Securities Regulation and Cryptocurrencies

Securities regulation is a complex area of both U.S. and International laws. In this post I will focus on the high-level US law on securities regulation and its intersection with cryptocurrencies. Much of the structure for this post will mirror this book, "SECURITIES REGULATION, Cases and Materials, 10th Ed., by Cox (2022).

The first question is "Why do we have securities laws?" The securities laws exist because of the unique informational needs of investors. Securities are not inherently valuable. Deciding whether to buy or sell a security requires reliable information about the issuer's financial condition, products and markets, management, and regulatory climate. Only with this data can investors attempt a reasonable estimate of the present value of the bundle of rights that ownership confers.

Securities are bought and sold either as issuer transactions or trading transactions.

Issuer transactions are those involving the sale of securities by the issuer to investors. It's how businesses raise capital to grow or simply survive. (In this author's opinion, the sale of the pre-farm is how the business is surviving, therefore if it is a securities transaction then it is an issuer transaction.)

Trading transactions are the purchasing and selling of outstanding securities among investors. This is usually done on stock exchanges like the NYSE or Nasdaq.

The first of the federal securities laws enacted was the Federal Securities Act of 1933, which regulates the public offering and sale of securities in interstate commerce.

When a financial instrument has the status of a security, the full weight of the securities laws (registration and prospectus requirements, anti-fraud provisions) are brought to bear on the transactions underlying its marketing and sale. The definition of a security is of great importance. The complexity of defining what is a security has led to a body of law that is both unsettled and evolving, especially as applied to cryptocurrencies, initial coin offerings, and related virtual instruments.

The Howey Test

One of the most famous cases related to securities is the United States Supreme Court case, Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293(1946). The Howey company owned citrus acreage in Florida. Prospective customers were offered a land sales contract and a service contract. The primary purchasers were non-residents of Florida. The legal issue in the case was whether the land sales contract, the warranty deed, and the service contract together represent an "investment contract."

"An investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party..."

The key words in the Howey test are "investment of money", "common enterprise", and "expectation of profits from efforts of 3rd party".

The meaning of "common enterprise" was addressed by the case of In re Living Bens. Asset Mgmt, 916 F.3d 528 (5th Cir. 2019) where the Court found that mere dependency on the continued solvency of the promoter as being sufficient to find the presence of a common enterprise under broad vertical commonality.

BTC vs XCH - Similarities and Differences

BTC and XCH are both cryptocurrencies. The SEC has decided that Bitcoin is not a security because its essential attributes are those of a currency. It is analogized to gold, the price of which is a function of market forces rather than the efforts of a discrete group of promoters.

XCH, on the other hand, relies largely on the efforts of Chia Network, Inc for its continued adoption and success.

As William Hinman, the SEC’s then-Director of the Division of Corporate Finance, noted:

If the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful. . . .

Newer cryptocurrency/blockchains may rely on networks that are dependent on the efforts of promoters, and in such cases the Howey investment contract standard may be met.

The basic idea is that a crypto start-up token is a security because investors are relying on the start-up to develop the necessary network and liquidity to give their tokens value, while the tokens of issuers with fully developed networks are not securities because token purchasers are no longer relying on the originator of the tokens to create value through network development.

In my next post we will deep-dive into the Ripple case and see how XRP is similar and different from XCH.