One day after the SEC town hall in Atlanta, Georgia, William Hinman, Director for the Division of Corporation Finance of the SEC, gave a landmark speech declaring that Ethereum was ‘not a security’. These important statements follow on previous statements from SEC Chairman Jay Clayton, whose comments at a hearing in front of the House Appropriations Committee on April 26, 2018, gave the crypto community some relief by declaring that Bitcoin was ‘not a security’. With his recent comments, Director Hinman expressly answered another key question for the community. While his remarks are not law, they came with much needed insight into how regulators are continuing to evaluate crypto.
Perhaps not surprisingly, at least to those who follow such matters in the community, Hinman’s remarks about Ethereum seemed to run right through the Howey Test. For those unfamiliar, the Howey test is a four-pronged test long used by the SEC that contemplates whether or not a particular instrument constitutes an “investment contract”, which is a type of security. Under the four-pronged test, an investment contract is (1) an investment of money; (2) made in a common enterprise; (3) with an expectation of profits; (4) to be derived from the efforts of others. Using this test (reaffirmed by Hinman), it does not matter if the token is labeled as a “utility token”, as the analysis relies on ‘substance over form’ and the economic realities underlying a transaction.
- The classification of a digital token is not static. A token’s treatment under US law may change over time.
- “[I]f 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.”. Note, although the SEC calls it “decentralized”, most may otherwise refer to this as “functionality”. Accordingly, Network Decentralization does not equal SEC Decentralization.
- As most knowledgeable lawyers in the space do (like us!), separate the sale of the token from the token itself. Apply securities laws when it fits.
- Hinman’s remarks pose some interesting questions for industry participants. One thing is clear, you cannot go this process alone. Engage with experienced lawyers in the space who truly understand (and care) about the technology and are capable of navigating the applicable laws.
Still Left with Questions
How do we know if a network is sufficiently decentralized? The answer, as with many aspects of this area of the law, at least for now, is that we do not exactly know, and facts and circumstances always matter. However, it would probably not be difficult to start by weighing the differences between the promises made in any particular white paper and the parts of the platform that are already functional. The existing consumptive purpose for a token should reduce if not take away any speculative purpose for the token.
The SEC has yet to address whether or not a digital token can change to a ‘non-security’ during a pre-sale phase, if some functionality of the ultimate underlying platform is built. This point is particularly important because purchasers of digital tokens under the guise of securities laws subject to securities lock-ups need to know if they can use securities protections or if the sale (or use!) of their token ceases to be a sale of securities. The SEC stated concerns in its Atlanta town hall event about flowbacks (in the Reg S context) and complying with other requirements of private placement offerings. Again, Director Hinman’s remarks are directly related to federal securities laws. He did not address the need to understand or comply with other federal, state, and non-US laws and regulation related to money transmissions, banking, commodities, and tax.
Bonus! Bitcoin and Cryptocurrency Get Referenced by SCOTUS
Now, after Director Hinman’s remarks, Supreme Court Justice Stephen Breyer, albeit in a dissenting opinion, gave the first Supreme Court opinion reference to Bitcoin and cryptocurrency. Breyer wrote: “Moreover, what we view as money has changed over time. Cowrie shells once were such a medium but no longer are…our currency originally included gold coins and bullion, but, after 1934, gold could not be used as a medium of exchange…[P]erhaps one day employees will be paid in Bitcoin or some other type of cryptocurrency.”.
Coupled with the SEC’s remarks, Justice Breyer’s remarks are a giant step forward for the crypto community. While these remarks are not binding law, it does show a shift in the regulators’ and justice department’s sympathies toward cryptocurrency as a legitimate form of value.
Commentary by Stan Sater & Jeffrey Bekiares, Esq. Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]