Is crypto a currency or a security? Litigation Involving The SEC May Provide Guidance – Tech

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United States: is crypto a currency or a security? Litigation involving the SEC can provide guidance

November 09, 2021

Kane Russell Coleman Logan

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What started with Bitcoin in 2009 has evolved into a market of over 6,500 digital assets in increasing competition with traditional products offered by financial institutions. The rapid expansion of digital assets, including cryptocurrencies, has led to increased regulatory oversight in which the key question is whether these assets should be classified into currencies or securities. This classification is important because it determines the laws and regulations applicable to a particular asset. Determining whether a cryptocurrency is actually a currency or a security is a challenge. But a lawsuit filed by the Securities and Exchange Commission (“SEC”) late last year, which is currently pending in the United States District Court for the Southern District of New York, will likely provide some evidence. further guidance on this issue.

On December 22, 2020, the SEC filed a lawsuit against Ripple Labs, Inc. (“Ripple”) and two of its executives, alleging that the defendants did not register the XRP cryptocurrency with the SEC or did not not meet an exemption from registration, in violation of federal securities laws. As of the date of this writing, XRP is currently the eighth largest cryptocurrency with a market cap of around $ 53 billion.

In recent years, the SEC has ruled that the two largest cryptocurrencies by market cap, Bitcoin ($ 1.2 trillion) and Ethereum ($ 533 billion) are not securities, in part on the grounds that they are decentralized with no person or company controlling the cryptocurrencies. . XRP differs from Bitcoin and Ethereum in that the latter are created in a gradual process called mining in which tokens are created over time. In contrast, 100 billion units of XRP were all created in 2012 for Ripple. Ripple currently owns the majority of XRP and sells it in scheduled lots. This arrangement has led some observers to view XRP more as a company stock than a currency.

In order to determine whether XRP is a security, the Southern District of New York will apply what is known as the “Howey’s test,” a test developed by the United States Supreme Court in 1946 in SEC v. WJ Howey Co., 328 US 293 (1946) – to assess whether certain transactions qualify as “investment contracts”. According to the Howey test, a transaction is an investment contract if: (1) it is an investment of money; (2) there is an expectation of benefits from the investment; (3) the investment of the money is in a joint venture; and (4) any profit arises from the efforts of a promoter or a third party. The first prong of the Howey test is generally satisfied in an offer and sale of a digital asset because the digital asset is bought or otherwise acquired in exchange for a value, whether in the form of currency or an asset. other consideration. Additionally, when valuing digital assets, courts have generally found that a “joint venture” exists. Therefore, the main issues with analyzing a digital asset as part of the Howey test are whether there is an expectation of benefits from the investment and whether those benefits come from the effort of an investment. promoter or a third party.

To determine if there is a reasonable expectation of profit, the SEC has issued guidance indicating that the more of the following characteristics are present, the more likely it is that there is a reasonable expectation of profit:

The digital asset gives its holder the right to share the income or profits of the business or to make a gain on the capital appreciation of the digital asset; The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future; Buyers would reasonably expect that the efforts of a developer or third party would result in capital appreciation of the digital asset and therefore be able to generate a return on their purchase; The digital asset is offered widely to potential buyers as compared to being intended for the intended users of the goods or services or for those who need the functionality of the asset; There is little apparent correlation between the purchase / offer price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset; A promoter or third party has raised more funds than what may be necessary to establish a functioning network or digital asset; A promoter or a third party may benefit from holding the same category of digital assets as those distributed to the public; A developer or third party continues to spend funds from the product or operations to improve the functionality or value of the network or digital asset; and The digital asset is marketed, directly or indirectly, using the expertise of a promoter or a third party, based on the future (and not present) functionality of the digital asset, based on promises creation of a business or operation relative to the assets currently available, and a promising appreciation of value.

In assessing whether a profit comes from the efforts of a sponsor or a third party, the SEC has issued guidance indicating that the investigation of whether a buyer relies on the efforts of others focuses on two key questions: (1 ) does the purchaser reasonably expect to rely on the efforts of a developer or a third party; and (2) are these efforts arguably the most important (including essential management efforts that affect the failure or success of the business) as opposed to efforts that are more corporate in nature.

If a digital asset exhibits the above characteristics, it is most likely that the SEC will consider it to be a security subject to SEC registration requirements. Indeed, it seems that the SEC considers most cryptocurrencies to be securities. However, the SEC has provided guidance on the characteristics of digital assets that are less likely to be considered securities. In particular, digital assets with the following characteristics are less likely to meet the Howey test:

The distributed ledger network and digital asset are fully developed and operational. Owners of the digital asset are immediately able to use it for its intended functionality on the network, especially where there are built-in incentives to encourage such use. The creation and structure of digital assets is designed and implemented to meet the needs of its users, rather than fueling speculation about its value or the development of its network. The prospects for appreciation in the value of the digital asset are limited. For example, the design of the digital asset predicts that its value will remain constant or even degrade over time, and therefore a reasonable buyer should not hold the digital asset for long periods of time as an investment. When it comes to a digital asset called virtual currency, it can immediately be used to make payments in a wide variety of contexts or as a substitute for fiat money. Any economic benefit that may arise from the appreciation in the value of the digital asset is ancillary to obtaining the right to use it for its intended functionality. The digital asset is marketed in a way that emphasizes the functionality of the digital asset, not the potential for increasing the market value of the digital asset. Potential buyers have the option of using the network and using (or having used) the digital asset for its intended functionality. The restrictions on the portability of the digital asset are consistent with the use of the asset and do not facilitate a speculative market.

Essentially, the SEC guidelines state that the Howey’s test can be avoided when there is a specific use case for a digital asset and the asset has limited prospects of appreciation characteristics that are not present in the asset. the vast majority of cryptocurrencies. This is because most crypto developers first create their digital asset and develop a use case after introducing the asset. This approach likely results in the creation of an asset that violates SEC regulations in the event that the asset is not registered. While the SEC’s case against Ripple is ongoing, it will likely provide additional insight into how the factors set out in Howey should be applied to digital assets. But given the many regulations that may apply, developers should coordinate with a lawyer to avoid violations of SEC requirements, money transfer regulations, and other laws that may apply to their creations. digital.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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