Cryptocurrencies like Ether, DAO, Bitcoin and Facebook’s Libra are electronically generated and stored currencies by which users can trade real or virtual objects with one another, bypassing traditional central clearinghouses. Given that these cryptocurrencies are starting to replace some national currencies and financial products, should they be regulated? And, if so, how? Some countries, such as China and Russia, prohibit Initial Coin Offerings (ICOs) altogether, while others strive to reach an understanding of the currencies in order to come up with coherent regulation. As for the U.S., in April 2019 the Securities and Exchange Commission (SEC) finally issued its framework for “investors contract” analysis of digital assets.[1] However, the SEC guidelines are not legally binding and leave considerable ambiguity.

Although the technology underlying most cryptocurrencies is very similar, the logic behind them differs. Some cryptocurrencies function like regular national currencies and have traditional currency traits. As such, they provide a medium of exchange, unit of account, and store of value.  Other cryptocurrencies, however, may represent other rights as well and so can be viewed as closer to financial products (such as securities or derivatives).

Section 5 of the Securities Act and the SEC rules promulgated thereunder are full of prohibitions, conditions, and exceptions with regard to the registration of securities. However, the basic principle is clear: Unless exempted by law, all securities offerings must be accompanied by registration with the SEC. The Supreme Court observed that the definition of “security” includes “commonly known” instruments that are traded for investment or speculation as well as certificates of interest or participation in profit sharing mechanisms.[2] In a different ruling, the Supreme Court said there is no need for courts to analyze each instrument on a case-by–case basis when all instruments of that type are clearly “securities.”[3]

Instruments not “commonly known” as a security may still be one under the definition of an “investment contract.” The U.S. Supreme Court defined that term as involving three main elements: (1) an investment of money, (2) a common enterprise, and (3) an expectation of profits derived solely from the efforts of others.[4] Over the years the courts have maintained most of this definition but replaced the word “solely” with the question of whether the efforts made by the managers of the firm (other than the investor) are undeniably significant ones.[5] This definition prompts the need for differing regulatory responses to cryptocurrencies that change value based on the efforts of others and those that don’t.

The latest cryptocurrency is Libra. It will allow users to send money to others or buy things with almost zero fees. It is meant to be used as a global coin which will, in part, replace some fiat currencies. Libra will be held on a wallet application such as Facebook’s planned Calibra wallet that will be built into Messenger, Whatsapp and its own app. The interesting question is whether Libra qualifies as an “investment contract.” Examining Libra through the three requirements in the Howey case shows that (a) there is an investment of money; (b) the Libra Association is a common enterprise and; (c) as Facebook plans to market and distribute Libra on Whatsapp, Facebook’s own messenger, and its standalone app called Calibra (a new Facebook subsidiary), holders can expect profits derived solely from the efforts of others. In addition, the reserve ratio of the cryptocurrency, which of course affects the value of the token, will be determined by the association members. It thus seems that the new Libra is an investment contract, even though the idea behind it is to make it more like a fiat currency. Therefore, the Libra Association will be well advised to issue the token in accordance to U.S. securities regulation.

ENDNOTES

[1] SEC, framework for “investors contract” analysis of digital assets (April 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets (hereinafter SEC Guidelines).

[2] SEC v. W.J. Howey Co., 328 U.S. 293, 297 (1946))

[3] Reves v. Ernst & Young, 494 U.S. 56, 62 (1990).

[4] Howey, 328 U.S. at 301.

[5] SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973); accord SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 (5^th Cir. 1974).

This post comes to us from Hadar Jabotinsky, Cegla Visiting Research Fellow at Tel Aviv University Law School, Israel. It is based on her recent paper, “Facebook has just Re-Sparked the Debate with Regards to the Regulation of Cryptocurrencies – Between a Currency and a Financial Product,” available here.