Very pleased to catch up with Adam B. Levine, Stephanie Murphy, and my good friend Jonathan Mohan on the original (and still best) Bitcoin podcast, Let’s Talk Bitcoin, for the first time since 2014.
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.
This blog post can be summed up in one word: “frustration.” It shows how tired the market is of technobabble euphemisms, and how much people outside of Coinland want to see some enforcement to level the playing field for businesses that choose to *not* raise with noncompliant ICO coins.
This is a follow-up from my post last week titled “Whether Ether is a security.”
Turns out that Ether very probably was a security, per this morning’s report in the Wall Street Journal:
Looking forward to writing the follow-up, “Ether is a security,” in due course, although I will not be able to write it until such time as a federal judge has a chance to weigh in on the matter. Until next time, then.
Disclaimer: English lawyer, not practising this year, yes in England “practise” is spelled with an “S” when used as a verb, ergo I’m not your lawyer and this blog post is not legal advice.
I am often asked, directly, whether I think this coin or that one is a security (and thus required to be registered with the SEC before being offered to the public) or not. Virtually every time I demur.
Part of the reason for this is that although I am a securitization lawyer by training, I am not, as yet, U.S. qualified and the Howey test is a U.S. question. Most of the reason for this is that the question of whether a thing is or is not a security is a highly fact-dependent and, sitting from my perch on the East Coast and not in the offices of the issuers of these coins, I am in a very bad position to ascertain what is going on behind a company’s closed doors, what’s in their private correspondence and what intentions lay behind their issuances.
As I said to Marc Hochstein, Coindesk’s editor in chief, this morning when asked me that very question about Ripple and Ether,
I think that neither Ethereum’s promoters nor Ripple Labs’ promoters have satisfactorily answered that question to date, and that it is their job rather than mine to do so. Let me just say that if I were starting a software company in the United States today, given the noises being made by the SEC and by other financial services regulators I would not put an exchange-tradable token at the center of the offering unless that token were a representation of a legally-recognized interest and structured on the basis that the token will be regulated by the securities laws.
Whether Ether and/or Ripple are in fact investment contracts under the SEC v. W.J. Howey test is now an issue of public concern, with financial services culture hero Gary Gensler arguing that Ether might be classed as a security (properly, an “investment contract”), and Coin Center’s Peter van Valkenburgh arguing that it shouldn’t because a sufficient degree of “decentralization” should exempt a cryptocurrency from regulation.
Suffice it to say, in what will not come as a surprise to many of you, I tend to agree with Gensler as to the U.S. position. Law is, of course, a local phenomenon; thus when it comes to England and Wales, my home jurisdiction, I do not think Ether tokens as they exist today should be classified as a security, as I set out in more detail here.
But talking about law is boring. Talking about decentralization is exciting, hip and fun. For this reason, rather than quote chapter and verse on the Howey test, I am going to talk about the “Decentralization Defence” that we’re hearing cryptocurrency advocates wheel out in response to Gensler’s comments.
Peter’s Coin Center piece argues Ether is not a security because it has successfully managed to out-decentralize other cryptocurrencies:
But today, the value of ether and the functionality of the Ethereum network is not reliant on the Foundation, rather it flows from the efforts of thousands of unaffiliated developers, miners, and users. That decentralization is hard to differentiate from Bitcoin’s, a cryptocurrency Gensler suggested is almost certainly not a security for the very reason we’re discussing: no discernable third party (no common enterprise) upon whom we rely for any expectation of profits.
I’m going to disagree with that, on three points.
1. Horizontal Commonality
A common enterprise can be established horizontally, i.e. when investors have shared interests in a common fund. The authorities may need to stretch existing precedent if they wish to argue that a headless Nakamoto Scheme is capable of forming such an enterprise. Whether law enforcement intervenes and how will be fact-dependent. I can think of a number of different theories they could use but they do not bear repeating here.
Github is also a very obvious central point of failure for the purposes of the decentralization analysis. There’s a main repo. Who controls it and how is relevant.
Yes, Bitcoin has a repo, too, and I don’t think Bitcoin is an investment contract. But the background facts for Bitcoin are quite a bit different than those for Eth (and in my view having a Github repo with admins, in every case, would be a factor weighing in favour of a finding of commonality / weighing against a finding of decentralization).
3. The pre-sale
Here we are not looking at the obvious concerns around the presale, its terms and its legality. We are asking whether the pre-sale was actually a decentralized exercise, with decentralized results, that would militate against a finding of horizontal or vertical commonality.
Despite Coin Center’s protestations to the contrary, the fact is that nobody actually knows how decentralized the world’s supply of Ether is. The ecosystem feels and looks decentralized, in that no single person or group has claimed or has appeared to exercise dominion over it. But that doesn’t mean such a person or group doesn’t exist.
In my view, most of the Ether sold in the 2014 token pre-sale in exchange for Bitcoin may have been paid out to one person or, more likely, a handful of close associates working in concert. My reasons for believing this are anecdotal, but based mainly in this chart which shows the inflow of BTC to the Ethereum wallet address during the Ethereum pre-sale:
Compare this to the curve for, say, 23y = x^7:
Now compare it to a random Kickstarter…
…Or the Tezos raise, which was 30 times the size of the Ethereum raise with what we should expect are many, many more contributors, thus offering an ostensibly much larger sample size:
I could grab plenty more ICO fundraise charts but hopefully by now you’ve caught my drift: while ICO raises are sort of similar in that we usually see an initial rush of investors that gradually tapers off, with a little boost just before the sale ends, the initial two week-period of the Ethereum pre-sale looks more than merely typical, there’s very little randomness in it – it looks perfect. Seeing as human beings are generally imperfect, that’s what makes it a worthy candidate for forensic analysis. “Donations” from Eth-heads around the world not only flowed into the Ethereum Project’s wallet in great quantities, but they flowed in with the mathematical precision of a power function, 24 hours a day, 7 days a week, for two weeks straight. Notable too is the fact that ICOs tend to front-load contributions into the first days of the raise; Ethereum, by contrast, seemed to save the bulk of the contributions for later on.
My preliminary conclusion is that human beings engaged in financial speculation do not usually behave in the manner the Ethereum chart appears to show. This is especially true when we consider that the Ethereum community was as small as it was back in 2014. If someone wants to science the daylights out of this and show how unlikely, given what we see with other ICOs, it is that the Ethereum pre-sale curve is the result of natural, random market conduct, by all means. The data’s all there on the blockchain.
I’m thinking that, unless Vitalik subtly managed to telepathically hack everyone’s brains so buyers would participate in the pre-sale in an organized fashion, it would appear that a lot of Ether – enough Ether to move markets or, if the system migrates to proof-of-stake, enough to play a meaningful role in determining consensus on a block-by-block basis – was sold to not a lot of people. Depending on what those people then did (marketing? Other promotion?) this may be relevant for showing a common enterprise through vertical commonality, which is a lot easier to demonstrate than horizontal commonality. If the degree of influence is so significant that those holders can call the shots on consensus or market movements, well, that’s pretty significant for a securities analysis.
Summing up, unless we can show that this Ether has been sold into the wider market, this chart lends itself to the proposition that Ethereum is not as decentralized as we might hope. If true, this fact likely has legal consequences and rather undermines the “Decentralisation Defence” being put to the regulators by industry lobbyists.