Aesop’s fable of the Tortoise and the Hare cautions that “the race is not always to the swift.”[1] It appears that the Securities and Exchange Commission (SEC) has thus far taken this message to heart in its regulation of the crypto industry. SEC Chairman Gary Gensler recently likened the state of the crypto industry to the “Wild West,” arguing that a lack of regulatory protections has led to risky conditions and a paucity of trustworthy information for potential investors.[2] However, as crypto usage continues to soar[3], the SEC seems poised to flex its regulatory muscle to catch up in the race.[4]
Given the relative newness of the industry, a few definitions may be helpful. A cryptocurrency is an encrypted digital coinage system that allows users to procure goods and services without a central authority.[5] Transfers of cryptocurrencies are recorded on blockchains, which are immutable ledgers that “keep records of ownership and transaction timestamps, eliminating the possibility of digital copying and, thus, double-spending.”[6] Many cryptocurrencies, but notably not Bitcoin, launch and raise capital through initial coin offerings (ICOs).[7] In an ICO, a new cryptocurrency solicits public investors to contribute funds in exchange for tokens.[8] Unlike an IPO, wherein an investor purchases an ownership stake in a company, ICO investors purchase valueless tokens in hopes that widespread adoption will cause the token to increase in value over time.[9]
Proponents of crypto contend that widespread adoption will facilitate investment for sophisticated and unsophisticated users alike. First, many bullish crypto supporters claim that cryptocurrencies are an effective hedge against inflation because their values are linked to speculation instead of conventional money supply dynamics.[10] In addition, crypto enables decentralized finance (DeFi), an “open, permissionless, and highly interoperable protocol stack built on public smart contract platforms, such as the Ethereum blockchain.”[11] Proponents argue that by eliminating banks and custodians, DeFi reduces transaction costs, increases transparency, expands access to those who may otherwise be unable to borrow, and allows those holding cryptocurrencies to earn interest by investing in decentralized lending funds governed and secured by smart contracts.[12]
The SEC now seems intent on using the tools already at its disposal to regulate some crypto products as securities. This position has a basis in federal statutes and Supreme Court precedent. Under Section 5 of the Securities Act of 1933, it is unlawful to sell unregistered securities.[13] The Securities Act considers many types of traditional investment vehicles to be securities, as well as “notes,” “certificate[s]of interest or participation in any profit-sharing agreement,” and “investment contract[s].”[14] In Securities & Exchange Commission v. W.J. Howey Co., the Supreme Court broadly defined an investment contract as any agreement that “involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”[15] This standard is referred to as the Howey test.
The SEC has consistently maintained that ICOs are investment contracts, and thus securities, because they pass the Howey test.[16] As former SEC Chairman Jay Clayton stated before the Senate in 2018, “[t]o the extent that digital assets like ICOs are securities — and I believe every ICO I have seen is a security — we have jurisdiction, and our federal securities laws apply.”[17]The SEC has already used this analytical framework to bring 39 actions – either via administrative proceeding or litigation – challenging unregistered ICOs between Q3 2013 and Q4 2020.[18] All of these allege violations of Section 5 of the Securities Act of 1933, and some allege fraud as well.[19] As a result, many companies offering ICOs have chosen to either register and comply with SEC guidelines, or to bar US investors from participation in ICOs to skirt SEC oversight.[20]
ICOs were just the tip of the iceberg. US regulatory agencies are now shifting their focus to other crypto lending products and stablecoins – cryptocurrencies that are tied to the value of assets such as the US dollar and make it easier for holders to transact and lend due to perceived short-term stability.[21] In September 2021, leading US crypto exchange Coinbase revealed that the SEC had served the company with a Wells Notice informing the company that it could expect to be sued if it launched its Lend product.[22] Lend would enable Coinbase users to lend stablecoin through their platform for a 4% APY.[23] Though the SEC did not publish its rationale, Coinbase reported that the SEC invoked the cases Howey and Reves v. Ernst & Young, which established a test to determine whether a note is a security.[24]
Courts will consider Coinbase’s Lend product to be a note, and thus a security, under the Securities Act of 1933[25] if it fails the “family resemblance” test outlined in Reves.[26] The family resemblance test first presumes that all notes are securities, but that presumption may be rebutted by showing that a note “bears a strong resemblance” to a judicially enumerated exemption.[27] If there is no strong resemblance to an exemption, the court may consider additional factors to consider whether a new exception should be created. A note is likely to be considered a security, and not deserving of a new exemption if (1) the seller’s motivation is to raise money for business or investment purposes and the buyer’s motivation was for profit, (2) the note is available to a broad segment of the public for investment purposes, (3) the general public would expect it to be a security, and (4) there are no other substantial regulations governing the note that make securities regulation unnecessary.[28] Given the SEC’s strong record in recent crypto actions, and the weight of the case law, Coinbase and other platforms may be forced to register with the SEC and abide by its rules if they wish to launch lending products.
I expect that the Biden administration will gradually take more aggressive steps to regulate the crypto industry in the name of consumer protection. Regulators and lobbyists are already engaging in fierce debates over imposing reserve requirements for stablecoin companies to alleviate digital bank run concerns.[29] Moving forward, the administration may exert pressure on Congress to pass legislation granting additional authority to regulatory agencies to regulate the industry. SEC Chairman Gary Gensler recently requested that, in doing so, the legislature focus on crypto trading, lending, and DeFi platforms.[30] Finally, it is possible that a national dialogue may begin surrounding the adoption of an official digital currency to supplement the US dollar. Whatever steps the government chooses to take to protect crypto consumers, it is crucial that they keep in mind the potential public benefits of decentralized currencies and related DeFi vehicles. A balance must be struck between installing guardrails on the industry and impeding its natural advancement, driven by legitimate consumer demand.
[1] The Hare and the Tortoise, Libr. of Cong., http://read.gov/aesop/025.html (last visited Sept. 23, 2021).
[2] Gary Gensler, Chairman, SEC, Remarks Before the Aspen Security Forum (Aug. 3, 2021), https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.
[3] See Eric Young, More Than One in Ten Americans Surveyed Invest in Cryptocurrencies, Nat’l Op. Rsch. Ctr. at the Univ. of Chi. (July 22, 2021), https://www.norc.org/NewsEventsPublications/PressReleases/Pages/more-than-one-in-ten-americans-surveyed-invest-in-cryptocurrencies.aspx.
[4] See Eric Lipton et al., Regulators Racing Toward First Major Rules on Cryptocurrency, N.Y. Times (Sept. 23, 2021), https://www.nytimes.com/2021/09/23/us/politics/cryptocurrency-regulators-rules.html.
[5] Ryan Farrell, An Analysis of the Cryptocurrency Industry (June 9, 2015) (thesis for Wharton Research Scholars Program, University of Pennsylvania), https://repository.upenn.edu/cgi/viewcontent.cgi?article=1133&context=wharton_research_scholars.
[6] Id.
[7] See Howey Test, Investopedia, https://www.investopedia.com/terms/h/howey-test.asp (last visited Sept. 23, 2021).
[8] See What Is An ICO?, Investopedia, https://www.investopedia.com/news/what-ico/ (last visited Sept. 23, 2021).
[9] Id.
[10] Vildana Hajric, Don’t Count on Bitcoin Hedge to Be a Sure Thing, Bloomberg Businessweek (Mar. 17, 2021, 5:00 AM), https://www.bloomberg.com/news/articles/2021-03-17/is-bitcoin-an-inflation-hedge-the-opposite-effect-could-happen-in-recession.
[11]Fabian Schar, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, 103(2) Fed. Rsrv. Bank of St. Louis Rev. 153, 153 (2021), https://files.stlouisfed.org/files/htdocs/publications/review/2021/04/15/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets.pdf.
[12] Id. at 153-54.
[13] 15 U.S.C. § 77e.
[14] 15 U.S.C. § 77b(a)(1).
[15] 328 U.S. 293, 301 (1946).
[16] See Framework for “Investment Contract” Analysis of Digital Assets, SEC (April 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets; see also Gensler, supra note 2.
[17] Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission: Hearing Before the S. Comm. on Banking, Hous., and Urb. Affs., 115th Cong. 5 (2018) (statement of Jay Clayton, Chairman, SEC).
[18] Simona Mola, SEC Cryptocurrency Enforcement: Q3 2013 – Q4 2020, Cornerstone Rsch. Grp., https://www.cornerstone.com/Publications/Reports/SEC-Cryptocurrency-Enforcement-Q3-2013-Q4-2020.pdf.
[19] Id.
[20] See Anna Irrera & Michelle Price, Cryptocurrency Issuers Clean Up, Shun U.S. Investors As SEC Gets Tough, Reuters (Mar. 21, 2018), https://www.reuters.com/article/us-crypto-currencies-usa/cryptocurrency-issuers-clean-up-shun-u-s-investors-as-sec-gets-tough-idUSKBN1GX2OX.
[21] See Lipton, supra note 4.
[22] Paul Grewal, The SEC has told us it wants to sue us over Lend. We don’t know why., Coinbase Blog (Sept. 7, 2021), https://blog.coinbase.com/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea-why-a3a1b6507009.
[23] Id.
[24] Id.; see generally SEC v. W.J. Howey Co. 328 U.S. 293 (1946); Reves v. Ernst & Young 494 U.S. 56 (1990).
[25] 15 U.S.C. § 77b(a)(1).
[26] Reves, 494 U.S. at 64-65.
[27] See id.; see also Exch. Nat. Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir. 1976) (Types of notes that are not “securities” include “the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a ‘character’ loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized).”).
[28] Reves, 494 U.S. at 66-67.
[29] See Lipton, supra note 4.
[30] Gensler, supra note 2.
