Toward a Better Coordinated Regulatory Response to Cryptoassets

On Monday, January 8, 2021, Tesla announced in a filing with the Securities and Exchange Commission that it had purchased $1.5 billion worth of Bitcoin.[1] This purchase coincided with a dramatic increase in the price of the cryptoasset, which was trading at around $37,000 per Bitcoin on February 5, 2021, but climbed to over $48,000 per Bitcoin on February 11.[2] Bitcoin is unusual in the United States, because it is one of a handful of cryptoassets that are not regarded as securities and regulated as such by the Securities and Exchange Commission (SEC). In fact, of cryptoassets with a floating value that are readily convertible into government-backed or “fiat” currency, it is one of only two that the SEC has agreed to be outside the scope of its regulatory authority.[3]

The problem is not that the SEC seeks to exercise authority over cryptoassets. Indeed, there is enough fraud and misconduct in the crypto ecosystem that some regulatory oversight is essential.[4] The problem starts with the fact that the SEC is forced to regulate crypto under statutes and regulations that were not adopted with anything like crypto in mind and is greatly compounded by the fact that multiple other agencies at both the federal and state level also seek to regulate crypto transactions.

The SEC’s authority is derived in pertinent part from the Securities Act of 1933 (the ‘33 Act),[5] which defines security to include “investment contracts.” This phrase was initially defined in 1946 by the Supreme Court in SEC v. W.J. Howey Co.[6] as existing when an investor contributes money to a common enterprise expecting profits solely from the efforts of others.  Over the years, this “Howey test” has been broadened so that it now covers any investment of value in a common enterprise where the purchaser is led to expect profits from the essential entrepreneurial or managerial efforts of others.[7]

Since 2017, the SEC has taken the position that cryptoassets should be evaluated under this approach,[8] concluding early on that virtually every such asset is likely to be a security even while maintaining that crypto needs to be evaluated case-by-case.[9] The only two convertible cryptoassets with a floating value that have currently been recognize as outside the scope of the ‘33 Act are Bitcoin and Ether.[10]

In order to assist entrepreneurs in understanding how to apply the Howey test to cryptoassets, the SEC released a detailed framework in 2019.[11] Unfortunately, the framework consists of more than three dozen subparts and is especially confusing because of guidance suggesting that an asset might start as a security and at some unknown future date cease being one, or conversely might start out as something other than a security and then become one later on.[12]

Not surprisingly, this has resulted in significant confusion and protracted litigation. The SEC devoted untold hours to litigating the issue in two high profile cases, SEC v. Telegram[13] and SEC v. Kik.[14] In both cases, the SEC’s position ultimately prevailed at the trial court level, and the cases settled with no appeals. Even more recently, the SEC has initiated a complaint seeking to reach the same result in SEC v. Ripple Labs.[15]

By being forced to continually relitigate the issue of whether a particular cryptoasset is a security under a decades old test, the SEC is left with fewer resources to consider how cryptoassets should be regulated and when exemptions from the traditional registration requirements might be appropriate. In addition, the SEC is more likely to seek out higher profile issuers, such as Kik, Telegram, and Ripple, even in the absence of fraud or evidence of criminal activity, simply because legitimate entrepreneurs are less likely to hide their activities and assets. High profile cases also generate more attention and thus may be likely to deter others from ignoring the rules that the SEC seeks to apply. This results in a sub-optimal enforcement strategy from the perspective of actually hindering illegal activity, protecting investors, or encouraging capital formation.

Further complicating the regulatory environment is  that other agencies at both the federal and state levels also seek to exercise regulatory authority over cryptoassets. The Commodity Futures Trading Commission released a Backgrounder in 2018 opining that cryptoassets were commodities,[16] and thus subject to its jurisdiction. The Financial Crimes Enforcement Network (FinCEN) recently reaffirmed its longstanding position that cryptoassets that can be converted into fiat currencies (directly or indirectly) should be regulated as virtual currencies,[17] meaning that Bank Secrecy Act[18] requirements apply to many crypto-based businesses. The IRS gave notice in 2014 that it would treat and tax crypto as property,[19] creating potential problems for issuers and issuers alike. In addition, there is a mishmash of conflicting and overlapping state laws and regulations for crypto as well, making it incredibly difficult to be a legally compliant crypto entrepreneur in the United States. Various resources trying to keep track of state crypto laws have to be updated regularly in order to stay even reasonably current.[20] It is so difficult, in fact, to keep abreast of the changing regulations and to comply with requirements, that there are reports that the U.S. is the country most likely to be excluded from crypto offerings, followed by North Korea, Iran, and Syria.[21]

While fraud and other crimes are certainly possible with cryptoassets, the reality is that this is a burgeoning technology with tremendous potential. The failure of the U.S. to have a single point of regulation means that we will not be well positioned to take advantage of the technology when developers are pushed overseas. Our citizens are similarly denied legitimate and potentially valuable investment opportunities. Moreover, by making compliance essentially prohibitively difficult, we push crypto entrepreneurs who do wish to stay in the U.S. to the very fringes of legitimacy. None of this is desirable.

Unfortunately, to avoid these pitfalls, congressional action is likely to be necessary. While the SEC has the resources and expertise to regulate crypto, it does not have the luxury of considering how best to regulate what is in essence a brand new asset because it is stuck with decades old laws. It must then continually relitigate the application of the law to new forms of crypto. In addition, it cannot simply decide that other agencies should stand down or acquiesce in the view that crypto is generally a security. Similarly, it cannot unilaterally decide to preempt inconsistent state regulation.

A new congressional directive, classifying cryptoassets as securities, preempting inconsistent state law, and directing the SEC to specifically identify appropriate exemptions for crypto sales that do not need the intricate disclosures typically associated with registration, could be a push in the right direction. If other agencies were required to accept this classification, we would no longer be in an era when crypto can be forced to act as a security, a commodity, a virtual currency, and simple property all at the same time and subject to  myriad conflicting regulations because of those classifications.

ENDNOTES

[1] Tesla’s form 10-K for the year ended December 31, 2020 can be found at https://www.sec.gov/Archives/edgar/data/1318605/000156459021004599/tsla-10k_20201231.htm. The reference to the $1.5 billion Bitcoin purchase in early 2021 appears at p.23 of that document.

[2] The trading price of Bitcoin is tracked on CoinMarketCap.com.  It is possible to check the historical pricing of Bitcoin (or any of traded cryptoasset) by selecting it and creating a chart for the time period in question, in this case the week of February 5 to 11, 2021.

[3] The SEC has issued three no action letters in regard to the sale of cryptoassets, but each of those cases (which have no precedential value) was very limited. The cryptoassets affected by these no action letters include those issued by TurnKey Jet, Pocketful of Quarters, and IMVU. See SEC, FinHub (archived at https://perma.cc/W8GW-7WU7) (click on “Regulation, Registration and Related Matters” for a list of No-action letters). The first two of the named issuers prevented their tokens from being resold, and the third required all sales to be at a fixed rather than variable price, thus preventing any possibility of appreciation.

[4] Consider the Department of Justice October 2020 Report on Cryptocurrency, which mentions “crime” and “criminals” 168 times. Report of the Attorney General’s Cyber Digital Task Force, Cryptocurrency, DOJ (Oct. 2020) (archived at https://perma.cc/4CGU-ZPB9).

[5] Securities Act of 1933, codified at 15. U.S.C. §77.

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

[7] See SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476 (9th Cir. 1973), cert. denied, 414 U.S. 821 (1973).

[8] See SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, ‘34 Act Release No. 81207 (July 25, 2017) (archived at https://perma.cc/F862-YS5V).

[9] See, i.e., SEC Public Statement, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017) (archived at https://perma.cc/TY9T-MKWX).

[10] The SEC’s former Director of the Division of Corporation Finance, William Hinman, first opined that these assets would not be securities because of how decentralized they have become. SEC, Speech, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018) (archived at https://perma.cc/H3YU-DX3K).

[11] SEC, Public Statement, Framework for “Investment Contract” Analysis of Digital Assets (modified Ap. 3, 2019) (archived at https://perma.cc/J4KQ-HW52).

[12] SEC Commissioner Hester Peirce has explicitly acknowledged the confusing nature of the framework. See SEC, Comm’r Hester M. Peirce, How We Howey, Speech (May 9, 2019) (archived at https://perma.cc/729A-CG6C).

[13] Order, SEC v. Telegram Group, Inc., No. 19 Civ. 9439 (PKC) (S.D.N.Y., March 24, 2020) (https://perma.cc/4WWK-LKBX).

[14] Opinion and Order on Motions for Summary Judgment, SEC v. Kik Interactive, No. 19 Civ. 5244 (S.D.N.Y., Sept. 30, 2020) (https://perma.cc/43WJ-K7JA).

[15] SEC v. Ripple, Complaint, 20 Civ. 10832 (S.D.N.Y., filed Dec. 22, 2020) (archived at https://perma.cc/C3GK-ZXY5).

[16] CFTC, CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets (Jan. 4, 2018) (archived at https://perma.cc/D56F-UK3D).

[17] FinCEN, New FinCEN Guidance Affirms Its Longstanding Regulatory Framework for Virtual Currencies and a New FinCEN Advisory Warns of Threats Posed by Virtual Currency Misuse (May 9, 2019) (archived at https://perma.cc/XQQ3-2R6V).

[18] The Bank Secrecy Act of 1970, more formally known as the Currency and Foreign Transactions Reporting Act, requires financial institutions operating in the U.S. to assist in detecting and preventing money laundering and funding of criminal enterprises. The provisions of the act appear in various chapters of title 12 of the U.S. Code.

[19] IRS, Notice 2014-21 (archived at https://www.irs.gov/pub/irs-drop/n-14-21.pdf).

[20] See, i.e., Matthew E. Kohen & Justin S. Wales, State Regulations on Virtual Currency and Blockchain Technologies, Carlton Fields (Originally published Oct. 17, 2017, updated July 14, 2020) (available online at https://www.carltonfields.com/insights/publications/2020/state-regulations-on-virtual-currency-and-blockchain-technologies-(updated-july-2020)).

[21] Lukas Hofer, Why Token Issuers Exclude U.S. Investors, ICO.li (Ap. 26, 2019) (archived https://perma.cc/JUB8-MCTF).

This post comes to us from Carol Goforth, a University Professor and the Clayton N. Little Professor of Law at the University of Arkansas (Fayetteville). It is based on her recent article, “Cinderella’s Slipper: A Better Approach to Regulating Cryptoassets as Securities,”  forthcoming in 17 Hastings Business Law Journal (2021) and available here.

Leave a Reply

Your email address will not be published. Required fields are marked *