In June, the head of the Division of Corporation Finance at the SEC, William Hinman, opined that Bitcoin was not a security, “but that many, but not all, ICOs are securities and will come under the regulatory control of the SEC and relevant securities laws.” He went on to say that the “primary issue in determining whether cryptocurrencies and ICOs were securities was the expectation of a return by a third party, specifically whether there was a person or group that sponsored the creation and sale of the asset, and who played a significant role in its development and maintenance.” Despite Hinman’s assertion that cryptocurrencies will be regulated by the SEC, it remains unclear whether the SEC has the power to do so currently.

The SEC has regulatory authority over securities as identified in section 2(a)(1) of the Securities Act of 1933. The phrase “investment contracts” potentially allows the SEC to regulate investments which do not fit in the other enumerated categories. The Supreme Court articulated a four-part test in SEC v. W. J. Howey Co. to identify what investment contracts are. The court stated an investment contract is a transaction or scheme whereby 1) a person invests their money 2) in a common enterprise 3) and is led to expect profits 4) solely from the effort of the promoter or third party. Hinman’s comments seem to reference parts 3) and 4) of the Howey test, which were expanded upon by courts in cases subsequent to Howey.

In United Housing Foundation v. Forman, the Supreme Court held that profits in the investment contract context are defined as appreciation in capital or participation in earnings. While cryptocurrencies do have the ability to appreciate in value, statements by the SEC chairman imply the agency’s hesitation stems from the fact that many investors and cryptocurrency firms see cryptocurrencies as replacements for traditional currencies, which have never been considered securities at least in part because people do not purchase them for profit. This is a strange move by the SEC because there is no real reason to accept that cryptocurrencies are alternate currencies just because they are billed as such. Courts evaluating investment contracts have looked at substance over form, and here cryptocurrencies undergo massive fluctuations in value, and frequently have to be converted into a traditional currency, like US dollars, in order to be used to buy goods or services. A court could rule against the SEC on this point, but the agency’s attitude seems to be the bigger obstacle to regulation as an investment contract currently.

In SEC v. Merchant Capital LLC, the 11th Circuit held that solely through the efforts of others means relying on the managerial efforts of others. The issue for the SEC here is that cryptocurrency operations are highly decentralized and the value is determined almost exclusively by supply and demand as opposed to an investor buying into a business opportunity run by a third party, as was the case in most of the opinions cited in this post. This means the ‘Williamson factors’ applied in Merchant Capital are very hard to sort through because it is difficult to assess the information, power, and control discrepancies between the investors and ‘managers.’ For the short term this means that the more centrally operated cryptocurrencies will likely come under SEC regulation, whereas the decentralized ones, like Bitcoin, will remain unregulated. Whatever the reason for the SEC’s general inaction thus far, unless there is a centralization of supply/ management or the perfect case for the agency, it is hard to see how decentralized cryptocurrency operations can be regulated as investment contracts.

Cory Crosbie-Foote

 

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