The SEC has announced new guidance affecting crypto. This guidance will lead to creating specific new regulations as to what is, and what is not, a securities offering. This guidance is based on the 80-year old US Supreme Court “Howey” case defining what is a “security.” This post describes the legal theory behind Howey, how the SEC has applied Howey to crypto issuances, and how it appears that proposed regulations will loosen previous SEC positions that claimed that much of crypto coin or token grants involved unregistered securities. This general approach is not unexpected given the current Administration’s romance with crypto, including of course the new Trump coins.
Howey involved the owners of orange groves selling interests in such groves in exchange for an investment, with a right to part of future profits. Since the investor sought a return based on the operation of a business by the offeror of the profits interest, SCOTUS equated the transaction (buying a part of real estate, eg the orange grove) to the investment in a share of stock the value of which would rise or fall based on the success of the offeror in making a profit.
There are all sorts of crypto offerings, of course. Early in the crypto age, some offerings, like Howey, involved using the proceeds from the purchase of a digital asset to develop a resort, or a hotel, or a restaurant, or some other amenity. Since the value of that asset would increase upon completion of the facility, and since the purchase of the interest served the venture capital purpose of building a business which would return a profit (although not shared with the token holder), the SEC easily concluded that the interest was a “security” wolf in sheep’s clothing. (In this post, henceforth I may refer on occasion to any digital asset, whether called a coin or token or however designated, as an “interest.”)
But early crypto also had numerous other variations. A simple “drop” or offering of a coin at a set sales price, with no promise of anything except that the coin could be traded, really did not fit Howey. Nor did interests that offered a right in some sort of a particular asset (such as a sculpture or painting). It is true that under the Biden administration, the SEC had a strong temptation to find a securities offering in interests wherever possible, correctly sensing that buying a coin or the like in hopes that it would itself appreciate created a fraud risk for the buyer as there was no direct substance to the coin (it was not a precious metal and it represented no future value except for the coin appreciation itself). Since the issuer of the coins retained a huge position in the coins and often received a fee for any transfer of the coin, the issuer could reap substantial profit by selling its own coins (which had almost no cost) and in collecting fees. Also these early offerings were endorsed by famous sports or entertainment personalities who received coins in return. The SEC successfully sued some of these endorsers as profiting from the sale of a security.
Back to today. The new SEC regulations promise to identify which of such coins and other digital interests are in fact not securities and thus exempt from need to register or make full SEC disclosure. And it will be clear that the listing of a coin on blockchain is irrelevant; onchain listing may make a market easier to maintain, but if a coin or token is not a security upon issuance blockchain listing is irrelevant. Digital commodities and digital collectibles (conveying rights to art, music, videos, trading cards, characters, internet memes) have no inherent value and are not economic property and hence not securities. (Note: these interests have no inherent value but someone still may pay for them and thereafter resell them at a profit, passing along the same “nothing” to the buyer.)
Further, if someone holds a non-security interest and reserves the right, upon future resales, to divide that owner’s interests into parts and keep a “royalty” interest in future trading profits, since there is no Howey “managerial effort” there still is no security. (Note further, there is already a Federal law exempting stablecoins (the “Genius Act.”)
Two further guidance statements do seem to open the door to risk of misleading initial or subsequent purchasers of digital interests. First, even though Howey says something is a security if its promised value can be attributed to the offeror undertaking a business, if the promise is general or vague so that there is no likelihood of such profit, then it is not a considered a security (this seems an invitation to gull the gullible); second, even if the issuance is indeed the issuance of a security, once the business is established then the interest ceases being a security (for shares of stock, the trading in the aftermarket of something that is a security remains highly regulated).
And if this lack of protection to the public is not already problematical, it seems that if a coin or token is offered without any promises whatsoever about forming or expanding a business, and afterwards the offeror says “by the way, I am using the token price to build a very profitable business and all of you can benefit in some way” then that does not necessarily alter the nature of the token and make it a security (even though such hype no doubt can increase its market value). And, if the hype turn the non-security token at some point in time into a security, and the promoter in fact fulfills the promise to build a business, once built the securities designation terminates.
Thus an interest can be exempt on issuance, then become a security, then regain exempt status.
SEC chair Atkins has promised an upcoming SEC rule to provide clear safe harbors reflecting the foregoing, which would “provide crypto innovators with bespoke pathways to raise capital in the US while providing investor protections.” Further, the rule would provide a “startup exemption” for digital interests that are in fact securities, lasting perhaps four years, until the proposed business is operational. In this manner, raising capital through share issuances would still require full SEC registration and disclosure, but if you propose to finance with crypto then–never mind. You would have to be dumb not to try to raise start-up funds in crypto. The likely effect of such an SEC rule is to firmly cement crypto as a currency of choice within American business (not itself a problem in the eyes of many but not of all).
Some of these provisions are reflected already in proposed legislation (The Clarity Act) which is stalled in the Senate, so Atkins noted that his regulatory approach would give the SEC a “head start” on what the bill contains; thus in part this SEC guidance end-runs Congress in its law-making role, an administrative finesse not unknown to the current Administration.
The purpose of the SEC and its supporting legislation is to protect the investing public from fraud by requiring scrutiny and disclosure. This SEC guidance opens the door to fraud on the American public. While current SEC regulation has become enormously complex, expensive to comply with and no doubt in various areas overblown, this guidance seems incredibly dangerous. Further, if implemented I suspect that a subsequent Administration might well reverse much of it, creating a jumble in sorting out what had happened in the marketplace, well after many people had made digital interest purchases which had proven financially unfortunate.
My securities law professor, Louis Loss, an American legal icon involved with drafting the Securities Exchange Act of 1934, is rolling over in is grave.
