SEC: Bitcoin Is Not Governed By Securities Laws

June 15, 2018Alerts Cryptocurrency Alert

In an important development for the cryptocurrency industry, the U.S. Securities and Exchange Commission has declared that Bitcoin, Etherium and other coins operating on truly decentralized platforms are not securities.

The agency’s reasoning was revealed in remarks by William Hinman, Director of the SEC’s Division of Corporate Finance, at the Yahoo Finance “All Markets Summit: Crypto” on June 14. (See transcript below)

Hinman explained that, since the value of cryptocurrency is not based on the expectation of profits resulting from the success or failure of the issuer, it does not compare to a typical security.

In his remarks, Hinman also gave tacit approval to a path built on traditional offering models.

Dual Tokenization = Token Security + Virtual Currency

The TSO Model

Companies that are raising capital and want those who contribute the capital and early users of the products to benefit from the success of the enterprise – conduct a Token Securities Offering, or TSO (e.g., Reg. A or Reg. D). The tokens are a class of stock, may be entitled to vote and receive dividends (or not), and can trade on upcoming SEC-compliant token securities exchanges (e.g. Circle, tZERO).

We believe these tokens can be properly issued as rewards to platform users under a Regulation A+ offering, and are currently seeking SEC approval of that model. In that case, some issuers will find the next step to be unnecessary.

Virtual Currency and/or Utility Tokenization

If a company wants to generate tokens to be used as currency on the platform or other platforms, enabling participants to pay for products or services with tokens and trade them on crypto-exchanges, the token needs to be structured as a separate virtual currency. It cannot be the security token issued in the TSO.

We realize this is not fully satisfactory, and regulatory and tax challenges remain. However, this a good step forward to recognizing the benefits of blockchain and the cryptocurrency ecosystem.

Remarks by William Hinman, Director
SEC Division of Corporate Finance
Yahoo Finance “All Markets Summit: Crypto” – June 14, 2018

“I do think … that some of the industry participants are beginning to realize that, in many cases, it could be easier to start a blockchain-based enterprise in a more conventional way. We meet with industry participates all the time, and we’re hearing that they sort of recognize the value of structuring things in phases, with phase one being done as an offering on a more conventional basis. You’re either registered or exempt, equity or debt offering. And then once that funding allows the network to get up and running, then distribute or offer blockchain tokens or coins to participants who need the functionality that the network and the digital assets offer. This allows the tokens and the coins to be structured and offered in a way where it’s then more evident that the purchasers are not making an investment in the development of an enterprise. In other words, it’s easier to make the case that the token at that phase is not a security.

“When I look at Bitcoin today, I don’t see a central third party whose efforts are a key factor in determining the success of that enterprise.”

“Returning to ICOs that we are seeing, strictly speaking, the token, the coin, whatever the digital information packet is being called, all by itself we don’t think is a security, just as oranges in the Howey case were not securities. Central to determining whether a security is being offered, however, is how it’s being sold, and the reasonable expectation of purchasers. When someone buys a house unit to live in, it’s probably not a security, but under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. If the housing unit is offered with a management contract or other services and purchasers are encouraged to invest rather than reside, that could be a security. Case law tells us that. There are cases on that.

“Case law similarly tells us that when a CD, a certificate of deposit – expressly exempt from being treated as a security under Section three of our Securities Act – when that CD is sold as part of a program organized by a broker who offers retail investors promises of liquidity, a potential profit from the changes in interest rates, the Gary Plastic case teaches us that the instrument could be part of an investment contract that is a security.

“The Howey and the Gary Plastic case reasoning applies to digital assets. The digital asset, again, is itself simply code, but the way in which it’s sold as part of an investment to non-users by promoters to develop an enterprise can be and, to that extent, most often is, a security, because its evidences an investment contract. And regulating these transactions as securities transactions makes sense. The impetus of the Securities Act is to remove information asymmetries from promoters and investors. In a public distribution, the Securities Act prescribes information that investors need to make an informed investment decision, and the promoter is liable for misstatements in the offering materials. That’s an important safeguard, and that’s appropriate for many of the ICOs that we see, probably most of the ICOs we see.

“The disclosures required under the federal securities laws nicely complement the investment contract element about the effort of others. As an investor, the success of the enterprise and the ability to realize a profit on your investment turns on the efforts of that third party, so learning information about the third party – its background, its financing, its views on the risks of the venture, its plans, what it will do with the funding, whether it has a financial stake and interest itself, how long will its interest take place – these kinds of things are a prerequisite for the investors in those coins making an informed investment decision. And without a regulatory framework that promotes disclosures of what the third party knows on those topics and what the investor might not know, without that, then there is gonna be risk associated with that investors, investors will be uniformed and be more at risk.

"When the efforts of the third party are no longer key in determining the enterprise’s success, material information asymmetries recede.”

“So this points to the way, in some ways, also how a transaction might not represent a securities offering. If the network on which the token or coin is to function is sufficiently decentralized and the purchasers no longer have a reasonable expectation that a person or a group is [going to] carry out essential managerial or entrepreneurial efforts, those assets might not represent an investment contract. Moreover, when the efforts of the third party are no longer key in determining the enterprise’s success, material information asymmetries recede. So what I was talking about – what the third part promoters know about but the investors don’t know about – if this is highly decentralized, that information asymmetry recedes. As the network becomes more truly decentralized, the ability to even identify a promoter or to make the requisite – and someone that could actually make the requisite disclosures – become, in many cases, difficult or perhaps much less meaningful.

“So when I look at Bitcoin today, I don’t see a central third party whose efforts are a key factor in determining the success of that enterprise. The network on which bitcoin functions is operational, 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. Moreover, putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network its decentralized structure, we believe current offers and sales of Ether are not securities transactions. As with Bitcoin, applying a disclosure regime, the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens that function on them as securities may not be required. And of course, there will continue to be systems that do rely on central actors, whose efforts are a key to the success of the enterprise. In those cases, the application of securities laws protects investors who purchase coins.

“I should add that, regardless of the applicability of securities regulation to the distribution of the assets, as our Chairman Clayton has pointed out, regulated financial entities may have other legal duties related to cryptocurrency transactions. There is a plethora of Federal regulations that apply beyond the securities laws. The anti-money-laundering rules, the know-your-customer rules. The Commodities Exchange Act may be relevant; the IRS Code. And of course state, financial intermediary and money servicing laws all come into play.

“But I’d like to emphasize that the analysis of whether something is a security is something that we look at as not a static point. It doesn’t strictly adhere to the instrument itself. You have to look at the circumstances. So when digital assets with utility function solely as a means of exchange on a decentralized network are repackaged and sold as part of an investment strategy that could be a security. An example, if a promoter were to place Bitcoin in a fund or trust and sell interests, that would probably be a new security. Similarly, investment contracts could be made out of virtually any asset provided that the investor is reasonably expecting profits from the promoters involved.

“We understand that promoters and market participants want to understand whether their transactions in a particular digital asset involve the sale of a security. We’re happy to help promoters and counsel work through those issues. We stand prepared to provide more formal or interpretive no-action guidance about the proper characterization of a particular digital asset in a proposed use. For example, we’ve been asked for reviews on the SAFT, a Simple Agreement for Future Tokens. As I hope this speech makes clear, that the legal analysis as to any particular SAFT must follow the economic realities of what’s going on in that particular enterprise. And I believe a digital asset sold as part of a securities transaction may, depending on the circumstances, may be able to be resold as a non-securities transaction, but I expect that some, perhaps many, digital assets, including those originally packaged as parts of SAFT will retain the characteristics of a security for some time.

"But again, whether a network is at the decentralized state where tokens that trade on it might be viewed as something other than security is a fact in circumstances test, one which we are prepared to help issuers and other market participants answer. Come see us. We also recognize that there are other implications other than the federal securities laws of whether we call a particular asset a security. Our divisions of trading and markets, our investment management division, they’re all focused on issues such as broker dealer issues, the exchange trading of these products, fund registration, matters of market manipulation, custody valuation. All these issues come into play when we have a security that’s captioned coin.