Print
E-MailThomas Lee Hazen is the Cary C. Boshamer Distinguished Professor at the University of North Carolina at Chapel Hill School of Law. This post is based on a recent article by Professor Hazen, forthcoming in the North Carolina Journal of Law and Technology.
The securities laws contain a broad definition of what constitutes a security. Finding a security to exist triggers many regulatory provisions of the securities laws. There is considerable case law interpreting the now well-developed test for what constitutes an “investment contract” leading to the finding that a security exists. However, to date, there is relatively sparse authority applying the securities laws to virtual, digital, or crypto currencies. In my article, I examine the investment contract analysis and concludes that initial coin offerings and many, if not most, digital currency transactions involve securities and therefore are subject to SEC jurisdiction and to the jurisdiction of state securities administrators. The article then outlines the regulatory consequences of applying the securities laws to digital currency transactions.
Over the years, a wide variety of nontraditional investments from orange groves to earthworms and scotch whiskey have been held to be securities. But what about virtual, digital, or crypto currency?
During the seventeenth century, speculation resulted in the infamous tulip bubble. As compared to crypto currencies, tulips at least have some intrinsic value. In light of the massive investor losses that have occurred and are likely to continue to result from virtual or crypto currencies, appropriate regulation is necessary.
The securities laws’ definition of “security” is expansive because of its inclusion of “investment contract” in the statutory definition (e.g., Section 2(a)(1) of the Securities Act of 1933, 15 U.S.C. § 77b(a)(1)) and the courts’ interpretation of that phrase. The seminal Supreme Court opinion set forth that
“[a]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.” (S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946)).
The article explains that under most, if not all, circumstances, crypto currencies are likely to be securities. In addition to these factors, courts have looked to the presence or absence of another applicable regulatory regime in order to determine whether an investment contract and thus a security exists. In a close case, the presence of a regulatory scheme covering the investment in question mitigates against classifying the investment as a security. Conversely, the absence of a parallel regulatory scheme to reduce risk will mitigate in favor of finding a security. Although there is some regulation of crypto currency exchanges that register as money transmitters, that regulation does not involve investor protection. This absence of other investor protection regulation weighs in favor of classifying crypto currencies as securities.
An alternative to the Howey test developed under state securities laws containing the investment contract language and has been favorably acknowledged in some federal decisions. (See, e.g., Silver Hills Country Club v. Sobieski, 5361 P.2d 906 (Cal. 1961); State by Comm’r of Sec. v. Hawaii Mkt. Ctr., Inc., 485 P.2d 105, 109 (Haw. 1971)). This risk capital analysis is not as limiting as the Howey test since it is not tied to the four Howey factors.
The article explains why initial coin offerings (ICOs) implicate the registration and disclosure requirements of the federal securities laws. Even beyond ICOs, crypto currency transactions often will implicate the securities laws. For example, the antifraud provisions as well as the broker-dealer and exchange registration requirements for those in the business of marketing crypto currencies should be applied to many crypto currency transactions. In the unlikely event that federal regulation can be avoided, state securities laws have used a broader test for classifying investments as securities. Accordingly, state laws may reach transactions not pursued by the SEC. It follows that with the exception of true utility tokens with no investment market, many, if not most crypto currencies are likely to implicate the securities laws at least at some point during their life cycle.
The complete article is available here.
