, but it emphasized that counsel should consider a number of factors in determining whether a token being offered is a security, including the following:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
For more on these issues, see our prior posts:
- Initial Coin Offerings (“ICO”) Regulation
- SEC: Virtual Tokens Issued in Blockchain-Based ICO’s may be “Securities”
- Cryptocurrency Regulation: Recent Developments
- Bitcoin, Blockchain, and the Revolution to Come
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