THE AMERICAN APPROACH
Under US federal securities laws, a digital asset is considered a “security” subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 if the asset is an “investment contract” under the test in four parts established by the Supreme Court of the United States in SEC vs. WJ Howey Co. (1946) (Howey Test). A regulated investment contract exists when there is: (1) an investment of money; (2) in a joint venture; (3) with an expectation of profit; (4) rely on the efforts of others.
The Securities and Exchange Commission (SEC) first applied the Howey Testing digital assets in 2017. Munchee Inc. announced an ICO to raise around $15 million to improve its iPhone app, taking the position that the ICO did not require SEC registration because its tokens would be “utility tokens”, i.e. a token designed with a particular use (in this case only for use in the Munchee app). The SEC rejected this position, concluding in December 2017 that Munchee tokens were regulated investment contracts because their appreciation in value created an expectation of profit by investors. The SEC announced this position several months before Munchee’s enforcement action (in July 2017) when it issued an investigative report (the DAO Report) in which it provided guidance on the applicability of federal laws on securities to digital assets.
In 2019, the SEC further explained its views on the applicability of the Howey analysis to digital assets in the “Digital Asset Investment Contract Analysis Framework” (2019 framework). Among other topics, the 2019 framework focuses at length on how the SEC determines whether a buyer has a reasonable expectation of profit from the efforts of others. The 2019 framework indicates that by applying Howey, the SEC will seek to determine whether (a) the buyer reasonably expects to rely on the efforts of a promoter, sponsor or other relevant third party; (b) these third-party efforts are meaningful and managerial rather than departmental; and (c) the buyer reasonably expects benefits, for example capital appreciation, resulting from the development of the initial investment or business enterprise, or participation in profits resulting from the use of the funds of the buyer, and not a simple price appreciation resulting solely from supply and demand for the underlying asset. The 2019 framework provides that secondary sales or offerings of digital assets are subject to the same analysis as an initial sale, plus additional considerations relating to the ongoing efforts of others.
While the 2019 framework lists many non-decisive factors that the SEC may consider in determining whether a digital asset is a security, SEC Chairman Gary Gensler said in April 2022 that he believed nearly all digital assets were securities. “The fact is,” he says in published remarks, “most crypto tokens involve a group of entrepreneurs raising funds from the public in anticipation of profits – the hallmark of an investment contract or security under our jurisdiction.” Conversely, former SEC Director of Corporation Finance Bill Hinman said in June 2018 that Bitcoin and Ether are not securities due to their decentralized nature and lack of a central third party. These opposing views are now being tested in the US District Court for the Southern District of New York. In October 2022, the court ordered the disclosure of internal SEC correspondence and documents produced as part of Director Bill Hinman’s speech (Hinman Documents), which many are eagerly anticipating. The SEC has since asked the court to seal the Hinman documents, among other things.
Some stakeholders act in accordance with Gary Gensler’s broad view of when digital assets are securities. Among other recent developments, Nexo has announced that it will be phasing out its services in the United States and has retired its earning products (which allow investors to earn interest on certain digital assets) from eight US states on December 5, 2022. Meanwhile, investors pursue Gemini for failing to register their interest earning program as a security.
Not all stakeholders agree that the SEC’s overall stance on digital assets is correct. In July 2022, digital asset exchange Coinbase submitted a petition to the SEC calling for a clearer set of rules to govern digital asset regulation, saying in part that traditional stock-focused securities regulation is not suitable for blockchain-based technology. The U.S. Commodity Futures Trading Commission (CFTC) is also challenging the SEC’s jurisdiction over digital assets. The CFTC regulates, among other products, leveraged commodity trading, derivatives, and futures. He took the position that Bitcoin and Ether are commodities subject to the jurisdiction of the CFTC and that fund managers investing in digital asset futures, or using leverage or margin to invest in digital assets, must register with the CFTC.
In the US Senate, Senators Cynthia Lummis (R-Wyoming) and Kirsten Gillibrand (D-New York) are crafting bipartisan legislation that would create a broad regulatory framework for digital assets and give the CFTC the bulk of oversight responsibility . Sen. Debbie Stabenow (D-Michigan) introduced another bill that would grant the CFTC broad jurisdiction over digital assets and trading platforms. In the U.S. House of Representatives, a bipartisan group has introduced legislation that would allow for the regulation of digital product exchanges by the CFTC and establish conditions for the sale of digital products and the registration of exchanges, among other requirements. These bills overlap but do not fully align. Moreover, these are just three of the more than fifty bills and resolutions introduced so far in Congress that relate to the regulation of digital assets.
Outside of the United States, several countries have taken significant steps toward regulatory frameworks that recognize and account for the variety of uses of digital assets. For example, in the UK, the Financial Conduct Authority has published Guidance on crypto-assets in 2019, which divides digital tokens into regulated and unregulated tokens. Regulated tokens, including (i) “security tokens” and (ii) “electronic money tokens”, provide rights and obligations similar to those provided by “specified investments” under the financial services and markets (FSMA), including property rights, reimbursement or the right to a share in future profits. Unregulated tokens include all other types of tokens, including utility or exchange tokens. The UK parliament is also debating the Financial Markets and Services Billwhich will provide regulators with greater oversight of the UK digital asset market and explicitly integrate digital assets into the FSMA.
Switzerland has adopted the Decentralized Registry Technology Act in 2021, which provides a legal basis for securities to be blockchain-based. In the meantime, the EU is introducing the Crypto Asset Market (MiCA), which would seize and regulate all digital assets not already covered by existing legislation. Australia, Brazil, Dubai, Hong Kong and Singapore are other countries that are trying to establish their own regulatory framework on digital assets.
The United States has yet to adopt a comprehensive regulatory and enforcement framework for digital assets. Participation in US digital asset markets should therefore be based on careful consideration of whether the transactions involved will be regulated as a security, a commodity, or not at all. International regulatory approaches differ significantly, requiring greater scrutiny and analysis when dealing with multi-jurisdictional digital assets.