Featured Expert Contributor, Legal & Regulatory Challenges for Digital Assets

Alter_Daniel_web2_8784879218361By Daniel S. Alter, a Shareholder in the New York, NY office of Murphy & McGonigle P.C.

A common criticism of Sigmund Freud is that he built a theory of the human psyche based largely upon experiences of the mentally ill.  The U.S. Securities and Exchange Commission’s (SEC) approach to regulating crypto assets labors under a similar bias.  The agency has developed a regulatory construct largely in response to a period of widespread abusive conduct in the digital markets.  Although the SEC’s intervention was historically justified, it may be time to reexamine and refine that regulatory construct in ways that still protect investors but better promote innovation.

Two years back, when billions of dollars in initial coin offerings (ICOs) hit the market—many of which were rife with fraud—the SEC invoked SEC v. W.J. Howey Co., 328 U.S. 837 (1946), to bring matters under control.  Applying the Howey test, the agency concluded that digital tokens, when used to raise capital, can fall within the definition of a “security” under the Securities Act and are thus subject to federal regulation as such.  A digitized security or “security token,” the SEC reasoned, is still a security—regardless of its transactional medium.

There was nothing inherently objectionable about that determination.  But when SEC Chairman Jay Clayton famously told Congress in February 2018 that “I believe every ICO I’ve seen is a security,” many in the crypto community heard the death knell for all utility tokens. “Utility tokens,” like security tokens, may be sold initially to fund the development of an online platform.  Once the network is operational, however, utility tokens become the currency for purchasing goods or services on that platform.  Their value measures their usefulness.

Not all utility tokens are alike, though. For example, those tokens issued by non-profit organizations and foundations seeking to build decentralized platforms of exchange (i.e., platforms that are ultimately governed and sustained by the community of token holders themselves rather than by a central management team), embody a new and distinct instrument of capitalism.  These group efforts are akin to public infrastructure projects designed and maintained to support the generation of private wealth.

Indeed, the motivating principle of this new paradigm runs counter to what is perhaps the most central consideration in Howey’s definition of security.  Made possible by distributed ledger technology, the expectation of profits from these utility tokens does not rely on “the entrepreneurial or managerial efforts of others.”  To the contrary, that profit expectation becomes wholly dependent upon the efforts of a technological community, in which token holders are themselves active participants.

This past year, Ethereum and the ether brought this fact into sharp focus for the SEC.  The Ethereum network was built with funds raised by the public sale of ethers (a form of utility tokens), but the SEC now seems to recognize that “ether is a kind of ‘crypto fuel,’ used to pay for the decentralized computation by which smart contracts are executed on the ethereum platform.”  With experience comes wisdom.

Last June, Bill Hinman – the Director of the SEC’s Division of Corporation Finance – delivered an important speech to stakeholders across the digital asset community.  He used his remarks as an “opportunity to address a topic that is [the] subject of considerable debate in the press and in the crypto-community—whether a digital asset offered as a security can, over time, become something other than a security.”  Director Hinman quickly rephrased the question in more transactional terms to ask whether “a digital asset that was originally offered in a securities offering [can] ever be later sold in a manner that does not constitute an offering of a security?”  His answer was “a qualified ‘yes.’”

According to Hinman, in circumstances “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created,” that asset sale may not constitute a security offering. In other words, Howey might not apply to all life stages of a utility token.

In a developing regulatory environment, where participants have been forced to read tea leaves rather than directives, Hinman’s tentative observation has provided valuable insight into the SEC’s attempt to grapple with a new asset class that does not fit neatly within traditional legal categories.  Fortunately, these efforts seem to be taking hold, as Chairman Clayton’s recent March 7, 2019 letter to U.S. Representative Ted Budd indicates.

In his letter, Chairman Clayton agreed “that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument.”  Clayton further conceded that a legal “designation may change over time if the digital asset is later offered and sold in such a way that it will no longer meet th[e] definition” of a security, “for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts.”  The Chamber of Digital Commerce welcomed Chairman Clayton’s statements as “demonstrate[ing] a deepening understanding within the agency of the nuances of this [crypto-based] industry and the digital assets of which it is compromised.”

The Chamber’s observation is correct and the SEC’s evolution in thinking is certainly an encouraging sign.  Perhaps now more than ever, though, is an appropriate time to ask whether the agency’s understanding is developing on the right track or is headed in the wrong direction.  For centuries, alchemy was a scholarly pursuit, but it rested on a mistaken premise.  Ultimately, the idea produced little of value.

The views recently shared by SEC officials posit a new taxonomy of hybrid financial instruments.  They describe some sort of molting investment product:  a digital token that over time sheds its defining characteristics as a security in a centralized venture and essentially transforms into a commodity that entitles its holder to goods or services offered through a decentralized blockchain network.  It is a “Secutility Token,” and by description it effectively starts as equity and morphs into a digital pork belly.  But is that right?

A familiar principle of computer programming instructs that “simple is better than complex.”  That insight also applies to securities regulation.  Do we really want to deal with the temporal de-securitization of utility tokens?  What conditions will mark the transition from security to non-security, or will we clearly know it when we see it?  Will we need to create accounting and administrative processes to document the change?  What will be the tax implications for token issuers and token holders?  These questions are among the myriad legal and financial challenges that would necessarily dog the Secutility Token.

Before we go down that complicated path, we should revisit a principal assumption.  The idea of a Secutility Token follows from the SEC’s apparent presupposition that all utility tokens begin as securities. Isn’t it simpler and more accurate, however, just to acknowledge that some utility tokens are never securities?  That they do not satisfy the Howey test precisely because their ultimate value is never pegged to “the entrepreneurial or managerial efforts of others?”

To be sure, utility tokens issued by for-profit organizations for use on privately maintained platforms are very likely securities—and would remain securities for at least as long as their value depended upon the efforts of the platforms’ operators. Gary Plastic Packaging Corp. v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985), made that point clear almost 25 years ago.  Gary Plastic teaches that financial instruments, which ordinarily do not qualify as securities (e.g., digital currencies for purchasing goods and services), can still be subject to securities regulation when their value is enhanced by the management efforts of others.  But the rule of Gary Plastic has no place on a decentralized platform.

This conclusion would not leave purchasers of non-security tokens unprotected from bad people.   One commentator has observed that “[v]arious regulatory authorities around the world are opening up to the idea that, when tokens have a clearly functional role within a blockchain network, it’s better to manage them with existing consumer protection and anti-money laundering laws than with burdensome securities regulation.”  Moreover, non-profit organizations that issue utility tokens to fund construction of decentralized platforms are often subject to strict government oversight.  Law enforcement, taxing, and other regulatory authorities are charged with protecting the assets of such organizations, and thereby reduce the opportunity to defraud token buyers.

There is much more thinking to do.  Whether an asset is treated as a security affects its use, reach, and development.  That determination can also have a negative impact on market innovations if—in the short run—the related regulatory burdens outweigh the benefits.  The hard work ahead for the SEC is in drawing careful legal distinctions between different digital assets.  As the Secutility Token makes obvious, any other strategy might cause more problems than it solves.