On June 14, 2018, the SEC’s Division of Corporation Finance Director, William Hinman, gave a speech titled “Digital Asset Transactions: When Howey Met Gary (Plastic).”  This speech provides additional insight into the SEC’s view as to whether cryptocurrencies and initial coin offerings (“ICOs”) are securities.  Here is a summary:

In his speech, Hinman explains that ICOs typically involve passive investors who purchase tokens in hopes that a promoter builds a successful network.  He posits that the networks involved are rarely functional, and that the token purchase “looks a lot more like a bet on the success of the enterprise and not a purchase of something used to exchange for goods or services on the network.”  These circumstances, combined with token marketing efforts that “are rarely narrowly targeted to token users,” are indicators that an ICO is a securities transaction.

ICO issuers have recently tried to avoid their tokens being classified as securities by labeling them “utility tokens” and arguing that the tokens are for consumptive use.  Hinman directly addresses this practice, stating that labeling something a “utility token” does not prevent it from being a security. While he conceded that tokens by themselves and tokens purchased for consumption only are likely not securities, he emphasized that the “economic substance of the transaction” determines whether a token sale is a securities transaction.  Specifically, the speech focused on the “investment strategy” used, and states that “virtually any assets” can be securities “provided the investor is reasonably expecting profits from the promoter’s efforts.”

To support the above concept that securities can be broadly defined to include an “investment strategy,”  Hinman explains that, as outlined in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., the Howey test “is not static and does not strictly inhere to the instrument.”  The non-static interpretation of Howey is critical because it indicates that tokens which start as securities can lose that designation over time as a token’s network becomes “sufficiently decentralized.”  Hinman clarified that a security-token loses its status as a security when it becomes decentralized enough that purchasers “no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,”  noting that, as a system becomes increasingly decentralized, “material information asymmetries recede” and the “ability to identity an issuer or promoter to make the requisite disclosure [required in securities offerings] becomes difficult, and less meaningful.”  This interpretation rewards systems that prioritize decentralization with a shield from securities laws, but creates ambiguity regarding the requirements for a network to become “sufficiently decentralized.”

In light of the above, Hinman finds that Bitcoin and Ethereum’s native token, Ether, are not securities because they are decentralized enough that the efforts of others are not a “key determining factor” in whether an investment in Bitcoin or Ether is successful.  The speech adds that applying the disclosure regime of the federal securities laws to Bitcoin and Ethereum transactions would “add little value”, and that, “[o]ver 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.”

The first two weeks in March 2018 have seen a number of developments with respect to the regulation of cryptocurrencies in the United States.

Regulation of Online Cryptocurrency Trading Platforms

On March 7, 2018, the Securities and Exchange Commission (“SEC”) issued a release addressing the regulation of online trading platforms (or exchanges) on which investors have bought and sold digital assets, including coins or tokens sold in initial coin offerings (“ICOs”).  Consistent with prior SEC articulated positions, the SEC stated that many of these tokens sold in an ICO meet the definition of a “security” and accordingly these trading platforms on which ICO tokens trade should register with the SEC as a national securities exchange or alternative trading system unless exempt from registration.  In its release, the SEC expressed its concern that many of these trading platforms may appear to investors as SEC-regulated exchanges, but are not and do not meet the regulatory and listing standards of a registered exchange. In light of this, in its release, the SEC listed a series of questions that investors should ask before trading assets on an online trading platform.  These include, but are not limited to, asking if:  (i) is the platform registered as a national securities exchange or an ATS with the SEC?; (ii) is there information in FINRA’s BrokerCheck ® about any individuals or firms operating the platform?; (iii) how does the platform select digital assets for trading?; (iv) what are the trading protocols?; (v) how are prices set on the platform?; (vi) how does the platform safeguard users’ trading and personal identifying information?; (vii) what are the platform’s protections against cybersecurity threats, such as hacking or intrusions?; and (viii) does the platform hold users’ assets?  If so, how are these assets safeguarded?  For a complete list of these questions and a copy of this SEC release see SEC Release.

Money Transmitter Rules Apply to Initial Coin Offerings

In a letter published March 6, 2018 by the Financial Crimes Enforcement Network (“FinCEN”), which had previously been sent on February 13, 2018 to Senator Ron Wyden of the Senate Committee on Finance, FinCEN reiterated that in combatting the financing of terrorism (“CFT”) and illicit financing of criminal activity, the Bank Secrecy Act (“BSA”) and anti-money laundering (“AML”) laws and regulations applied to virtual currency exchanges and administrators that are based in the United States or that do business in whole or substantial part in the United States. These would include “a developer that sells convertible virtual currency, including in the form of … ICO coins or tokens, in exchange for another type of value that substitutes for currency….” FinCEN indicated that these exchanges and administrators would be considered a money transmitter who would have to be register with FinCEN as a money service business (“MSB”) with an established written AML compliance program designed to mitigate money laundering risks. These AML/CFT compliance programs would include filing of BSA suspicious activity and currency reports, maintaining records for certain transactions over some monetary threshold and obtaining customer identification information. The letter also clarified that in the case of an ICO that is structured as a sale of a security or derivative, the participants in the ICO could be subject to regulation by the SEC or the Commodity Futures and Trading Commission (“CFTC”).  In such cases, the SEC or CFTC AML/CFT requirements would apply.  Companies and exchanges involved in ICOs should consult legal counsel to clarify and satisfy their respective AML/CFT obligations.

U.S. District Court  Rules that the CFTC has Authority to Regulate Cryptocurrencies Not Involving Derivatives

In a Memorandum and Decision of the United States District Court for the Eastern District of New York, issued on March 8, 2018, Judge Jack Weinstein issued a ruling as to the authority of the CFTC to prosecute a fraud case that it had brought against Patrick Kerry McDonnell, the operator of a cryptocurrency business.  Defendant McDonnell was alleged to have “operated a deceptive and fraudulent virtual currency scheme” whereby his company solicited investments from investors to assist them in purchasing and trading Bitcoin and Litecoin, but instead misappropriated their funds.  In his ruling, Judge Weinstein, after discussing the definition of a commodity under the Commodity Exchange Act (“CEA”) and relying, in part, on a 2015 CFTC administrative ruling that cryptocurrencies were commodities, held that “virtual currencies can be regulated by CFTC as a commodity,” and that, in the absence of federal rules, the CEA permitted the CFTC in a fraud case to exercise its jurisdiction over cryptocurrencies that did not directly involve the sale of futures or derivative contracts.

Judge Weinstein ruled that the CFTC could proceed prosecuting the case against the defendant and granted a preliminary injunction barring the defendant from further engagement in cryptocurrency investments as the case continues. For a copy of the case, see CFTC v. McDonnell.