If Ethereum were launched today, it would be a security

We learn today that the CFTC Chairman has declared Ethereum to be a commodity.

I think this view, understanding the word “commodity” in the plain and ordinary meaning of the term rather than as something which is capable of being the subject of a futures contract, is not correct. An Ether token has less in common with a soybean than it does with a share.

And before you chime in with the comment “durrr a security can be a commodity too,” from a signaling standpoint, if the CFTC is making this statement in public, it likely means is that the CFTC and the SEC have finally and irreversibly concluded their discussions in private as to how primary regulatory responsibility for Ether is to be apportioned between them, a discussion which is rumored to have been going on behind closed doors for years.

The market has accordingly taken the statement to mean that the CFTC will be taking point on regulating markets for the product and that the SEC is out of the game. This is the final stake through the heart for those Bitcoiners who had hoped Ethereum would be deemed a security and thus wiped from existence on U.S. exchanges.

Although this has undoubtedly cheered the folks at DevCon, as it should, I would struggle to advise a client that launching an Eth clone tomorrow – let’s call it Dogethereum – would be an advisable course of action.

Anything that I know of which has been created by a private company, by book-entry, and pre-sold to the public accompanied by offering documents, as an investable asset, has been, and should be treated as, an investment contract. Sales of these beasties should either be registered or subject to an exemption to the registration requirement. Numerous other products – Paragon, Airfox, Eos, Sia Veritaseum, and others – that are remarkably similar to Ethereum have been regulated and regarded as a security by the Securities and Exchange Commission. That’s both the initial offering and, in some cases, the resulting token (as in e.g. Paragon, where the SEC ordered Paragon to file a registration statement with respect to its tokens). Ripple Labs is being sued in a class action that claims it is selling securities. There are many other such cases.

Yet Ethereum is different.

There’s no magic, legally binding pixie dust here.  Regulators simply looked the other way. On several occasions. This may be because there was a different sheriff in town (Mary Jo White) when the Ethereum scheme first launched, or that the statute of limitations ran in August. Or because marmots from outer space secretly control the US government and decided to let this one scheme slide. Nobody knows. In any event, I am not sure why this scheme is different from all the others.

Legally speaking, I don’t think it is different. I think it’s just dumb luck. Simply because nobody from the government has endeavored to explain their regulatory forbearance doesn’t mean my position isn’t correct.

Ethereum is an experiment that cannot be safely replicated

To understand how

• Ethereum isn’t, legally speaking, any different from any other two-bit ICO, and
• how the “sufficiently decentralized,” or so-called “Hinman Test” (which has no basis in law) is not something to be relied upon,

We should ask ourselves one question:

“What would happen if we replayed the Ethereum ICO, exactly as it happened in 2014, today?”

Folks looking to sell Ethereum-like products today should not presume they are purely in commodity land. To do that would be a mistake and would run contrary to all we’ve seen from the SEC, in terms of both express guidance and what we can learn by implication from the regulatory treatment schemes that aren’t Ethereum have received.

Namely, that if you’re selling tokens for fun and profit without a no-action letter, you’re selling securities, and you should expect your activities to be within the SEC’s regulatory perimeter.

Revisiting Dogethereum, a hypothetical token sale that is in all material respects identical to Ethereum (hell, you could even fork the Ethereum codebase and offering documents, which are on GitHub, and try this out, although this would not be advisable), I am fairly sure that if you attempted to run that exercise tomorrow, with offering docs, marketing, etc., in the United States, you’d be selling an investment contract and the SEC would concur with this view.

I dare anyone to explain to me why such a scheme would not be an offering of investment contracts and what makes it different from Jay Clayton’s stance that “every ICO I’ve seen in a security.” 

I do not apologize for taking this view. I never will. Legal advisors have to be realistic when their clients ask them why it was OK for Ethereum to do something but not OK for the client to do it.

The reality is that selling unregistered investment contracts without registering or availing oneself of an exemption is against the law. If you want a lawyer who will tell you to “take a chance, we’ll try to make money and if it goes pear-shaped you can pay me to fix it,” good for you. You can hire someone else.

My answer is this: Ethereum’s different “because reasons,” not because of the law. The law is basically what the SEC has applied in its day-to-day enforcement activities since September 2018, and what is referred to in the settlements it concludes. Howey, the Securities Act of 1933, etc.

What crypto-bros like Coin Center would prefer the law to say on the subject of Ethereum is drawn from a throwaway line in a brief policy speech setting out the so-called “sufficiently decentralized,” or Hinman, Test upon which Ethereum supposedly relied. That “test” states, in brief:

[There are circumstances in relation to which] a digital asset transaction may no longer represent a security offering. 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. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.

This test should have been taken, at the time, with a pinch of salt.

First, what does “decentralization” even mean? Nobody agrees on the meaning of that term.

Second, and most significantly, it was made by Director Hinman in a personal capacity rather than on behalf of the Commission, so it never became official policy. It certainly wasn’t binding precedent.

Third, there appears to be no precedent provided whatsoever – either in that speech or since – for the proposition that something which starts its life as an investment contract can somehow lose that quality over time, any more than a share or a bond can somehow degrade with age. But that’s the tack Director Hinman took, which led him to conclude, in the same speech,

…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether,

i.e. the ICO was a securities offering,

the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

My question is this: how?

How does the SEC know for a fact that material information asymmetries receded, when the crowdsale itself was unsupervised (and most Ether thought to be held in very few hands)? How is Ethereum “decentralized” when most of its full nodes are run on AWS by one company and a full node can’t be run on consumer hardware? How is there not an issuer or promoter when there is a Swiss Stiftung literally named the “Ethereum Foundation” that organized the offering, is endowed with tens if not hundreds of millions of dollars of Ether generated in the offering, manages the meetups and web presences, holds all the IP and controls the GitHub repos, or large enterprises helmed by Ethereum founders that exercise outsize influence on the ecosystem? Don’t you think it might be possible, nay, even prudent, to get disclosures from people and companies like that?

The Hinman Test describes a hypothetical scenario where we can say with certainty that a cryptocurrency scheme has become natural, unmanipulated, and fair, where all market participants have the same information. It is unlikely this is the case with any cryptocurrency, including Ethereum.

Maybe folks figured this out as, in the 18-odd months since that test was first laid down, we’ve never seen the Hinman Test used again by the Commission in any context. The only time we’ve seen it is in that one speech where it explains that one decision. The idea of “true decentralization” does not exist in the Commission’s official guidance and the one time the concept of “decentralization” is mentioned, it is not defined. Although the idea that a security may be re-evaluated at a later date and found to have transmogrified into a non-security is in the guidance, this would not save Ethereum if we re-launched it from scratch tomorrow, and can be best understood as speaking to the commission’s thought process, and not as an expression of a rule of law.

I know of no legal precedent that supports the proposition that securities can transmogrify into non-securities, especially under circumstances where the security becomes more popular among the investing public and the purpose of the original unlawful scheme is fulfilled, and none is cited by the guidance.

The Hinman Test has not found its way into settlements with any coin issuers. It has never been raised successfully as a defense. The one company that publicly dared to raise it, Kik, was promptly sued shortly afterwards.

Apart from that one speech and that one decision, it appears that the “Hinman Test” doesn’t exist. Which means that if we were to re-run the Ethereum crowdsale from scratch today, Ethereum would be treated no differently than Paragon Coin.

Why is Ethereum the special case? Why did it escape scrutiny while Kik, and virtually every other coin offering the SEC has settled with or sued to date, has not? Maybe Ethereum got too big. Maybe the harm to investors and crypto businesses that would arise from deeming it an investment contract would have been too great. The only reasons I can divine that Ethereum is treated differently are that the scheme was enormous – hundreds of billions of dollars made and lost – and multiple major venture capital firms with a ton of exposure lobbied for this one unregistered, non-exempt coin offering to be treated in a particular way that sets it apart from every other unregistered, non-exempt coin offering ever conducted.

And they succeeded, because money talks. But you, startup entrepreneur, do not have that kind of money or access. So if you try the same thing, you are unlikely to succeed.

Concluding: as with the Eos settlement, this Ethereum revelation is not a green light to start selling tokens in the US with reckless abandon. It is an aberration, an outlier, a special case.

You can still get in trouble, and if you try to re-run the Ethereum presale line for line, even if you use the same marketing materials, make the same representations and use the same code, you probably will.

Be guided accordingly.