Cleary Gottlieb Discusses SEC’s Latest Take on Digital Assets as Securities

On Thursday, June 14, the SEC Director of Corporation Finance, William Hinman, stated his view that current secondary market trades of Ether are not now securities transactions as part of a speech on the treatment of digital assets under the securities laws.  While he expressly set aside the question of whether the capital-raising that initially accompanied the sale of Ether in 2014 was a securities offering, he confirmed previous suggestions that Ether is a prime example of a digital asset that may once have been offered as a security, but is now “something else” that is not  regulated by the securities laws.  While Hinman’s views are not binding on the Commission, his remarks strongly suggest the Commission’s willingness to consider whether certain digital assets that may be initially offered as securities over time can later lose their status as securities—a view that is shared by at least one CFTC commissioner.

The speech underscores progress the SEC and CFTC have made in creating a potential framework for applying the securities and commodity laws to widely traded virtual currencies, such as Ether and Ripple, which were distributed through initial coin offerings (ICOs), but have since developed characteristics of commodities.  Though SEC Chairman Clayton has consistently stated in public remarks that every ICO he has seen constituted a primary offering of securities, neither the Commission nor the Staff had—until now—specifically addressed whether those same tokens always remained securities.

In addressing ICOs, Hinman reiterated the SEC’s approach under Chairman Clayton.  He made clear that the way in which an asset is sold is central to determining whether purchasers have a reasonable expectation of profit, and that this expectation can be created through marketing efforts.  Indeed, issuers’ own statements that an offered token would appreciate in value have been central to recent ICO-related enforcement actions, such as Munchee and Titanium.

Hinman’s remarks affirmed the emerging view that a virtual asset sold through an ICO can evolve into a utility or other virtual asset that is not a security.  This is a significant development, and if confirmed by the Commission, will resolve one of the lingering questions about Ether and other virtual assets that started with ICOs.  In effect, Hinman signaled that after an asset is sold in an ICO and the issuer has used the proceeds from the sale to develop a network, the asset can cease to be a security.  If the tokens are sold, and subsequent purchasers buy the tokens, with an eye towards using them in the ecosystem developed by the issuer, rather than passively profiting off the issuer’s efforts to build the underlying network or other investment purpose, over time, the tokens can develop from a security into something more closely resembling a commodity.

According to Hinman, determining when this transition occurs “requires a careful and fact-sensitive legal analysis.”  But even with a thorough legal analysis, determining the point at which this transition occurs remains difficult in practice, suggesting that the Staff may expect gatekeepers to play a critical role in applying the current regulatory structure to the evolving technological landscape.

Despite these difficulties, Hinman walked through a version of the legal analysis required to make this determination, using Ether as an example.  In the process, Hinman shed significant light on an ongoing joint probe with the CFTC regarding whether Ether is a security or commodity.  Specifically, Hinman applied the “investment contract” test established by the Supreme Court in the Howey case, which treats as a security an investment of money in a common enterprise with a reasonable expectation of profit from the efforts of others, to Ether.  He then cited the decentralized qualities of the network on which Ether functions as the key factor for why it has ceased to have the qualities of “investment contracts.”

The key fact, according to Hinman, is that current holders no longer rely on the efforts of  third-party managers or entrepreneurs for the success of the enterprise.  Current purchasers of Ether “no longer reasonably expect” others to “carry out essential managerial or entrepreneurial efforts.”  Consequently, the level and type of disclosure required by the securities laws is therefore not necessary to aid in this hypothetical investor’s decision to buy or sell Ether.  Even if additional disclosure would help, given the decentralized nature of Ethereum’s network and highly dispersed ownership of Ether, the challenge of identifying a party that could make the requisite disclosures would present technical challenges and, in any event, imposing liability on an “issuer” that no longer exists would be impossible.

Hinman also provided some guidance and clues about the SEC’s next steps in this area from both regulatory and enforcement perspectives.  On the regulatory side, he stated that the SEC is prepared to issue “more formal interpretive or no-action guidance.”  Interpretive guidance expresses a Commission view, whereas no-action relief represents the Staff’s view, so providing the greatest degree of certainty would favor guidance over no-action relief.  On the enforcement side, though current offers and sales of Ether now are apparently not subject to the securities laws, Hinman appeared to leave open the possibility that the pre-sale of Ether in 2014 (and similar digital currencies) could remain subject to enforcement.  Given that Hinman’s speech could encourage growth in the market for these cryptocurrencies, it remains to be seen whether the SEC will take an aggressive enforcement posture against their initial distribution and “pre-evolution” secondary market trading, which could create unintended consequences for current owners for which Ether is not a security.

The speech provided important guidance and fresh insights on issues that have generated significant interest from the public and on Capitol Hill, though it left unanswered key questions regarding the Staff’s views.  Nevertheless, Hinman’s remarks should not only be welcome news for purchasers of Ether and similar digital assets, but also for virtual currency businesses such as Coinbase, Paxos (formerly itBit), and Gemini that facilitate exchange of these assets for fiat currency.  Since the SEC’s Director of Corporation Finance has now stated that he does not view a current purchase or sale of Ether as a securities transaction, these entities may not need to register as a national securities exchange or as a broker-dealer and comply with additional requirements of Regulation ATS in order to continue to facilitate transactions involving Ether and fiat currency.

This post comes to us from Cleary, Gottlieb, Steen & Hamilton LLP. It is based on the firm’s blog post, “SEC Director of Corporation Finance States That Secondary Market Sales of Ether Are Not Securities Transactions Now, but ‘Something Else’,”  available here.