U.S. Regulators Are Using an 80 Year-Old Lawsuit to Keep Crypto’s Goliaths Firmly Within Their Sights
Article by Frank America | Edited by Trewkat and Hiro Kennelly | Cover Art by ab_colours
SEC Origins and Purpose
Earlier this month, the U.S. Securities and Exchange Commission (SEC) took aim at Binance and Coinbase for allegedly operating cryptocurrency exchanges in violation of federal securities laws. Federal securities laws date back to the Securities Exchange Act of 1934, which saw the creation of the SEC and henceforth required registration from any company wishing to operate a brokerage, exchange, or clearing house for financial transactions. According to the SEC website, the Act has two main goals:
- require that investors receive financial and other significant information concerning securities being offered for public sale; and
- prohibit deceit, misrepresentations, and other fraud in the sale of securities.
Basically, if your business is telling people they could potentially make money by giving you money, you have to register with the SEC first.
The Howey Test
This line of thinking came to a head in the mid-1940s when the owner of a Florida orange grove was sued by the SEC. In deciding SEC v. W.J. Howey Co, the U.S. Supreme Court created a 4-prong test as to whether or not something is being sold as a security, or in other words, constitutes an investment contract. W.J. Howey subsequently lost the case against the SEC and was cited for not registering his leaseback contracts to investors as securities.
The SEC established these four criteria, all of which need to be satisfied for something to be determined an investment contract:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others.
While SEC Chair Gary Gensler has been asked to provide further clarification around blockchain, crypto, and decentralized finance as a form of an investment contract, the SEC remains quiet and has instead opted to provide clarification via enforcement actions. This is what led to the charges against Binance and Coinbase.
Is Crypto an Orange Grove?
When it comes to cryptocurrencies, there is a lot of nebulous territory. For example, staking your crypto on a centralized exchange is presumably a different animal than using a decentralized finance smart contract. A token that had an initial token offering may be something different than one that merely provides governance rights. Tokens that offer staking and rewards, or tokens which are largely centralized, seem to be in a different category than those that don’t. None of these nuances have been adjudicated, and all that U.S.-based crypto enterprises can do is to see what enforcement actions are occurring and what can be implied from them.
Under the SEC’s take in the Binance and Coinbase lawsuits, the following tokens (in no particular order) may, like Howey’s orange grove contracts, be securities:
SOL | ADA | MATIC | COTI | ALGO FIL | ATOM | SAND | AXS |
MANA | BNB | VGX | CHZ | NEAR | FLOW | DASH | NEXO | ICP
Noticeably missing from this list is ether (ETH), which may prompt a sigh of relief from many. Although Gensler wouldn’t comment on whether or not the SEC believes ETH is a security, the fact that it hasn’t been listed in this initial tranche bodes well for the Ethereum blockchain and its native token. Bitcoin has managed to escape the ire of centralized authority and is largely considered to be sufficiently decentralized and therefore not a security.
Nearly all tokenized crypto projects get hung up on the fourth prong of the Howey Test, which looks to see whether any investment profits are to be derived from the efforts of others. Coin Bureau recently put up a YouTube video analyzing this aspect of the Howey Test, text from which is below:
Derived from the efforts of others meaning that the expectation of profit is coming from an identifiable third party, be it an institution, an individual, or some combination of both. Now obviously almost every cryptocurrency meets the first three criteria. It’s the fourth criterion where things can get complicated. That’s because sometimes it’s not easy to identify a third party that’s creating an expectation of profit for a particular coin or token. These are quote “sufficiently decentralized