The SEC has been doling out failing grades to all but a few cryptocurrencies. However, Facebook, Inc.’s “Libra” token is an SEC brown-noser. Introduced to much fanfare on June 18, 2019, Libra is poised to buck long odds to gain a “like” from the SEC. This prospective new digital currency faces a frostier reception from other regulators.
Facebook—or, rather, the Libra Association—unveiled its White Paper on June 18, 2019, proclaiming, “The world truly needs a reliable digital currency and infrastructure that together can deliver on the promise of ‘the internet of money.’” The White Paper describes Libra and the Libra ecosystem as a “global currency and financial infrastructure.” Structured as a “stablecoin,” it uses the Libra Reserve to “support stability and value preservation” by backing the coin with a “set of stable and liquid assets.” Facebook also created “Calibra,” a digital wallet to aid transactions. Calibra is a subsidiary of Facebook and the Libra Association is an independent, not-for-profit membership organization.
Libra’s Regulatory Horoscope
Facebook promises it will not attempt to bypass existing regulation but will instead “innovate” on regulatory fronts. I read those tea leaves to say Facebook plans to cooperate (or appear to cooperate) with regulators while simultaneously lobbying them to be flexible with their enforcement or even to rewrite existing rules so they are more to Facebook’s liking.
The SEC is currently the preeminent regulatory force in the cryptocurrency space; Facebook constructed its Libra legal strategy accordingly. Libra is essentially an e-money business like PayPal. However, unlike PayPal, Libra will utilize a stablecoin to enable the creation of its own financial ecosystem of vendors and customers using Libra tokens as its digital currency. Customers buying Libra coins acquire a means of exchange. Their investment goes towards a digital coin of equivalent value rather than becoming an investment in building Libra’s financial infrastructure or a chance to see the value of the purchased digital coins meaningfully appreciate.
This scheme puts Libra in a strong position to avoid serious objections from the agency. We provide one analysis, based on the SEC’s recent articulation of the traditional SEC v. Howey test, below. In the meanwhile, politicians have begun to examine the Libra business model.
Political Challenges Already Outlined
Libra’s real legal challenges are likely to come from other regulatory agencies and from politicians. At least six federal agencies have regulatory oversight of aspects of Facebook’s plans and could slow or stop them.
The Senate Banking Committee has announced it will hold a hearing July 16 entitled “Examining Facebook’s Proposed Digital Currency and Data Privacy Considerations.” Senator Sherrod Brown, the leading Democrat on the Senate Banking Committee, has already staked his position via Twitter, declaring, “We cannot allow Facebook to run a risky new cryptocurrency out of a Swiss bank account without oversight.”
The House Financial Services Committee Chair, Representative Maxine Waters, has publicly called on Facebook to delay its planned 2020 Libra rollout. In addition, Waters has said she will hold hearings on Facebook’s plans for its new digital money business.
Many European politicians and institutions have already expressed deep skepticism of Libra, if not outright opposition. French Finance Minister Bruno Le Maire has stated the G7 must not allow Libra to “become a sovereign currency.” Le Maire worries that Facebook’s cryptocurrency might exploit consumer financial data, invade privacy, and produce a monopolistic situation. Similarly, German member of the European Parliament Markus Ferber warned last week that if Libra seeks customers from Facebook’s more than 2 billion active users, the Libra currency could become a “shadow bank.” Meanwhile, Britain’s three main financial regulators are working together to coordinate their response to Libra. As the politicians examine their alternatives, we anticipate that Libra may have weaknesses from a variety of regulatory angles.
Non-Securities Law Concerns
Some of the most significant concerns about Facebook and its Libra project include:
Privacy Risk. How will Facebook protect users’ financial data? Few have forgotten how Cambridge Analytica harvested data from Facebook accounts for political advertising purposes without user consent.
Governance Risk. The ostensibly independent Libra Association, a consortium of 100 organizations based in Geneva, Switzerland, will govern Libra. It is unclear what constraints will operate on the Association’s actions, including outside monitoring and enforcement. For example, will there be independent verification of the basket of assets Libra claims to hold?
Manipulation Risk – Primary Market. The Libra Association could manipulate Libra’s value for the benefit of insiders. What constrains the Association from minting as many Libra tokens as it pleases? The current most popular stablecoin, Tether, after refusing an audit, admitted in April 2019 that cash and short-term securities backed only 74% of the value of its outstanding coins.
Manipulation Risk – Secondary Market. The value of cryptocurrencies has proven susceptible to outside manipulation. Speculators betting on the widespread adoption of Libra could cause a de-tethering of the cryptocurrency from its underlying assets. If Libra’s value exceeds the sum of its parts, how might that affect the fiat currencies that will make up Libra’s basket of assets?
Banking Risk. Will Libra’s controls against money laundering and terrorism financing be sufficient? Libra claims it will use the same verification and anti-fraud processes that banks and credit cards use. What is the risk that the widespread adoption of Libra by banking customers could destabilize banks and the banking system? The implications of the Libra project for anti-money laundering/combating the financing of terrorism (AML/CFT) regulation and compliance received little or no attention until Robert Kim of Bloomberg Law analyzed them here.
Monetary Risk. What is the risk to countries if they can no longer control capital outflows? What are the risks if Libra supplants the local tender as the dominant currency?
Competition Risk. There is serious concern Facebook is trying to leverage its near-monopolistic power in social media to dominate a critical sector of the economy.
Those reservations are without considering Facebook’s poor reputation created by its less-than-confidence-inspiring handling of social privacy, election meddling, and hate speech concerns. The ill will engendered by those misadventures may ultimately derail Libra. However, the usual cryptocurrency nemesis, the SEC, is unlikely to cause Libra significant problems.
Libra’s Passing Grade on the Howey Test
Central to the SEC’s inquiry into Libra will be to determine what Libra is not: it is not an initial coin offering designed to bypass existing securities regulations to raise money on the cheap from the American investing public. Facebook knows the SEC will apply the venerable Howey test to Libra, and this pupil has come prepared.
The Howey test, as reapplied in the token context in the SEC’s recent TurnKey Jet, Inc. No Action Letter, provides that an “investment contract” is present where there is: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits to be derived solely from the efforts of others (e.g., Facebook). If any of those three characteristics is absent, the investment is not a security and does not fall within the SEC’s regulatory authority.
1. Libra Tokens Are an Investment of Money
Facebook intends to sell Libra tokens in the U.S. Those sales will require an investment of money by the purchasing public, satisfying the first prong of the Howey test.
In the future, users of Facebook or its other apps, WhatsApp, Messenger or Instagram, might receive small amounts of Libra without charge, a practice known as airdrops. Conditions attached to accepting those “free” airdrops could raise concerns from various regulators, particularly if Libra requires users to sign away their rights to their private personal data. Airdrops would help Facebook spread adoption of Libra, particularly by people in developing countries or by anyone who is unbanked or underbanked in the U.S. Were Libra to distribute all its tokens to the public via free airdrops (or a similar incentive program), then the above analysis might change.
The Howey test outcome in such a circumstance may depend on whether Libra attaches strings to receiving the airdrop. A court or the SEC could find that a user who gives up rights to their personal user data to receive a “free” airdrop has provided valuable consideration tantamount to the investment of money contemplated by Howey.
2. Not a Common Enterprise or an Investment Asset
In SEC v. Edwards (2004), the U.S. Supreme Court declined to resolve a three-way federal circuit split, leaving ambiguity as to what constitutes a “common enterprise.” However, the precise definition applied is unlikely to matter.
In its TurnKey Jet letter, SEC staff appeared to base their decision to bless TurnKey Jet’s token and its network on the reality that token buyers were not investing in the success or failure of the enterprise. Whether a common enterprise existed was not determinative to the SEC’s finding that the TurnKey Jet token was not a security. Libra token buyers likewise are not investing in Libra’s success or failure. Instead, Libra tokens will serve as a medium of exchange (cryptocurrency) with a value stabilized by the Libra Reserve.
3. Libra Users Will Have No Expectation of Profit
Conversely, Libra’s use as a genuine digital currency takes it out of the investment assets category regulated by the SEC. Libra buyers are ultimately purchasing only goods and services from vendors in Libra’s network, transactions the token facilitates. Libra coin holders have no stake in Libra as an investment that might produce profits. Therefore, the SEC is unlikely to deem Libra a security.
The Real Libra Securities Offering
Facebook plans a Libra private placement securities offering in the coming months to raise money to build Libra. Open only to accredited investors meeting extraordinary valuation ($1 billion) or money under management ($1 billion) criteria, these are the investors purchasing a security with an expectation of profit from the efforts of others. Unlike the breezy Libra White Paper that often paints with a broad brush, the confidential private placement memorandum is likely to contain many of the operational and aspirational details that regulators and politicians seek.
This private offering will produce Libra’s other token, a security token called the “Libra Investment Token.” Its stated purpose is to fund incentive programs and cover Libra’s operating costs. Should Libra prove successful, interest from the Libra reserve fund would go to these accredited investors (i.e., the founding companies and other early investors). Assuming Facebook conducts this Libra private placement in accordance with the securities laws, it will be exempt from the usual SEC registration requirements.
Ultimately, Facebook’s ability to build Libra into a profitable global business appears likely to depend on non-securities regulators and governments. Not only will governments need to permit Libra to operate as legal tender in their jurisdictions but countries will also be tasked with supporting Libra by enforcing Libra-related contractual obligations.
Should many people purchase Libra tokens and come to depend on the payment system, a government could someday find itself asked to provide liquidity support for the cryptocurrency in a time of crisis. That possibility is likely to make regulators and politicians studying Libra’s business plans even more uncomfortable.
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