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In the intersection of financial markets and the internet, sometimes it seems like the only certainty in the year of cryptocurrency and “meme stocks,” like GameStop and AMC, is the continuing legal haze of cryptocurrencies. In 2019, the SEC’s FinHub released a Framework for ‘Investment Contract’ Analysis of Digital Assets (“Framework”). However, far from illuminating the path to regulatory compliance for token and virtual currency offerings, the so-called “Framework” has done little to clarify when a digital asset constitutes a security. Instead, the frenzied rise of Bitcoin and Ethereum prices and the proliferation of altcoins has been matched only by the pace of SEC enforcement actions brought against cryptocurrency companies—even against those seeming to attempt adherence to the Framework to tiptoe their way around the Howey Test1.
To be fair, the Framework never advertised itself as anything more than the then-current views of the FinHub staff. It was essentially a good-faith attempt on the FinHub’s part to provide direction where there was little to no guidance as to one specific term: investment contracts. In particular, it provided several relevant factors for applying the traditional Howey Test for investment contracts in the context of a sale and offer of digital assets. Nevertheless, the Framework has done little to clarify the regulatory environment of initial coin offerings (“ICOs”) and other cryptocurrency sales because the key question remains: what makes something a blockchain-based security? While the cryptocurrency world, including developers, exchanges, and institutional and retail investors alike, await regulatory clarity (including via a potential new safe harbor) the only guide posts to be found are in the tombstones lining the road of SEC enforcement.
Tombstone #1: SEC v. Telegram Group
Settled in June 2020, the Telegram action highlights the key dispute between regulators and cryptocurrency advocates. Advocates argue that tokens are an asset with use and value as a medium of exchange on their respective blockchains, while the SEC emphasizes the “economic reality” of crypto, arguing that purchasers of cryptocurrencies and tokens purchase them not for their utility but for investment purposes.
Trying to navigate this dichotomy, Telegram sought separation of the creation of its TON blockchain network from the delivery of its Gram tokens. To do this, they raised funds via Rule 506(c)2 eligible simple agreements for future tokens (“SAFTs”), then upon launch of the TON blockchain, Telegram agreed to deliver the Gram tokens to these SAFT purchasers.
In designing its fundraising program, Telegram relied on the Framework’s explicit guidance that a digital asset issuer and purchaser can and should assess the facts and circumstances of the digital asset and the network at different points in time to determine whether the securities analysis has changed. There are two relevant points in time: pre- and post-TON network functionality.
Telegram argued that, initially, the SAFTs were securities, which funds were used in the development efforts of the blockchain network, but as soon as the network was functional, the Grams (received through the SAFTs) were a currency, not a security, since their whole purpose was as a medium of exchange for goods and services on the TON network.
The SEC argued that regardless of the Gram token utility once the network was functional, the entire process from SAFT to token was a scheme whereby securities were sold for speculative, investment purposes. The SEC even argued that the SAFT purchasers were actually underwriters due to their intent to resell the Grams since the SAFTs specifically permitted unrestricted resale of the Grams. The court and the SEC did not agree with Telegram’s argument that the SAFTs needed no restrictions since, upon network functionality, the Grams would no longer be securities but rather utility tokens to be used on the network, regardless of their fluctuating price. Perhaps just as significant as the SEC’s refusal to acknowledge that the dual use of cryptocurrencies as investments and utility tokens warrants special treatment under the securities laws, another major development from this case was the preliminary injunction that stopped distribution of the Grams not only to U.S. accredited investors but to all of the investors worldwide (only 39 of the 175 investors, representing a 25 percent of the funds, were U.S. investors), effectively shutting down the TON network completely. Such a result elicited the following response from SEC Commissioner Hester Peirce:
Who did we protect by bringing this action? The initial purchasers, who were accredited investors? The members of the public, many of whom are outside the United States, who would have bought the Grams and used them to buy and sell goods and services on the TON Blockchain? Did they really look to U.S. securities laws for protection? Would-be innovators, who will now take additional steps to avoid the United States?
– “Not Braking and Breaking,” (July 21, 2020), SEC.gov | Not Braking and Breaking.
Takeaways: Currently, the SEC will not permit a bifurcated offering system in which during stage #1 (pre-network functionality), securities are offered for cash, and in stage #2 (post-network functionality) those former-securities convert to utility tokens on a functional blockchain network where they can then be sold without restrictions. Initially, the cryptocurrency companies seeking to follow the guidance believed such a bifurcated offering would comply with SEC rules since the Framework emphasized that the Howey Test should be applied on an ongoing basis, meaning that once the utility tokens could be used as a medium of exchange on a functional blockchain network, they would no longer be considered securities. However, the Telegram action has shown that the application of the Howey Test in the beginning of an offering will predominate over the entirety of the utility tokens’ lifetime, even when the functional blockchain network makes the tokens more like Bitcoin and Ethereum than a security.
Tombstone #2: SEC v. Kik Interactive Inc.
The details of the Kik case are similar to Telegram’s: the company signed SAFTs wherein they agreed to distribute their Kin token in exchange for funds that would be used to develop the Kin blockchain, where the Kin could then be used as a medium of exchange. The SEC and the court likewise rejected this theory.
Takeaways: After Kik and Telegram, there seemed to be a unified theory of securities law as applied to cryptocurrency: tokens used merely as a medium of exchange are much less likely to be found to be securities and tokens that rely on the efforts of the issuer to derive their value are much more likely to be classified as securities. However, this unified theory is simplistic and fails to capture the complexities of the blockchain space. Further, it is a theory without guideposts and certainty and fails to explain why existing cryptocurrencies like Ethereum (which is backed by the ongoing efforts of ConsenSys and whose value is driven by the decentralized applications and smart contracts operating on it) are not securities while nascent currencies like Gram (which would have been backed by the ongoing efforts of Telegram and was explicitly nothing more than a medium of exchange) were stopped in their infancy. Further, based off the Ripple case (see Tombstone #3), there is potential that this theory is far from settled law and/or a more articulated framework may be forthcoming.
Tombstone #3: SEC v. Ripple Labs Inc.
Filed in December 2020, the Ripple case is the one everyone is looking to for potential revelations on what goes into the SEC’s determination as to when a cryptocurrency is a security. On April 6, 2021, the U.S. District Court for the Southern District of New York ruled that Ripple may take a look at some of the SEC’s internal communications to answer this very question—Ripple hopes to find evidence that the SEC at some point defined XRP as being similar to Bitcoin and Ether, both of which have escaped classification as securities where so many other alt-coins have failed.
This case is complicated by the fact that it was filed in the final days of Chairman Jay Clayton and nearly eight years after XRP was first brought to market. In that time, the token has been bought and sold countless times. Currently, 10,000 holders are seeking to intervene in the case, hoping to secure re-listing and resumption of trading on cryptocurrency exchanges like Coinbase, Crypto.com, and eToro.
Another twist occurred on April 9, 2021, when the SEC failed to obtain access to Ripple’s top two executives’ personal financial information. This comes after the executives’ effort to exit the case completely, arguing that their own sale of XRP into the market did not violate U.S. securities laws.
The discovery decisions noted above are far from the final word on the Ripple case, but they do show that, by siding with Ripple, the classification of cryptocurrency in the U.S. remains an open question.
Takeaways: While the Ripple case finds itself in its nascent stages, thus far, it is following a trajectory that seems friendlier towards cryptocurrency than other suits brought by the SEC. There is hope that regulatory clarity may finally bubble to the surface in its wake given that, presumably, the ruling may rely on the internal communications of the SEC on how it determines cryptocurrency security classifications. However, such hope should be tempered by the Telegram and Kik actions. In both of those cases, people hoped clarity to cryptocurrency classification would come, but the actions failed to bring us any closer to an articulable standard and the certainty that legal and business professionals alike crave.
Conclusion
These tombstones show that the regulatory framework for cryptocurrencies is far from settled. Perhaps just as notable as these actions, on April 17, 2021, Gary Gensler was sworn in as chairman of the SEC. Chairman Gensler has a reputation as a tough regulator, and has significant familiarity with cryptocurrencies and blockchain having taught a course on the subjects at the Massachusetts Institute of Technology. As institutional investors warm up to cryptocurrencies, Coinbase has successfully gone public and an increasing number of countries have launched digital currency projects, regulatory clarity is needed to provide room for cryptocurrency growth that balances innovation with investor protection.
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Notes:
1. The Howey Test comes from the seminal U.S. Supreme Court case where the Court defined “investment contract” as (i) an investment of money (ii) in a common enterprise (iii)(a) with a reasonable expectation of profits (b) to be derived from the efforts of others.
2 Rule 506(c) is an exemption to SEC registration requirements which permits issuers to broadly solicit and generally advertise an offering provided that all purchasers in the offering are accredited investors, the issuer takes reasonable steps to verify the purchasers’ accredited investor status, and certain other conditions in Regulation D are satisfied.
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