Many people new to the cryptocurrency space are surprised to hear one of the industry’s largest and more complex regulatory agencies is the U.S. Securities and Exchange Commission (SEC). That is all because of a 1946 case called SEC v. W. J. Howey Co. In Howey, the defendants offered real estate contracts for tracts of land in citrus groves. This case formed the test for determining whether transactions are investment contracts (and subject to securities registration requirements). Under the Howey Test, a transaction is an investment contract if there are the following elements:
An investment of money
A common enterprise
Reasonable expectations of profits
Profits derived from the efforts of others
Healthy tangerines are seen on a tree at a Arapaho Citrus Management grove in Fort Pierce, Florida … [+] on November 21, 2019. – Florida farmers have observed, almost powerless, the spread of the huanglongbing bacterium (“yellow dragon disease” in Chinese), known worldwide as “HLB” and native to China. It was first reported in Florida in 2005, and has been conquering groves ever since. The bacterium causes one of the most devastating citrus diseases called “greening”: the leaves of the infected trees turn pale, the fruit fails to ripen and remain green, and eventually fall to the ground. (Photo by Gianrigo MARLETTA / AFP) (Photo by GIANRIGO MARLETTA/AFP via Getty Images)
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Well, fast forward 70 years and this is the same case law that the cryptocurrency space must apply to determine whether issuing or listing a certain digital asset requires SEC registration. We are a long way from those citrus groves in 1946 and the complexities of applying this old law to new technology is difficult to say the least. The SEC has made efforts to bring clarity to the Howey Test as it applies to digital assets. It is the third and fourth prong that are usually the area for factual interpretation/debate and in April 2019, the SEC released their Framework for “Investment Contract” Analysis of Digital Assets. While helpful, by doing so, the SEC essentially turned the 4 prong Howey Test into dozens of considerations companies now need to consider before issuing or listing a cryptocurrency.
Regulation Through Enforcement Actions
On September 15th, the SEC announced an enforcement action and settlement with Unikrn, Inc. This is certainly not a first in terms of SEC enforcements against cryptocurrency projects but what makes this enforcement different is that Unikrn is alleged to have offered its tokens in an unregistered offering but there is no additional allegation of fraud.
This regulation through enforcement presents challenges for legal practitioners. Stephen Palley, who leads the technology practice at Anderson Kill, in Washington D.C., represents an array of businesses in the blockchain and cryptocurrency space. According to Palley, in spite of actions against Unikrn, Telegram and others, clients who want to be on the right side of the law are frustrated by the need to try to predict regulatory gray areas.
“Clients are coming to us for conservative compliance advice. Enforcement has a long tail (Unikrn took place several years ago) and can take years to be made public, so we don’t know what is going on behind the scenes. As a practitioner in the trenches, I can tell you that our clients wish there was more guidance to launch projects without fear of enforcement and there is a risk that this lack of clarity will stifle innovation by some and encourage imprudent fund-raising by others. This doesn’t change the advice that we give – which is to stay on the right side of the law – but clearer guardrails would be welcome.”
UNITED STATES – SEPTEMBER 24: Hester M. Peirce, second from right, a Securities and Exchange … [+] Commission commissioner, testifies during the House Financial Services Committee hearing on oversight of the SEC in Rayburn Building on Tuesday, September 24, 2019. SEC commissioners from left are, Allison Herren Lee, Robert J. Jackson, Chairman Jay Clayton, and Elad L. Roisman. (Photo By Tom William/CQ-Roll Call, Inc via Getty Images)
CQ-Roll Call, Inc via Getty Images
SEC Commissioner Hester Peirce, (affectionately nicknamed ‘Crypto Mom’), released a dissenting opinion regarding Unikrn and more generally, her thoughts about the SEC’s practice of regulating through enforcement actions. In her statement, Peirce stated that she recognizes “that the determination of whether an instrument is offered and sold as a security in the form of an investment contract requires a subjective weighing of the facts and circumstances. Such analysis, idiosyncratic by its very nature, does not produce clear guideposts for entrepreneurs and others to follow. The challenge of discerning a clear legal line is especially difficult with respect to new forms of business and novel technologies.”
Commissioner Peirce also noted that the terms of the settlement effectively force the company to cease operations, not because of fraud but solely because of a difference in interpretation of the Howey Test.
The Blockchain Association is a trade group based in DC working to improve the blockchain and cryptocurrency public policy environment so the industry can thrive. Kristin Smith, Executive Director explained to me, “Commissioner Peirce’s dissent makes it clear that the application of the U.S. securities laws to cryptocurrencies remains opaque, and that the SEC’s enforcement activity is doing little to clarify the situation. The net effect is stifling innovation, the costs of which we will never know.”
Proposed Safe Harbor
In February of this year, Commissioner Peirce proposed a three year safe-harbor that might resolve this issue. This three year window would allow projects to work towards the necessary adoption and decentralization required to pass the Howey Test, while not being subject to enforcement actions in the process.
As Commissioner Peirce noted in her statement, “Imagine if such a regulatory safe harbor had been available to Unikrn. Instead of permanently disabling its tokens as a result of today’s settled enforcement action, Unikrn, in concert with its token holders, might be devoting its time and resources to identifying new uses for the token and expanding its user base.”
Commissioner Peirce explained to me, “I continue to believe that we need a common sense framework pursuant to which tokens can be distributed to the public without fear of running afoul of the securities laws.”
And many in the cryptocurrency industry agree with this idea. Kristin Smith told me, “The Blockchain Association supports Commissioner Peirce’s Token Safe Harbor and we are committed to working with the SEC and Congress to clarify the legal landscape for cryptocurrency projects in the United States.”
Mark Murphy, COO of Digital Currency Group, the largest investment company focused on the digital currency market, commented, “The safe harbor provision proposed by Commissioner Peirce would be an important step forward for the development of blockchain technology in the United States.”
But Commissioner Peirce does not feel her proposal is the only potential solution. To her and many in the space, true regulatory clarity is all that matters. Commissioner Peirce explained to me, “The safe harbor I proposed is one possible approach, but the most important thing from my perspective is to get some legal clarity in this area as quickly as possible.”
In order for such a proposal to take effect, SEC Chairman Jay Clayton would need to bring the proposal forward and the five Commissions would then vote. There likely will be additional versions of this proposal before that happens. Industry feedback will aid Commissioner Peirce in fine tuning her proposal. And that support and feedback from the industry is extremely important for the process to move as efficiently as possible.
Mark Murphy explained to me, “We believe that industry participants should support regulatory and legislative proposals that leverage these innovative new technologies, foster innovation, and protect investors.”
Unikrn serves as a single, yet powerful example that lack of regulatory guardrails may stifle transformative projects. In a world where technology is constantly evolving, companies should be able to be innovative without fear of unexpected enforcement actions or forced to cease operations. The SEC needs to continue to elucidate the governing principles for modern technology.