Which Cryptos are Securities According to SEC Director William Hinman
2018 has been a tough year for cryptocurrency prices, as the combined global market cap has dropped $336 billion (-54.85%) YTD. While there are many contributing factors to this bear market, uncertainty over looming government regulations is likely a key contributor.
Before his analysis of how securities laws pertain to cryptocurrency, Hinman began his talk by expressing excitement for distributed ledger technology’s ability to facilitate the sharing of information, transfer value, and record transactions in a decentralized environment. He stated, “There is real value in creating applications that can be accessed and executed electronically with a public, immutable record and without the need for a trusted third party to verify transactions.”
Blockchain proponents will be happy to hear that someone inside the SEC sees value in the technology, but the real impactful insights came in his analysis.
What Tokens are Securities?
Thousands of ICOs have launched over the last year, with most of them attempting to avoid a security designation and evade the purview of the SEC. Perhaps the most common tactic has been to label a coin as a “Utility Token” to be used for the service of a platform.
Hinman made it clear that, according to the “Howey Test”, any coins whose investors expect a profit derived from the efforts of a third-party would be considered a security. This applies to most “Utility Tokens”, despite them not explicitly offering equity in the ventures.
To illustrate this, he referenced two examples,
“Simply labeling a digital asset a “utility token” does not turn the asset into something that is not a security. I recognize that the Supreme Court has acknowledged that if someone is purchasing an asset for consumption only, it is likely not a security. But, the economic substance of the transaction always determines the legal analysis, not the labels. The oranges in Howey had utility. Or in my favorite example, the Commission warned in the late 1960s about investment contracts sold in the form of whisky warehouse receipts. Promoters sold the receipts to U.S. investors to finance the aging and blending processes of Scotch whisky. The whisky was real – and, for some, had exquisite utility. But Howey was not selling oranges and the warehouse receipts promoters were not selling whisky for consumption. They were selling investments, and the purchasers were expecting a return from the promoters’ efforts.”
It appears nearly every coin whose creators raised funds via an ICO is considered a security by the SEC.
Bitcoin is Not a Security
In June, SEC Chairman Jay Clayton said in a CNBC interview that Bitcoin and cryptocurrencies like it are not securities. While his statement was fairly vague on the matter, this seems to coincide with how Hinman defined a security today.
Bitcoin did not raise any investments from the public. Instead open source software was released that allowed the public to interact with the network. There was and is no central authority that controls the supply of Bitcoins.
Though by definition Bitcoin clearly seems to not be a security, Hinman’s focus on decentralization was interesting:
“As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
And so, when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
Ether (Currency of Ethereum is Not a Security)
Though many have suspected the Ether currency of the Ethereum network would be labeled a security mostly due to it raising funds publicly, Hinman stated that Ether is not a security in its current state.
“And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.”
Cryptocurrencies Can Change from Securities to Non-Securities
Hinman’s remarks on Ether were remarkable and largely unexpected in the cryptocurrency community. While Ether should have been deemed a security in its early stages, it had in his opinion changed to a non-security due to its current decentralization.
He went on to make it abundantly clear that the status of a cryptocurrency as a security could change over time:
“Over 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. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument. Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security. If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.”
Today’s remarks by William Hinman are unquestionably a positive indicator for the regulation of cryptocurrencies, though the SEC’s job seems to have become more difficult. In addition to protecting cryptocurrency investors, the SEC will need to define what makes a coin sufficiently decentralized and adjust its focus accordingly.
Disclaimer: This article is not legal advice and was not written by an attorney. You should seek an attorney for all required legal counsel pertaining to cryptocurrency and investments.
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