William Hinman, Director of the SEC’s Division of Corporation Finance, recently reignited the quest to identify a cryptocurrency that is not a security. In June, Hinman stated during a speech that the SEC does not consider either Bitcoin or Ether to be a security. This statement marks a significant shift from the SEC’s prior actions and comments on the topic.
To date, the SEC’s answer to the question “is this token a security?” has uniformly been “yes.” If a particular cryptocurrency were not a security, it would be beyond the jurisdiction of the SEC to regulate. In other words, the token could be offered for sale without the offering being registered or exempted from registration. Trading platforms could permit secondary transactions of the tokens without the platforms registering as securities exchanges or alternative trading systems. A whole host of regulatory obligations on issuers, brokers, advisors, and others would evaporate if a particular token were found not to be a security.
Given the growing size of the burgeoning cryptocurrency market, both the jurisdictional issue and the regulatory consequences are enormous. Over the last several years, the proliferation of different cryptocurrencies and digital tokens has been impossible to avoid. Many new companies, in lieu of traditional capital generation, have opted instead to create their own digital tokens and raise capital through an “ICO” – an initial coin offering. Investors have been opening up their wallets to fund such businesses through ICOs in remarkable numbers. In all of 2017, 871 ICOs raised over $6.1 billion in capital; halfway through 2018, to date, there have been 868 ICOs raising nearly $5.5 billion (data from icodata.io).
Until very recently, the SEC has given little comfort to those hoping that not all tokens are securities. In July 2017, the SEC released an investigative report that discussed whether DAO Tokens, sold by a German Decentralized Autonomous Organization (“DAO”) created by German corporation Slock.it in an ICO on the Ethereum platform, were securities. The DAO Tokens were offered in exchange for Ether, the value of which was approximately $150 million USD. The SEC’s answer? Yes, DAO Tokens are securities. (See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017)).
In the months following the DAO Report, the SEC identified token after token that it deemed to be a security. In September 2017, the SEC broke new ground by charging fraud for the first time related to two separate ICOs. Maksim Zaslavskiy pitched the ICOs through his companies – REcoin Group Foundation LLC and DRC World Inc. – and allegedly made several misrepresentations to investors, including that the cryptocurrency issued by each company was backed by real estate and diamonds, respectively, and ultimately raised about $300,000. Subsequently, criminal charges were filed against Zaslavskiy. (See SEC Press Release 2017-185, “SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real Estate and Diamonds” (Sep. 29, 2017)).
Thereafter, like clockwork, the SEC has brought a series of enforcement actions, each one alleging the fundamental issue: this, too, is a security. December of last year saw cases in which Plexcoins and MUN tokens were found to be securities. The trend continued in 2018 with the SEC finding the so-called AriseCoin to be a security in an action filed in Dallas in January. In April, the SEC took the Centra Token to task, declaring it to be a security. Most recently, in May, the SEC found a token called “BAR” was a security. While none of these cases has been litigated to conclusion, the SEC’s position regarding tokens has been clear. SEC Chairman Jay Clayton reportedly went so far as to say, “I believe every ICO I’ve seen is a security.”
Against this backdrop, Hinman’s June speech—indicating that Ether may not currently be a security—appeared to offer a more nuanced view of the issue. He sharpened the inquiry, highlighting the relevance of several factors, including: whether a third party drives the expectation of a return, whether the network upon which the currency functions is sufficiently decentralized, the function of the currency as a bet on an enterprise’s success or as a utility to purchase goods and services, and the representations made to investors.
Hinman’s comments indicate that cryptocurrencies have something of a life cycle from a regulatory perspective—new tokens issued in ICOs are likely to be securities (subject to a case-by-case investigation), but are able to reach an inflection point upon which they lose that designation. While proponents of cryptocurrency are undoubtedly optimistic about the implications of this guidance, much remains unresolved. Hinman has provided some clarity by identifying the context-specific factors used to identify the security inflection point, but the critical balance between the factors still needs to be fleshed out in the coming months and years.
Hinman’s focus on the point in time when a “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” as the point at which a token may no longer represent a security, suggests an empirical test may be developed to demonstrate when a particular token has reached that point. We asked Eric Poer, an accounting and financial expert from FTI Consulting, to give us insights from a financial perspective. Mr. Poer stated, “Analysts and researchers are developing quantitative and empirical tools and methodologies to test token metric networks. For example, one recent academic study looked at 453 tokens that completed ICOs, that represented more than $5 billion in cumulative fund raising, that were subsequently traded on a secondary market for at least 90 days. Essentially, the study measured the effects of various factors and issuer characteristics on a token’s liquidity and trading volume, an indication of the market depth and interest in the token and perhaps an indication of the ‘decentralization’ referred to by Hinman. Such empirical analysis will be critical for those ICO issuers eager to show that what may initially have been a security has crossed the ‘Hinman threshold’ and shed that designation.” (See “Initial Coin Offerings: Financing Growth with Cryptocurrency Token Sales”, June 21 2018, Sabrina T. Howell, Marina Niessner, and David Yermack.)
Might Hinman’s comments be a prelude to some sort of official statement declaring a particular token to be outside the SEC’s jurisdiction? Perhaps. Certainly the SEC Division of Corporation Finance that Mr. Hinman heads has from time to time issued “no action” letters finding particular investment structures not to be securities. Corp Fin could do so here. Perhaps more significantly, the week after Hinman’s speech, SEC Chair Clayton provided testimony to Congress that touched on a variety of topics, including a favorable acknowledgement of Hinman’s comments. If the Commission were to put out a DAO 2.0 Report finding a specific token not to be a security and articulating why not, that would provide much needed clarity.
Nick Morgan is a partner in the Investigations and White Collar Defense practice at Paul Hastings. He focuses his practice on complex securities litigation in state and federal courts and representations involving government investigations and white-collar crime allegations levied against individuals and businesses. Before private practice, Morgan previously served as Senior Trial Counsel in the SEC’s Enforcement Division.
Thomas Zaccaro is a partner in the Investigations and White Collar Defense practice at Paul Hastings. He focuses his practice on civil, commercial and criminal litigation in state and federal courts with a special emphasis on defending corporations and executives in government investigations and other criminal and regulatory proceedings. Zaccaro was previously Chief Trial Counsel of the Securities and Exchange Commission’s Pacific Regional Office, where he was responsible for the management and supervision of all enforcement litigation conducted within the Pacific Region.
Michael Mottweiler is a summer associate at Paul Hastings in Los Angeles.