A new financial instrument is arising in the capital markets and it provides both benefits and challenges to the equity environment. Variously denominated as initial coin offerings, crowdsales, token launches, and crowdfunding, this mechanism, rather than offering equity in a start-up venture, offers discounts on cryptocurrencies before they become available on the several exchanges.
Such offerings are made into a fraught landscape where they risk being interpreted as securities offerings that are subject to regulation, oversight, and enforcement by the Securities Exchange Commission. While the innovative characteristics of digital currency ought be encouraged, the SEC may, for reasons I explore in this note, be inclined to bring this device within their purview.
ICOs generally hold their offerings to be outside the conventional definition of securities and, so, outside the legal framework applicable to securities. Nevertheless, there is an expressed sense in the marketplace that government regulation of cryptocurrency will be necessary for the mechanism to be fully utilized.
This paper will review briefly two reasons that U.S. law will likely conclude that cryptocurrency is a security subject to the American regulatory scheme, First, I argue that the offerings made via ICOs are in effect, if not name, securities subject to the associated law. Second, I present my view that the Securities Exchange Commission is likely to find it to be in the public interest to conclude that digital currencies should be characterized as securities.
I. The Offering of Digital Currencies by Companies Seeking to Raise Capital Fits the Legal
Construct of a Security
The law defining securities, for purposes of federal regulation, has evolved in considerable nuance and complexity. The Securities Act of 1933 rather quaintly defines a "security" as
any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
The Securities Exchange Act of 1934 uses a somewhat similar definition.
Section 5 of the Securities Act makes it unlawful to offer or sell any security unless a registration statements is in effect for that security or there is an exemption from registration available. That section also requires the use of a statutorily prescribed prospectus document.
Finance is, in the practice, much more intricate than the plain language of the statutes appears to acknowledge, and, so, the courts have articulated considerable law particular to a wide range of circumstances encountered in application an in an evolving industry. Controlling these interpretations is the Supreme Court case SEC v. W.J. Howey Co. That case articulated both the priority of substance over form in evaluating whether a device is a security, as well as a test consisting of four distinct elements:
The first Howey test looks for an investment of money into some enterprise. Court cases has since broadened that notion to include any form of consideration;
Such an investment must be made into a common enterprise. Court rulings have articulated both "horizontal commonality" and "vertical commonality."
Horizontal commonality describes the pooling of value from several investors who share in the profits and risks. Most circuits that have considered the issue of what is a common enterprise find it satisfied where a movant shows horizontal commonality, that is the pooling of investors' funds as a result of which the individual investors share all the risks and benefits of the business enterprise] These circuits focus on whether the scheme involves a "pooling" of assets. For the common enterprise test to be satisfied, horizontal commonality requires that an investor's assets be joined with another investor's assets into a joint venture where each investor shares the risk of profit and loss according to their individual investment.
Vertical commonality is split into "Narrow" verticality and "Broad" verticality.
i. The narrow vertical view is held by the Ninth Circuit. The narrow vertical approach finds a common enterprise if there is a correlation between the fortunes of an investor and a promoter. Under narrow vertical commonality a common enterprise is a venture in which the fortunes of the investor are connected with and dependent upon the efforts and success of those seeking the investment. It is not necessary that the funds of investors are pooled; what must be shown is that the fortunes of the investors are linked with those of the promoters, thereby establishing the requisite element of vertical commonality. Thus, a common enterprise exists if a direct correlation has been established between success or failure of the promoter's efforts and success or failure of the investment. Under this view, the test is satisfied if the promoter and the investor are both exposed to risk and the profits and losses of investor and promoter are correlated.
ii. The broad verticality test finds a common enterprise if the success of an investor depends on a promoter's expertise. "Broad vertical commonality ... only requires a movant to show that the investors are dependent upon the expertise or efforts of the investment promoter for their returns." The Fifth Circuit and the Eleventh Circuit (because of the Eleventh Circuit's adoption of pre-split Fifth Circuit opinions) both follow this view. These courts focus on the expertise of the promoter in the industry of the alleged security. If the investor relies on the promoter's expertise, then the transaction or scheme represents a common enterprise and satisfies the second prong of the Howey test.
The third prong of the Howey test requires an expectation of profits. Profits can be in the form of a cash return on the principal investment, capital appreciation, dividends, interest, or other earnings. For purposes of the Howey test, "profits" mean return to the investor, and not to the success of the enterprise. For example, a Ponzi scheme has no possibility of real prosperity, but certainly involves a security. This test looks to the motivation of the investor.
The fourth test in Howey calls for the expectation of profits to be derived solely from the efforts of the promoter or some third party. The efforts of the promoter or third party must have a clear role in the success or failure of the enterprise.
We can examine just what it is that ICOs are offering by reviewing their descriptive so-called "White Papers" which offer the promoters' outlines of the business model and goals of the enterprises. I have reviewed dozens of such white papers and find these elements in common among them:
-A description of the rapid growth presently occurring in the market space the enterprise proposes to enter
-A description of the unique value proposition the enterprise claims to possess (generally using rhetoric focused on results, rather than specific methods and always couched in highly technical language
-Many falsely claim their descriptive language or process is trademarked or otherwise lawfully protected from cooption
-In return for the solicited investment, the promotions offer early or discounted access to some form of digital currency, sometimes the promoter's own brand of such digital currency
-A vague growth model is postulated, based on such things as "activity" within the proposed business ecosystem, transaction fees derived from cyptocurrency trades, or growth of other users' participation in the system itself
-Investment in the offering is virtually always through some existing digital currency or, in some cases, precious metals, such as gold
I found no ICO White Paper that did not articulate, or at least imply, satisfaction of all four of the Howey tests for a security. Most satisfied both the horizontal and both vertical tests for a common enterprise. Often, the efforts by promoters to avoid using language they might have considered admissions of Howey criteria worked to render the rhetoric of those white papers cumbersome and incomplete.
In short, the promoters of ICOs conspicuously promote their own skills, insight, and claims to exclusive intellectual property as the value drivers of the enterprise upon which their respective enterprises will generate returns to investors, whose pooled investments are sought to capitalize the business. While nearly all of the white papers I reviewed were cautious to avoid references to specific return values or rates investors might expect, without exception, they all make repeated mentions of "profits" or some synonym thereof By either direct evidence, or by implication, then, these ICO white papers describe "securities" that meet the Howey tests.
II. The Digital Currency Market Space Exhibits Characteristics Which May Make it a Good
Subject of Regulation
The statutory authority to regulate these offerings aside, the SEC has an imperative to examine them in detail. Indeed, the SEC has, on more than one occasion, suggested that digital offerings are securities.
At least two other U.S. supervisory entities have articulated their views that digital currencies are subject, to varying extents, regulatory oversight.
The Commodities Futures Trading Commission has designated bitcoin as a commodity, subjecting it to the CFTC's trading rules. As well, the IRS has characterized cryptocurrency as "property" and not "currency," thereby disqualifying it for treatment with exchange gain or loss under Reg. §1.988-2.
The argument that the marketplace will serve to govern itself in this sector is somewhat belied by the fact that the marketplace in Bitcoin does not operate with an even hand.
As shown in Figure 1, the volatility of the conversion price of the pairs of Bitcoin/U.S. Dollar and Bitcoin/China Yuan has been growing at a faster rate for the Yuan than for the Dollar, especially since April of 2017. This has created a structural opportunity for arbitrage and can leave investors subject to unregulated speculation in cryptocurrency. Given that bitcoin and similar devices trade anonymously, the opportunity to generate large profits, outside the purview of the tax authorities, could, no doubt, attract any number of participants with obscure intent to the marketplace.
The attraction of a market so apparently open to manipulation by substantial participants may also be worth consideration.