Not your lawyer, not legal advice.
Following my post Whether Ether is a Security, in which I agreed with Gary Gensler’s assessment that Ether is probably a security, and Ether was (probably) a security, in which the WSJ leaked that regulators did in fact consider Ether to be a security, SEC director William Hinman announced today that it is his view that Ethereum is likely not a security – although it may have been one in the past.
This has been received by the market as semi-official opinion of the agency, as it should be. In practice, I suspect this means that some might expect a great many unregistered investment schemes – no matter how harebrained or illegal – dating back to the 2014 era will get a free pass.
Although I’m an English lawyer, my personal view that this interpretation of what was and continues to be an ICO-funded scheme doesn’t gybe well with the purpose or substance of U.S. securities law.
Just about everyone appears to agree that Ethereum was a security when it was first issued. “Promoters,” Hinman said in his speech, “in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing… [where] Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases… it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey.” In other words, very much what happened with Ethereum four years ago.
Hinman suggests, however, that the wide adoption of secondary market transactions have caused the Ether instrument to lose its qualities as a security. Or more to the point, that the transactions in Ether are not sales of a security. “Putting aside the fundraising that accompanied the creation of Ether,” he continues, “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.” (Emphasis mine.)
This is because, he argues, “if the 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 – the assets may not represent an investment contract.”
Except it totally is
I join Chairman Clayton and Director Hinman in thinking that a “decentralized” scheme – which I define as
“a (1) cryptocurrency scheme, (2) in relation to which neither an originator nor promoter has sold or distributed tokens for value to third parties, and (3) which utilizes a consensus algorithm that ensures the process of adding blocks or transactions to the shared transaction history is not controllable or censorable by one person or a reasonably foreseeable cartel”
is not an investment contract and should not be subject to securities regulation.
Where I struggle is in understanding how tokens issued by a scheme start life as investment contracts, and then, despite openly flouting the law for years and seemingly only because the scheme has successfully evaded enforcement action during that time, despite being part of and enabling what former SEC Commissioner Joseph Grundfest called “the most pervasive, open and notorious violation of federal securities laws since the Code of Hammurabi,” the tokens issued by such a scheme could conceivably lose their status as investment contracts.
With such a scheme it is the instrument, aka the token, which is the investment contract. It is the mode of that investment contract’s issuance which should determine the character of the entire scheme. As Chairman Clayton made clear when he carved out Bitcoin from the SEC’s purview, we are concerned with the initial sale of the token for value with an expectation of profits etc., not the secondary market transactions in such a token, when determining the token-qua-instrument’s character and whether the securities laws apply to it. Tokens are the thing that the public values; they are the evidence of the share in the scheme, “it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” Howey.
The property that backs the token and of which it is a proportional share, if any, is the goodwill of the underlying chain ecosystem to which that token relates, which can be and is quantified as a “market cap” on websites like Coinmarketcap, calculated as the spot price of the token multiplied by the total tokens outstanding.
Secondary trading of the token-qua-investment-contract ought not to change the investment contract into a cryptocurrency, any more than a secondary trading of, say, a private company share doesn’t transmogrify the share into money. If there’s a precedent that supports the SEC’s current proposed approach, I’m not aware of it.
Anyway. I don’t think it should be terribly difficult for the SEC to get on board with that approach once they get some skeptical input to counter some of the input I know they’ve had from the lobbyists (I’m easy to get hold of, guys). Especially since, towards the end of Director Hinman’s speech, he rattled off a list of criteria, one of which refers to a token as an “instrument:”
I will leave it to you, dear reader, how you might have applied these factors in 2014. If we assume for the sake of argument that the Howey criteria are met, and if we pay very close attention to the word “scheme” in Howey’s “contract, transaction, or scheme,” it seems clear that later decentralization should not save a cryptocurrency scheme from earlier transgressions; where the later-mined tokens are part of the same scheme as the presale coins and facilitate its objectives, and it was an investment contract at inception, then as a practical matter the Ether sold in the presale and the Ether today are all part of the same scheme, albeit one that has achieved completely its promoters’ original goals.
Indeed, decentralization does not terminate the initial investment contract; it is the purpose and objective of the initial investment contract. Funding marketing efforts and becoming a decentralized cryptocurrency is the point of the exercise.
To think otherwise is to effectively allow crypto-token systems to outrun regulation even if at their genesis they violated the laws. It does not take long for a cryptocurrency system to grow beyond the immediate control of its creators; even with Ethereum, it would have been very difficult, as a practical matter, for the system to be unilaterally controlled by the Ethereum Foundation or the core team mere days after the system launched (ignoring the DAO hard fork, which was the result of an at-the-time-unforeseeable cartel of most of the major economic interests in Eth trying to extricate themselves from a plainly absurd $150 million unregistered investment scheme, which also escaped scrutiny despite being a flagrant violation of U.S. securities laws and, presumably, the public offering rules in every jurisdiction in which DAO Tokens were sold).
“Decentralization” is, accordingly, not a good measure for deciding whether securities laws should apply to a scheme, as a scheme can become functionally decentralized fairly quickly merely by choosing an appropriately decentralized consensus algorithm. Today, that means proof-of-work.
Why have we now changed the subject to be about secondary market transactions in Ether instead of the thing that is possibly the investment contract and may have been all along, Ether itself? Lord only knows. But in my view, coins, when sold to obtain investment capital, should be treated as an investment contract of a kind, no matter how “decentralized” the system eventually becomes. (Note, whether Ethereum is decentralized – or will be after the transition to Proof of Stake, where its largest holders will have a meaningful input on consensus – is an open question.)
Speaking of which,
“Decentralization” is legally meaningless
The term “decentralization” has no legal meaning, at least not yet. It could mean that a scheme uses POW consensus even if the supply of the cryptocurrency was pre-sold to a handful of large promoters who funded its early development (purely hypothetically). It could mean that the cryptocurrency has a hard-cap and is reliant in practice, if not in theory, on one company’s contributions to the network, as with Ripple. It could mean many investors hold the coins but consensus is determined by a cartel, like Eos. It could mean that, as with Bitcoin, three major mining pools and a small group of “core” devs have outsize influence over the currency.
If “decentralization” is a defense, all of the schemes outlined above will plead it. All of them will be both right and wrong to varying degrees.
Put another way, “decentralization” is a buzzword, not a term of art. We should therefore avoid entirely use of the term and look to processes the law understands – issuance and sale – to inform our regulatory approaches. Relying on this amorphous, non-legal, coin-specific concept of “decentralization,” as Coin Center argues we should, muddies the waters completely unnecessarily, introduces a huge amount of legal uncertainty, has no basis in existing law and will result only in further confusion in the marketplace, exposing retail investors to more risk.
I have a pretty simple way of looking at tokens, one which squares the circle nicely when we’re trying to ask why Bitcoin shouldn’t be a security where something like Ether should. The most important question, the threshold issue, is whether the issuer or creator of the chain sells any of the tokens/coins.
This way of thinking about token transactions is elegant in its simplicity; e.g., it is hard to argue that a mined coin on a chain where no tokens have ever been sold or distributed by the issuer to the public is an investment contract, as there is no valuable consideration moving between the user and the blockchain’s creator, ergo no investment of money, ergo no investment contract. Tokens that are not sold are made, through mining or similar processes. Last time I checked, cryptocurrency mining was perfectly legal.
This means, given current market dynamics, from the perspective of a scheme promoter, assuming a scheme is “decentralized” per my definition given above,
- If you’re selling/distributing tokens, and especially if you’re pre-selling them, to US persons, you probably have an investment contract on your hands.
- If, like Satoshi Nakamoto, you’re not selling or distributing tokens to US persons, you probably don’t.
Again, none of that is legal advice, but more a point for discussing whether the SEC’s proposed regulatory approach could benefit from revisions.
Anyhoo. Whatever people think of today’s statement of policy, it hints towards a liberal approach to cryptocurrency structuring. I don’t like that it hints towards that approach, as I think cryptocurrencies are economically extremely dangerous, but I have to concede that’s where it points.
I still think industry-specific regulation is now due. We will almost certainly not get it for at least half a decade or more. But its absence should not be interpreted by entrepreneurs as a free-for-all; remain mindful that this is the first round of a regulatory boxing match in what promises to be a decades-long bout. Remember also that securities regulation is fast-moving field where what worked yesterday might well not work tomorrow. See, e.g., U.S. v. Newman, where the Second Circuit Court of Appeals, overturning itself, criticised the government’s “overreliance on our prior dicta” to inform “the doctrinal novelty of its recent insider trading prosecutions.” Judicial gaslighting par excellence.
“Doctrinal Novelty” – these are two words all lawyers in blockchain should keep in mind as we advise on and unravel these new and interesting technologies.
Entrepreneurs, on the other hand, should not commence a coin issuance free-for-all in response to today’s semi-official statement from the SEC, although I fear now that many of you will. If your behavior gets too out of line, you will ruin the party for everyone.
To sum up, compliance is a long game. Plan accordingly.
4 thoughts on “Ether is not a Security?”
Very nicely done, Good Sir Preston. Solid analysis and I agree completely that we’re seeing what could be some overexuberance on the part of the cryptoasset community with regards to Hinman’s statements. Many are missing the nuances and qualifying language; there is ample use of the conditional in the remarks. We are wise not to take an “all-or-nothing” approach to this. Compliance is, as you note, a long game, and it is far more broad, deep, and multi-layered — as well as ever-evolving — than many appreciate.
In marmots we trust.
1. I was really hoping that you were going to hone in on the major qualifier in Hinman;s statement – “Putting aside the fundraising that accompanied the creation of Ether.” To me, this qualifier took off the table the most important part of the analysis here – how ETH was sold – which is the crucial point in your elegant approach of asking whether the token was pre-mined and sold. Instead, what we were left with was what we arguably already knew – the underlying ether token is not a security. Could it be that this intentional punting allowed for some logic contortion as (I suspect) the SEC started with the conclusion that ether is not a security and had to back into this conclusion? It could be possible. For instance, I take the regulators at their word that the truly do not want to disrupt innovation. Could the SEC have given ETH a pass here as with its widespread adoption and still untapped potential, ETH provides said innovation? As a proponent of cryptos in general and ETH in specific, I ultimately like the outcome here. But I do not think the contortion act will be performedagain (any reliance upon this statement as precedent could be beaten down with the stick of “facts and circumstances”). To put another way, the ETH genie was too large for the SEC to get back into the bottle, so ETH got a free pass. I dont think there are any other genies out there (with the exception of RIpple).
2a. In your approach, you mention selling and distributing as connected terms. What is the difference? Does distributing amount to developing a allocation protocol method such as proof of work (i.e., set up a contest where the prize goes to the first to solve a puzzle)? If so, isn’t this what Satoshi did? Or do you mean something else by distributing? Are you attempting to capture an airdrop scenario where nothing was sold, but was certifiably distributed? Could you please clarify. I respect your careful selection of words and would like to better understand their use.
2b. If an airdrop is included in your definition of distribution – do you therefore think that such schemes could trigger securities laws? I, for one, do not believe that airdrops constitute securities offerings as they completely destroy the first prong of the Howey test as there is no investment of money involved.
Your thoughts are greatly appreciated. I’ll thank you in advance should you find the time to respond.
A fellow marmot fan.
Hey there, Marmot Fan. (You certainly know how to get me to respond.)
1. I think they punted on this point, yes. In my view the initial sale was an investment contract offering.
I also think that the argument that cryptocurrency is necessary for innovation holds very little water. Most of the hard crypto that went into Eth, and the basic operating principles of the EVM, were more or less done and ready to go in January of 2014 (before any tokens were generated or sold). If Eth had venture-funded and then rolled its chain on Day 1 without having sold tokens to the public, this discussion would in my view be moot. But that’s not where we are.
2a. See 2b.
2b. “Distribution” means “title transfer.” Mining does not so much transfer title as create new title over something that did not exist before. Airdrops however are clearly a transfer from A to B. The courts have found on prior occasions that airdrops of securities, which the user needs to go and claim through a web portal and provides e.g. identifying information, are ICs because there is value moving between the parties – in exchange for your efforts to obtain the security, you obtain the security. Not distributing *at all* nukes the “investment of money” part of the Howey analysis. It means you can’t sell tokens to US persons to pre-fund or fund your operations (compare with Ripple Labs’ Modus Operandi) or do other kinds of marketing stunts with the coins or pre-seeding influencers with large coin balances (as Ethereum did).
I’m not a lawyer, but EOS (biggest ICO in history – $4B) seems like the reverse case to me: something that wasn’t a security during the ICO, but is now.
The ICO was technically a payment for release of bare software only and they left the details of possible launch to others; potentially there are going to be several networks based on the code and there’s nothing that forces them to respect the ICO token distribution.
After the launch tokens on a particular network seem like a straight shares in a stock company to me, with no conceivable way to use the vague decentralization criteria:
– users vote with their tokens to elect 21 block producers. The elected producers can do everything, including deleting/editing accounts.
– ‘EOS constitution’  – their version of Articles of Association
– self-appointed arbitration court that already made a judgment to freeze some accounts 
– ability to rent unused bandwidth . ‘Bandwidth’ is generated by staking EOS tokens and gives access to resources; the owner doesn’t have to do anything (eg. run a node) so it’s a pure dividend.
What do you think? Would this be considered a security in the UK and/or Malta? Malta is important as that where several cryptocurrency exchanges have moved.
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