Does Cryptocurrency Fit Comfortably Within US Securities Laws?

Exploring the SEC’s Stance and Understanding the Impact of Crypto Regulations on Society and Culture.

I am still on a high from Friday, having possibly had the most productive day in years. By lunchtime, I had not only enrolled in law school but also completed all required courses, passed all exams, and thus earned a law degree. On top of that, I installed a new government in exile, changing the course of world affairs. Splendid! In case I lost you there, let me clarify a bit. I was heavily preoccupied with two issues.

1 Introduction

One issue concerns a petition by members of my local gym regarding recent management decisions. The other pertains to the potential overall impact of the ongoing legal proceedings taken by the SEC against various companies in the crypto sector, and what the courts have begun to say about whether and how crypto assets should be deemed securities under US law. Let's delve into these issues starting with the complex world of crypto regulation

1.1 The legal debate whether crypto are securities under US law

The legal dispute between Coinbase and the SEC produces a lot of interesting material from which to learn in more detail how the law applies and makes it easier to imagine how markets could evolve.

WARNING: My article is not legal advice; you should not act on anything you read here.

Now that this is out of the way, I can assure you that I am superbly qualified to write an entertaining blog post about US securities law, evidenced by an imaginary law degree from an imaginary law school. I've got it all covered!

1.2 Background: Virgin Active switches to royalty-free music

And what about an exile government? Ah, yes. I had indeed proclaimed a new exile government seated in London. It is called Free Virgin and should not be confused with the exile and later provisional government called Free France between 1942 and 1946. My exile government was necessary in my efforts to contribute to an initiative dealing with unpopular changes at my local gym.

The Telegraph has an article about that feud: Virgin Active switches to mind-numbing royalty-free music. And there are no conditions for citizenship, so you are more than welcome to get involved: Virgin Rebellion.

I would love to explain why I am so interested in the #VirginRebellion because it epitomises in many ways one of my big professional interests, which is how technology is changing society and therefore ourselves.

2. Virgin Active - An ‘Arttech’ Case Study

So here is the deal. Virgin Active, a gym franchise now owned by some private equity firm, seems to be trying to beef up its finances, and I have no reason to doubt that this is necessary since the lockdown and related issues have impacted such businesses immensely. One cost-saving measure identified is the use of royalty-free music. Goodbye to paying Beyoncé for playing one of her songs during a spin class in Fulham; hello to generic knockoff music (although this is a bit unfair, but I will come back to this). The service is provided by a Swedish company called Epidemic Sound. I mention Sweden because it's also the birthplace of Spotify. Swedes and music. Why and how can such a country excel at pop music? I will never understand this mystery, but I have come to accept it.

For me, it's an interesting case study because it perfectly highlights how the law, tech, and the needs of human beings intertwine and what to make of it.

2.1 Overdue Legal Reform

Epidemic Sound has created a large catalogue of songs that are perfect for films and all sorts of social media. But does this make suitable workout music? The correct answer is no. These genres differ quite a bit in terms of speed and song structure. This is because they target creators, and the music is structured around their needs. Epidemic resolves a real problem with music copyright. Suppose you have a licence for a song in country A but not in B; how do you manage that if your material is distributed globally on social media without running afoul of some rules? I get contacted several times a day with claims that something I posted somewhere infringes on someone's copyright. But it’s usually an attempt to gain access to passwords. It is a business that, at its origin, has the fact that copyright law and management of such rights are no longer really fit for purpose.

2.2 AI and Music Creation

Interestingly, Epidemic Sound is my preferred music and sound effect platform, and I have tried them all before finally settling with them for any content I produce. They have an AI search engine which is amazingly in tune with the emotional subtleties of a video sequence and finding appropriate music. What sets them apart for me is the quality of the music. I don’t know how to describe it or how it's achieved, but they have a cinematic quality to their music that’s stunning. The music is, of course, created by artists whom the company engages with and coaches. This is a wonderful example of how technology such as AI can accelerate artistic developments.

2.3 Decentralisation May Increase Freedom, or Undermine It

I am still very opposed to the idea of being limited to their catalogue. It constrains the ability of gym instructors to be creative, who often have their signature sound. Personally, I initially chose classes based on whether I liked the music or not. For a company that prides itself as a champion of creativity, the irony that its services are used to stifle creativity should give pause for thought. Generally speaking, this change continues to negatively impact instructors, who are the heart and soul of this franchise. I don’t feel good about this, and they deserve our support.

Another downside is that it seems Virgin Active is ignoring any concerns, actively suppressing dissent; a gym instructor who makes a negative comment on social media may even risk losing their job. Coming from the financial services sector, I know that banks also love to control the opinions expressed by their employees arguing regulatory requirements or listing obligation. Yes, but it is a real and growing issue, and we need more protection: being the kitchen chef and posting “don’t eat here, my food is awful” is one thing, but expressing concerns or dissenting views over controversial business decisions needs protection.

In this day and age, this includes the zealous overreach of an employer’s marketing or legal department. That’s my opinion, and I recognize others may see it differently. Maintaining an authentic voice in a society where technology controls the places for public debate is a challenge. It also illustrates the limitations of a decentralised marketplace when different actors have varying levels of economic independence from the desires of other agents.

3. The Evolving US Legal Framework for Crypto

Let’s dive into the recent court decision regarding the SEC's allegations against Coinbase, Inc. Have you caught up with it yet? And thank’s to the excellent lawyer who found this nugget and was kind enough to share it.

It presents a comprehensive and well-crafted overview of the existing laws that apply to the realm of cryptocurrencies, at least from one District Judge's perspective. There are a few aspects of the judge's decision that I find a bit unclear. Just to be safe, here's another WARNING: This is not legal advice, and anyone in trouble with the SEC on such matters should seek their own professional advice.

The document provides a thorough overview of the applicable law, which got me thinking about the potential complexities for crypto-related businesses in the U.S. and the need for legal reform. Could there be new opportunities here, akin to Epidemic Sound? Luckily, we have some time to figure this out before the Swedes come in. It isn't about music, so I can beat them by a mile.

The court ruling on this particular motion—whose final decision remains to be seen—concludes that the SEC has sufficiently argued that Coinbase operates as an exchange, a broker, and a clearing agency under federal securities laws, and that through its Staking Program, it engages in the unregistered offer and sale of securities.

The decision was penned by Katherine Polk Failla, a District Judge in New York, who uses quite poetic language to address the issue:

“At first blush, the addition of the prefix ‘crypto’ to a commonly understood word like ‘asset’ may suggest a paradigm shift.”

She concludes this line of thought with a serene tone and the softest of irony: “[The] ‘crypto’ nomenclature may be of recent vintage, but the challenged transactions fall comfortably within the framework that courts have used to identify securities for nearly eighty years.”

This is brilliant, Madam Judge. Perhaps you should start a blog on the fusion of law and technology. And if Failla does indeed suggest Italian ancestry, maybe we could pivot to “La Fusionista - La fusione tra diritto e tecnologia.” DM me! However, I am not so comfortable with how "comfortably" everything fits—there are aspects that the judgment does not seem to take into consideration regarding the functioning of crypto.

3.1 The Theory of Considering Crypto as Investment Contracts

Here comes now the DIY lawyering to summarize the document and spare you the effort: The U.S. legal definition of a security encompasses a broad array of investment instruments, including "investment contracts," which are characterized by three critical elements: an investment of money in a common enterprise, with the expectation of profits derived primarily from the efforts of others.

What initially swayed me, albeit slightly, was the argument that lawmakers intended for the concept of investment contracts to encompass any model or arrangement, even those not yet conceived. This adaptability is often touted as characteristic of common law legal systems. Therefore, it should be no surprise that the law gives the SEC such a broad mandate. I always feel such ideas are akin to the following scenario: Consider a case from 1604, where a piglet was stolen from a market town in England. The resolution of that ancient dispute then informs how we interpret and apply laws to contemporary issues like a crypto theft from last week. How common law lawyers find this ‘accretion by law’ reasonable and not a bit irritating, I will never understand.

Particularly in this case: A justification for the Securities Act and Exchange Act was that securities markets had grown and represented perhaps the most significant avenue for raising funds, making orderly markets a question of national interest. Is that still the case today since fundraising through IPOs is probably less important nowadays—in relative terms—than it was then? And of course, these changes in the regulatory approach are not subjected to the same rigorous debate and approval process as new legislation. And is this justified when it comes to crypto? Not a legal question, but an emotional one.

3.2 Howey Test to Determine Securities Status

Returning to investment contracts and their three characteristics, also known as the Howey test, I can't help but wonder why they could not have chosen something else to name the ‘Howey' test. It reminds me of 'Howie', who was Colt Silvers’s sidekick in the TV show "The Fall Guy", a show I am quite fond of. And now, I'll probably have its theme song stuck in my head for hours.

But, moving on, here’s what the document says about why crypto sometimes meets this test:

• Investment of Money: There is a "slashing risk" when participating in a staking program, suggesting that offering such services could meet the condition of an investment of money.

• Common Enterprise: A crypto arrangement can meet this condition, for example, in cases where the proceeds from selling the initial coins are pooled to develop the token's ecosystem, potentially increasing the value of the tokens for all holders.

• Expectation of Profits Derived from the Efforts of Others: The SEC argued, and the court acknowledged, that the promotional activities of the protocol developers lead investors to expect profits derived from these efforts.

This leads us to the part where a real law degree would be useful, as I sometimes get criticised for my creative legal reinterpretations, though I prefer to think of it as 'a new read'. It usually goes like this:

• Me: "Because of this and that, I think there's an argument to be made why this rule does not apply."

• Legal Person: "No, you cannot, you can't."

• Me: "Says who?"

• Legal Person: "THE LAW!!!"

• Me: "Pah. Let’s get a second opinion."

I often get it wrong, but sometimes I get it right, and that makes it all worthwhile.

3.3 Truth in Securities Act

The Howey/Howie test is based on the Securities Act of 1933, following the stock market crash of 1929, and is often referred to as the "Truth in Securities Act." A ‘truth act’—sounds like something I might have concocted.

It introduces disclosure requirements for security issuance because, without such rules, “it became possible for men of character and honesty to become the innocent agents of spreading misinformation.” With this in mind, consider this scenario: if the US Congress were to approach the SEC with a prospectus called the Securities Act, proposing some crypto-like investment contract, the SEC might say no and request changes. Why? Because company law is managed at the state level, not nationally, which means the Securities Act doesn’t legislate ‘securities’ per se, but only public offerings of securities in interstate commerce. This matters because the SEC does not contend that tokens, in themselves, are securities; rather, the dispute arises over ‘whether transactions in which a particular token is implicated qualify as investment contracts.’ This nuance makes some of the Court’s arguments also a bit unclear.

“Whether a fact be true or false is not always easy to determine. It may be literally true but convey a different impression. It may be a half truth and misleading because it omits pertinent qualifications. It may also be ambiguous, false in one sense, true in another.”

John C. Doerfer, The Federal Securities Act of 1933 , 18 Marq. L. Rev. 147 (1934).

Indeed, it depends.

3.4 Open Questions and Practical Implementation Challenges

So, assume US markets stick with the model that declares cryptocurrencies are not securities, agreed? However, depending on certain circumstances that are not always within a provider's control, this situation could change, bringing the assets into scope. Perhaps some protocol provider launches a new advertising campaign, announcing something like:

"Drop date for SEC coins, your investment into a new ecosystem for investor protection."

And voilà, we have an unexpected gender reveal baby shower coming up. It's not easy at all for any bank involved in safekeeping crypto to implement a model that would suddenly change the ‘asset type.’

Coinbase, we learn, has "established a systematic analytical process for reviewing crypto assets, specifically to determine which could be deemed 'securities' under the SEC’s definition." What happens if a crypto startup comes along and says, "I think this sentence here on the website of the Bitcoin Foundation is relevant promotional activity, and I think it's therefore an investment contract"?

Does this now apply to everyone? I hope Coinbase has included this risk in their prospectus because the court ruling makes it clear that the SEC must enforce and having such a control process and getting it wrong is no defence. I’m not sure if that is entirely accurate, but assuming it is, this makes it a very unattractive position in a bank: being the head of 'my first mistake in this job will be my last in this job.'

I am a bit confused by some of the arguments made to conclude that these instruments fit comfortably within the existing framework.

Consider this: an issuer owes no contractual obligation to a buyer, and Coinbase argues that these transactions, therefore, are not securities. To be fair, that has been my expectation as well. But now comes the magic trick: the Howey test looks at substance over form, so the lack of a contractual relationship doesn’t matter because people who buy SOL, for instance, do it believing Solana is making savvy investments to enhance the protocol and thereby have a profit expectation. Whether they do anything or not makes not difference.

But how does this align to the definition of crypto cited by the Court at the beginning including this: "Each blockchain has its own ‘native token,’ i.e., a digital asset designed [..] to ensure the proper function of the blockchain’s protocol."

What this means is that someone might buy such assets not in the hope of profit from an increase in value; they might instead spend it and expect to lose 100% of it, perhaps to pay for gas fees needed to tokenize something. Now please show me such situation for any existing securities.

Or consider the discussion that buyers expect a return on investment "solely by the efforts of others," which is part of the Howey test. So you have SOL, and Solana has some fancy advertising promising the moon. In this case, you are ‘you' and Solana is ‘others,' and therefore another condition is met. But is that so?

'Others' does not mean just any other but implies the promoter or third-party managers. In a decentralized network, however, shouldn't we expect that higher participation in the network increases its value? Nobody needs a telephone if they are the only one who has one. Therefore, the effort that's needed is the effort of "other others" because Solana does not control the citrus grove or whatever the company assets were (which was what the Howey test was about). Some of these legal inferences feel a bit like comparing apples with oranges, and therefore the conclusions seem arbitrary. I suppose logic was never a major concern of the law.

Let me give you one more example where this problem is very obvious, I think.

Staking. If there is no chance of loss, you don't get federal protection for your investment and the SEC would lose it case. So, what constitutes such a risk with staking? We learn, "For example, once a customer’s crypto-assets are staked to the underlying blockchain protocol, those assets are at risk of being lost in the event the relevant blockchain is forced (or chooses) to shut down or cease operations." What? How? Okay.

In what way does this risk correlate to staking? None. You cannot avoid this risk by not staking. Actually, one could argue that not allocating assets to staking increases the risk because it would require less crypto to manipulate the consensus mechanism. The ruling discusses this a bit but then simply says, "Well, protocol shutdown risk is inherent to staking.” So? How is this an argument? If we are debating whether the sky is blue or yellow, and I say, "Snow is white, therefore I am right.” Would you say: “Oh yeah, that makes perfect sense!”

And how are the assets lost if THE blockchain is forced to shut down, let’s say all the nodes go offline—the assets are where they always were, in the records maintained by each node. And why is a penalty e.g. node downtime a loss when it could also be fair to consider smaller penalties simply the cost of operation?

But I can already hear the objection from the real lawyer: "No, you cannot say that." But you know what my response will be: "Pah, let's get a second opinion!"