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How Securities Laws Impact Cryptocurrencies

Posted by Ryan M. Newburn | Dec 06, 2022 | 0 Comments

Since the launch of Bitcoin in 2009, the cryptocurrency market has emerged as a trillion-dollar industry around the globe. People exchange coins like Bitcoin, Ethereum, and Dogecoin on various markets, raising questions about whether these coins and tokens are securities. Cryptocurrency emerged as a novel attempt to replace fiat currency as a means of exchange and a store of value, but it has long since grown.

Though crypto gained popularity due to its lack of oversight and government interference, regulators have set their sights on exercising control over the market to challenge nefarious actors abusing the system.

Are Cryptocurrencies Securities?

In the United States, the Securities and Exchange Commission (SEC) regulates markets and protects investors based on authority from the Securities Act of 1933 and the Securities Exchange Act of 1934. A security is a type of company ownership one can have in an entity that could include any:

  • Note
  • Stock
  • LLC Unit
  • Partnership Interest
  • Option, warrant or other convertible

The Howey Test, established by the Supreme Court in SEC v. Howey Co., 328 U.S. 293 (1946), clarifies that a security can be “an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.”

How the SEC Currently Categorizes Cryptocurrencies

SEC Chair, Gary Gensler, has taken the stance publicly that cryptocurrencies may satisfy the requirements of the Howey Test, as “[p]promoters are marketing and the investing public is buying most of these tokens, touting or anticipating profits based on the efforts of others." Therefore, if tokens are securities based on the circumstances and background of the facts, then cryptos must be registered as securities under federal law.

Already, the SEC has successfully brought legal action against crypto creators and platforms who fail to abide by their federal regulations, such as failure to disclose information or unregistered sale of securities.

Legislation Involving Cryptocurrencies

In 2021, Congress passed the Infrastructure Investment and Jobs Act, some of the first U.S. legislation with provisions regarding cryptocurrency. The act referred to crypto as "digital assets." It defined them as "any digital representation of value recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary."

The act also established that anyone who "transfers digital assets on behalf of another person" will be considered a "broker." Consequently, centralized cryptocurrency exchanges must issue a Form 1099-B to customers and the IRS. The form will help investors keep track of the yearly gains and losses from the crypto exchange but also make it much more difficult to hide digital assets from the IRS.

In addition to agency regulation from the SEC and the new congressional legislation, cryptocurrency exchanges and investors may need to comply with state regulations. Many states, including Delaware and New York, require a license for the transmission of digital currency, and companies like Coinbase and Binance already maintain money transmitter licenses in several states.

Future Regulation of Cryptocurrency

The SEC and Congress have expressed their intention to create further legislation increasing crypto oversight. For instance, the SEC has nearly doubled the size of its crypto assets and cyber unit.

In September, Binance, the largest cryptocurrency exchange platform, converted some stablecoins – a cryptocurrency whose value is pegged to the price of another asset – to Binance tokens, potentially destabilizing their value. Since, according to Gensler, assets like stablecoins have features similar to, and potentially competing with, money market funds, other securities, and bank deposits," and raise important policy issues, he calls for greater restrictions.

Unsurprisingly, this has led many figureheads of the crypto industry to increase their lobbying efforts in Congress. For example, Jake Chervinksy, head of policy at the Blockchain Association, tweeted, "Crypto is a novel & unique technology: how it should be regulated is a major question for Congress (not the SEC Chair) to decide." While organizations like the International Monetary Fund (IMF) call for a global response to cryptocurrency that is coordinated, consistent, and comprehensive.

Biden's Executive Order on Cryptocurrencies and the SEC

Additionally, in March, President Biden signed an executive order calling federal agencies, particularly the SEC and the Commodity Futures Trading Commission (CFTC), to examine the risks and benefits of cryptocurrency. The White House also provided a new crypto framework that eliminates illicit activity and safeguards financial stability. The White House is considering increasing penalties for unlicensed money transmitting while conducting a more thorough risk assessment of digital assets. The framework also points out the risks imposed by stablecoins and suggests working with financial institutions to identify and mitigate cyber vulnerabilities.

Importance of SEC Enforcement

According to research from the Federal Trade Commission (FTC), over $1 billion in cryptocurrency has been lost to fraud since the beginning of 2021. For the benefits of the cryptocurrency market to come to fruition, sensible regulations of digital assets may be essential. Digital assets can lead to a lot of theft. Hackers and trustees of accounts can gain access and steal these digital assets. Many thieves and bad actors are using digital assets to facilitate illegal activities, such as money laundering.

According to some financial experts, cryptocurrency regulation could be good for investors since more regulation could mean more stability in a historically volatile market. According to Aaron Klein, a senior fellow at the Brookings Institute, the new regulation can protect long-term investors, prevent fraudulent activity, and provide clear guidance to allow companies to innovate in the crypto world. Moreover, regulations may help instill consumer confidence, encouraging investment in digital assets and growing value.

Notable SEC Enforcement

Ripple

In 2020, the SEC filed an action against Ripple Labs and two of their executives, seeking injunctive relief and civil penalties, alleging that they raised over $1.3 billion through the sale of an unregistered digital asset securities offering. Ripple began selling the digital asset XRP worldwide to finance the company's business.

The SEC complaint alleges that Ripple 1) failed to register the token offerings and sales of XRP; or 2) failed to satisfy the exemption from the requirement to register. Therefore, this violated the Securities Act of 1933. The battle between the SEC has been ongoing for two years, as Ripple challenges that XRP is not a security and, therefore, cannot be regulated by the SEC. The result of this lawsuit could have major implications for the cryptocurrency market's future.

Coinbase

In July of 2022, the SEC announced charges against a former Coinbase product manager, Isan Wahi, and two others for perpetrating a scheme to trade tokens before major crypto asset announcements that would be made available to trade on Coinbase. According to the complaint, Coinbase treated the information as confidential and warned employees not to trade based on or tip others with the information.

However, Wahi allegedly repeatedly tipped off his brother and friend on listing announcements, generating illicit profits totaling more than $1.1 million. While the SEC pushes for injunctive relief and civil penalties for violation of securities antifraud provisions, the U.S Attorney's Office (USAO) simultaneously announced criminal charges against all three defendants.

Kraken

According to the New York Times, the Treasury Department Office of Foreign Assets Control (OFAC) has been investigating Kraken, a crypto exchange platform, since 2019 for allegedly violating U.S. sanctions to allow users in Iran and elsewhere to buy and sell digital assets. Since 1979, the OFAC has prohibited exporting goods and services to people or entities in Iran. The sale of digital assets to Iran could lead to a significant fine on Kraken by the OFAC.

Additionally, the CFTC issued an order in 2021 filing and settling charges against Kraken. The order alleged that the company illegally offered margined retail commodity transactions in digital assets. It further alleged that the company failed to register as a futures commission merchant (FCM). This entity solicits and/or accepts orders to buy or sell futures contracts, options on futures, and forex contracts and accepts customer assets to support such charges.

As a result of the illegal offer, Kraken is ordered to pay $1.25 million in civil monetary penalties and is enjoined from further violations of the Commodity Exchange Act (CEA). Kraken's transactions were unlawful because they did not occur on a designated contract market (DCM) and illegally operated as an unregistered FCM.

BitMEX

In 2021, the CFTC found BitMEX, a cryptocurrency exchange platform, violating the CEA for operating a facility to process or trade swaps without registering as a designated contract market (DCM) or a swap execution facility (SEF). Moreover, BitMEX operated as a futures commission merchant (FCM) without CFTC registration. Consequently, BitMEX entities were required to pay a $100 million civil monetary penalty and are enjoined from future violations of the CEA.

FTX

With the recent crash of FTX, many lawsuits are expected to be filed against the company and its leadership. These lawsuits will be a great test for how securities laws may apply to tokens and other cryptocurrency products.

ICOs

An initial coin offering (ICO) is the cryptocurrency equivalent of an initial public offering (IPO) in the industry. A company seeking to raise money to create a new coin, app, or service can launch an ICO to raise funds. Anyone can launch an ICO, leaving space for nefarious actors to trick investors into believing they have a legitimate ICO and then go with the money.

The SEC formerly released guidance on ICOs, warning investors that trading any unregistered asset, such as an initial coin offering, is a risky investment. The case of REcoin in 2017 demonstrated the potential for the sale of an ICO with no actual foundation, no blockchain, and no staff or operations. Investors must be wary of exchanging ICOs, especially those not subject to SEC protections.

Conclusion

Cryptocurrency is still a volatile and largely unsupervised market, but the SEC and other federal agencies continue to apply pressure and pursue regulation. To be an active and smart investor, conduct research and observe the news surrounding cryptocurrency regulation. If you have any questions, contact our securities attorneys here at Newburn Law for a free consultation.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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