Welcome back to this week’s edition of Not Legal Advice!
Last week I didn’t write Not Legal Advice because I spent the week traveling to see clients and attend the Satoshi Sidetable and Free State Blockchain events hosted by Bruce Fenton and Chainstone Labs in Portsmouth, NH.
The conference was awesome, so thank you Bruce & team for the invitation to speak. Well worth the trip and I highly recommend it next year.
If you don’t know Bruce, you should make a point of getting to know him. Immediately.
Anyway. After a thoroughly high-energy week traipsing around the northeastern U.S. in my truck, I decided to spend my Sunday walking around in the trees and enjoying the crisp New England autumn, rather than sitting behind my computer.
I have no such excuses this week, however, so we are right back to it:
- Bitfinex claims it’s a victim
- Is the Hinman Test dead?
- Mr. Zuckerberg goes to Washington
1. Long-suffering Bitfinex plays the victim card
First, in 2017, it gets subpoenaed by the CFTC. Then, in 2018, it’s reported that they’re under investigation by the DOJ. Then, also in 2018, major ringleaders at their (alleged) banker, Crypto Capital Corp (“CCC”), gets indicted by the feds and $800 million of Bitfinex money entrusted to CCC – without so much as a written contract, if the reports are true – gets seized. Then, in 2019, they are placed under investigation by the State of New York. Later in 2019 they got sued for $1.2 Trillion.
Then, this week, the President of CCC is arrested in Poland on money laundering charges… and the Polish prosecutors didn’t have very nice things to say about Bitfinex, apparently. CoinDesk reports:
Polish authorities claim that Molina Lee is wanted in Poland for laundering up to 1.5 billion zloty or about $390 million “from illegal sources,” according to the Polish report.
Authorities wrote that Molina Lee’s crimes included “laundering dirty money for Columbian drug cartels using a cryptocurrency exchange.”
Polish prosecutors claim that Crypto Capital held accounts in Bank Spółdzielczy in the town of Skierniewice and that Molina Lee and Bitfinex laundered illegal proceeds through the country.
Bitfinex didn’t take that allegation lying down, and responded:
In a statement released Friday, Bitfinex said it will “make its position clear” to U.S. and Polish authorities and will continue to pursue the funds that Crypto Capital lost. According to the statement, Crypto Capital had misrepresented its “integrity, banking expertise, robust compliance programme and financial licences” to Bitfinex.
Molina Lee is wanted in Poland for laundering up to 1.5 billion zloty (about $390 million) “from illegal sources,” according to reports in Polish newspaper W Polityce. Bitfinex denied rumors that it had played any part in the payment processor’s money laundering.
“We cannot speak about Crypto Capital’s other clients, but any suggestion that Crypto Capital laundered drug proceeds or any other illicit funds at the behest of Bitfinex or its customers is categorically false,” wrote Bitfinex general counsel Stuart Hoegner.
The company is innocent until proven guilty, obviously, as this is America, but I think we can agree that the long-suffering Bitcoin exchange has had a rough ride. Quite the fall from grace for what was once the largest Bitcoin exchange, by volume, in the entire world.
2. Is the Hinman Test dead?
Ethereum is undoubtedly responsible for more legal confusion in the U.S. crypto-markets than any other project of its kind. The confusion began after Division of Corporate Finance Director William Hinman announced his so-called “sufficiently decentralized” test, or “Hinman Test,” in June of 2018, in this policy speech. It goes as follows:
Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, 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. And, as with Bitcoin, applying 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 (emphasis added) networks and systems where regulating the tokens or coins that function on them as securities may not be required. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.
This was followed by pronouncements by SEC Chairman Jay Clayton in early 2019 to that effect. The SEC’s commentary was followed by additional statements in early October by CFTC Chairman Heath Tarbert that Ethereum was in fact a commodity and not a security, but at some later date a code fork could result in the coin becoming a security once again. He said:
“It stands to reason that similar assets should be treated similarly. If the underlying asset, the original digital asset, hasn’t been determined to be a security and is therefore a commodity, most likely the forked asset will be the same. Unless the fork itself raises some securities law issues under that classic Howey Test.”
To wit: Ethereum started its life as a securities offering and then became “sufficiently decentralized” in such a way that it lost its character as a security and became something else, but at some future date due to some future forking activity (*cough* proof of stake *cough*) the system might become a security again.
Mind you, when someone dares to point out that Ethereum should have been treated first and foremost as a security, what invariably happens – every single time – is that a number of legal eagles crawl out of the woodwork to point out that anything is capable of being treated as a commodity, including securities.
This is, of course, legally correct. But it’s not practically correct. Practically, someone re-launching Ethereum from scratch, line for line, with the same marketing, same documentation, and same code, will discover that the resulting product would undoubtedly be treated as a security, as I wrote in my blog post two weeks ago titled “If Ethereum were launched today, it would be a security.” Which I haven’t really heard any practitioner disagree with. Meaning the SEC would and should get involved in regulating the asset before the CFTC has even gotten out of bed.
Where the SEC claims that Ethereum transactions started as securities transactions but are no longer securities transactions, because transmogrification, I find no precedent anywhere in American law that supports the proposition that a security can become a non-security, much less then move back afterwards.
For this reason, I have arrived, fairly recently, at a theory about the Hinman Test for securities transmogrification. My theory is that, since every system that has attempted to raise the Hinman Test as a defense (Kik and Telegram in particular) has been savagely rebuffed (sued) by the SEC, that the Hinman Test does not in fact exist, it is fiction, and that the most plausible explanation for the absence of enforcement action against Ethereum is that extremely aggressive lobbying by Silicon Valley venture firms convinced the SEC that Ethereum wasn’t a security despite the fact that it is, and it’s too late now for the SEC to turn back. Even though it should.
In a new development, the theory that the Hinman Test does not actually exist has been backed up by statements from the heads of the federal regulatory agencies themselves. Thanks to Nic Carter for asking this very insightful question:
Generally speaking, if a law isn’t written down in statute or isn’t found as a rule in the C.F.R., and there’s no precedent for it anywhere else, it doesn’t exist. SEC v. W.J. Howey, Co., a Supreme Court precedent, is the rule in this instance. That rule doesn’t permit for transmogrification. It asks one question, whether the thing in issue is a
a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits… from the efforts of the promoter or a third party
and if the answer to that question is in the affirmative, it provides no means by which a scheme can somehow turn back over the passage of time, enabled by regulatory forbearance, and erase its prior status because somehow the investment scheme becomes… too successful? Such a conception of the Howey Test defeats the Howey Test’s entire purpose, which is to restrain these schemes and ensure the term “investment contract” in the Securities Act is capable of eternally constituting “a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. 293 (1946). The purpose of Howey is to capture those schemes, not to allow them to wriggle away.
In the absence of legislation from Congress, a contrary rule shouldn’t be adopted by federal regulatory agencies that are generally tasked with enforcing the law, not writing it.
The classification of Ethereum as a “used-to-be-a-security, transmogrified-into-a-commodity, and could one-day-be-a-security-again critter” is absurd. It makes no sense. It does not comport with existing law. It’s a lot of intellectual hoop jumping which could be very easily resolved by simply admitting that the federal regulatory apparatus made a mistake with Ethereum and doesn’t want to burn thousands of Ether investors, including large venture funds, in whose hands these Ether unregistered securities may be found.
Is it time to declare the Hinman Test dead? I think so. Question is, will the SEC correct course on Ethereum, which, due to the bloat and the fact that it is mostly run on nodes managed by one company, and its suspect premine, is likely one of the most centralized cryptocurrencies in existence? Especially since it is likely to only become more so if the promised migration to proof of stake/”Ethereum 2.0″ proceeds?
ADDENDUM, 28 OCTOBER 2019
A colleague points out:
Someone at DC Fintech week noted that in 2013 the SEC released a 21(a) report – like the Report on The DAO – for Eurex Deutschland, which offered security index futures. Security index futures are subject to SEC or CFTC jurisdiction depending on how many securities are in the index. Originally, the underlying was a broad-based securities index (based on various thresholds) – a commodity, subject to CFTC jurisdiction. It registered with CFTC. But over time, the underlying changed to a narrow index (after it crossed one of the thresholds) – which is considered a security, subject to SEC jurisdiction. It did not, however, register with the SEC, which the SEC says was unlawful. Like The DAO, however, the SEC chose not to impose penalties.
I see what you’re saying. Like it’s not a Howey analysis. It’s a mechanical thing – their index went from 5 securities <50% to 5 securities > 50%[,] in line with voluntary SEC/CFTC administrative guidance that created a bright line not present in the case law. That’s very different from a Howey investment contract turning into a non-investment contract by operation of invisible qualitative factors no one can really measure, in a real-world fact pattern, decided by a court.
Basically. And even if we were to look at this from a quantitative standpoint, 72 million Eth were issued in the pre-mine and 108,334,927 Eth are in existence today – meaning that the “security” component of the coin (the premined bit) is still 66% of the overall supply.
3. Mr. Zuckerberg goes to Washington
I’m so sick of hearing about Libra. As I said to Peter McCormack on his podcast:
The thing that really bothered me about the Libra whitepaper was that they think we’re stupid, they think we’re dumb, they think we were born yesterday… but in fact they’re the neophytes, they’re the newbies, they just showed up, and this is our house.
Facebook’s public statements on this project have all been long obfuscation and short substance, so I won’t waste your time with a detailed breakdown – all you need to know is that the company continues to not give straight answers about privacy, data protection, and regulatory treatment that anyone who has operated in cryptoland for more than a year will be familiar with and expect concrete responses to particular questions. Which the members of the House of Representatives were unable to ask, since (with the notable exception of Rep. Warren Davidson) it appears that every other member of the House Financial Services Committee can’t tell the difference between a blockchain and a chimichanga.
The live Q&A added little to the written testimony. Essentially, Zuck showed up in Washington and told the Congressmen that his company is woke af, meets diversity quotas, was there on a charitable mission to bank the unbanked, and if the Congress didn’t get out of his way, that American financial innovation would be leapfrogged by China. As his lieutenant David Marcus tweeted:
What I think Facebook doesn’t understand is that China never deplatformed anyone any American has read or listened to, or moderated any of their social media posts for political reasons. Facebook has.
The American populace doesn’t like it, doesn’t trust it, and isn’t going to be goaded into making it easy for a Swiss-incorporated for-profit “non-profit” to operate on American soil that gives Facebook unlimited access to our financial data whilst allowing Facebook to not actually go through the onerous regulatory process of operating a financial institution.