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E-MailM. Todd Henderson is Michael J. Marks Professor of Law at the University of Chicago and Max Raskin is Adjunct Professor at the New York University School of Law. This post is based on their recent article, forthcoming in Columbia Business Law Review.
Cryptocurrency is back in the news with bitcoin and other digital assets plummeting and volatility roaring back after a year of relative calm. The exuberance of a bull market is giving way to the discovery that some in the industry have been swimming naked, and are only now being uncovered as the tide goes out. On the regulatory side, the Securities and Exchange Commission has stepped up its enforcement actions against actors who profited during the bull market and are alleged to have violated federal securities laws. But there has been no systematic effort to categorize digital assets for regulatory purposes.
Markets are built on trust. Buyers and sellers have to trust each other or mutually beneficial trades will not happen. Where brokers or other intermediaries are used, the amount of trust needed increases significantly. A complex market, like an equity or digital asset market, needs more than individual trust—it needs a trust infrastructure where market participants understand and will adhere to a basic set of rules of acceptable behavior. Such clear rules allow good actors to differentiate themselves from bad ones, thus raising the overall quality of the market. In the absence of such rules, cheaters and fraudsters will flourish, causing good actors to flee and market confidence to erode. Investor confidence, liquidity, and market integrity are all interrelated.
The rise of digital assets, made possible by innovations such as distributed ledgers and blockchains, poses a challenge to government regulators. Digital assets herald undeniable potential and risk. But they do not as a category fit neatly into existing regulatory buckets, such as, currency, personal property, or securities. Rather digital currencies span all of them in interesting ways. Predictable and thoughtful regulation has not yet been developed in most jurisdictions. This regulatory lacuna helps to perpetuate fraud and limits the potential of the market.
We have recently published a short essay that takes an initial step in the direction of addressing this classification problem: A Regulatory Classification of Digital Assets: Towards an Operational Howey Test for Cryptocurrencies, ICOs, and Other Digital Assets. This article proposes a way of thinking about digital assets that gets to their core features necessary for applying federal securities laws.
Digital assets pose two fundamental problems to securities regulators. The first is an information asymmetry problem; the second is a police power problem.
Information asymmetries are the animating force behind most securities regulation. The three pillars of modern securities law—mandatory disclosure, strict anti-fraud rules, and insider trading limitations—are designed to put traders on an equal information footing, regardless of whether they are inside or outside of a particular firm whose stock is being traded. The contention is that market forces will not provide the optimal amount of information, and that the government must therefore compel it. The antifraud rules in turn are designed to make any disclosures credible. The argument goes that in the absence of a way for issuers to vouch for their disclosures, the market will have a “lemons problem” where buyers cannot distinguish the good from the bad, but sellers can. After all, if fraudsters can make promises as easily as upstanding issuers, then the good firms will leave the market because they will be confused with the bad firms. If fraud and exuberance are the primary drivers of these new digital asset markets, and because investors have become reliant on the SEC, the regulators will be an important actor in making an efficient market.
The second issue is that even if investors have perfect knowledge of the assets they are purchasing, the government may still wish to prohibit purchase of these instruments. This can be for a whole host of reasons, including national security, tax enforcement, or paternalism. This ambiguous “police power” is used to stop gambling and other activities that the government deems to be socially undesirable. The line is hazy. To most people, the difference between betting on whether the Bears will make the playoffs and betting on whether General Electric will hit quarterly earnings is slight. Why the latter is universally permitted and the former only in limited circumstances is likely because of a view by government regulators that betting on stocks is “good” for society, while betting on sports and so on is “bad” for society.
It is still too early to tell exactly which of the drivers of digital asset excitement are “good” or “bad.” This puts regulatory bodies in a tough position. Specifically, these new assets pose a problem for the Securities and Exchange Commission. There is almost certainly a structural problem with securities regulations as they exist today, but it may be the case that only bad actors have been taking advantage of the regulatory arbitrage made possible by things like initial coin offerings (ICOs). Representatives of institutional investors have told us that they will not put their clients into this market until it is made into a “fair and orderly market.”
More lax regulation of digital assets may give cover to bad actors, while the good actors are forced to contend with antiquated securities regulations. There has been a huge proliferation of products and both those products and the markets that trade them are changing rapidly. Even when and if things settle down, the assets themselves do not fit neatly into the regulatory dogmas of the quiet past. If the potential of digital assets is to be realized, a trust infrastructure is needed.
The SEC’s entrance into the fray has been largely through enforcement actions, consent orders, and informal guidance. They have not, however, announced any operational test for determining whether a digital asset is a security (“investment contract”) under Section 2(a)(1) of the Securities Act and Section 3(a)(10). For reasons discussed below, such a test would be welcome primarily because it would provide certainty to the market. Such a test would not tie the regulators’ hands with respect to ex post enforcement actions, maintaining flexibility.
With the above in mind, our essay seeks to propose such an operational test for digital assets. This test will proceed under the existing Howey framework, [1] which the Supreme Court and SEC use to evaluate the jurisdictional sections of the relevant securities statutes. One part of the test will be immediately useful and operational. We call this the “Bahamas test” and it makes a determination of whether a digital asset is sufficiently decentralized such that it is not a security.
The Bahamas Test seeks to answer the question “When is a digital asset sufficiently decentralized such that it is not a security for the purposes of the SEC’s jurisdiction?” As William Hinman, director of the division of corporation finance of the SEC, articulated in a speech—certain digital assets can be so decentralized that they are not securities. The best example of this is Bitcoin. There is nobody “there” to enforce the securities laws against. This is not because the “issuers” of Bitcoin were nefarious characters who ran off with investors’ money, but rather because the bitcoin project from the beginning was an experiment in decentralization where no one participant in the network had any rights or powers distinct from any other participant.
But what does it mean to be “sufficiently decentralized”? Our Bahamas test essentially asks: if the sellers fled to the Bahamas or otherwise ceased to show up to work—like Satoshi Nakamoto—would the project still be capable of existing? If the answer is “yes,” then the risk of fraud is sufficiently reduced such that the instrument is not a security. More technically, the Bahamas test asks if there is either an explicit or implicit contract to build or manage software such that if there was a breach of the contract, the project would fail. If there is no such contract, then the instrument is not a security.
The second part of the test, determining whether an asset satisfies the “expectation of profit” prong of the Howey framework, reveals the problems with the Howey framework. We leave to another day rethinking Howey. Instead, we offer a first cut at how digital assets of various types might be categorized under its tests.
The main difficultly in evaluating initial coin offerings and cryptocurrencies comes with respect to this “expectation of profits” prong of the Supreme Court’s Howey test. There are some tokens and cryptocurrencies that exist on decentralized, open source, and permission-less platforms where there are no “others” to satisfy the final prong of the test, even though they may be purchased with the expectation of profit. These are not securities under the traditional Howey test, and they should not in our view be regulated as such.
The challenge comes in differentiating between cryptocurrencies and tokens that have been described as “utility” or “consumptive” tokens with those that have been described as “investment” tokens. The spectrum that currently exists is between purely consumptive assets, mixed-motive assets, and purely investment assets. This has analogues in case law—one simple example is a concert venue that sells tickets to a reseller who has no intention of using them other than to sell to the final consumers; this is not treated as issuance of a security.
As our article details, this test comports with the SEC’s existing jurisprudence as articulated in its enforcement actions. It operationalizes the Howey test and helps to predictably define the reach of federal securities laws for regulators, judges, and lawyers and their clients. The reach of the securities laws means to get at promoters and entrepreneurs who promise a return based on some kind of efforts in exchange for the money of their investors. Our test captures this and provides a useful framework moving forward. Evaluating the normative justifications of federal securities laws, e.g. protecting entrenched interests by raising barriers to entry, is beyond the scope of the article.
We hope that with this article we will begin a conversation. The reason for this is not simply because we want to be cited in future law review articles and judicial opinions on the subject, but because we believe that certainty and predictability will lead to more innovation and creativity.
The complete article is available here.
Endnotes
1SEC v. W. J. Howey Co., 328 U.S. 293 (1946).(go back)
