By Ayomide Ogunsakin
What comes to mind when you hear the word “security” in relation to finance?Most likely, you first think of stocks, shares or other tradable assets investors buy to own company stakes.
However, flowing from recent regulatory stances and legal actions, there seems to be a move for crypto to join the league of established securities especially in the U.S- which we would focus on in this Issue.
A perfect example of this played out in June, when the U.S Securities and Exchange Commission (SEC), charged two crypto trading platforms—Binance (with its founder, Changpeng Zhao), and Coinbase—with the offences of unregistered sale of securities and operating unregistered securities exchanges respectively.
Not forgetting the legal tussle between the SEC and Ripple Labs, which has been on since 2020, it is evident that the outcome of these lawsuits and several others will set new precedents on who would regulate crypto and whether many of its big players would be required to provide far more disclosure than what crypto ordinarily demands, if it becomes officially recognized as a security.
Prior to these developments, a major attractive feature of cryptocurrency which drew in so many users, resulting in the explosive growth of the industry—with a massive $2.3 million market cap during the peak bull season in 2021—is the freedom it offers users from the control of intermediaries like banks, financial authorities like the SEC, and even governments at large.
Thus, crypto in its decentralized and autonomous nature has offered many advantages for users; but the innovation has also recently shown itself to be extremely volatile, susceptible to fraud (the FTX scandal is proof of this), money laundering and other illicit activities.
Furthermore, it lacks adequate investor protection measures.
These issues have given rise to the increased regulatory scrutiny by financial authorities- spearheaded by the U.S SEC-with sprinkles of lawsuits against crypto companies, executive orders on digital assets, and stricter crypto policies.
But on what basis exactly does the SEC push for cryptocurrencies to be handled and regulated as securities?
Enter The Howey Test.
Under U.S. securities law, the determining factors for whether or not an asset qualifies as a security or an investment contract were derived from a 1946 Supreme Court decision in the case of SEC v. W.J Howey Co., now known as the “Howey Test.”
In the well-established 77 year old Howey case, the U.S Supreme Court stated that “an investment contract, for the purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third part…”
Breaking it down further, this case set the precedent that for asset to be considered a security in the U.S, it must:
✓ Involve an investment of money;
✓ The money must have been invested in a common enterprise;
✓ The investor(s) must have had a reasonable expectation of potential profits from the investment;
✓ the profits must have been derived predominantly from the efforts of others.
Although this case has become a locus classicus in the SEC’s assessment of various financial instruments and arrangements—including cryptocurrencies and Initial Coin Offerings (ICOs), it does not set a bright line rule.
It only offers a multi-pronged analysis which must be satisfied before being applied.
With the many crypto enforcement actions filed between 2021 and now, the SEC has clearly declared war against unlicensed crypto and its issuers.
The agency argues that this decision is premised on the need to ensure investor protection, prevent more fraud and reduce market manipulation.
However, critics in the industry believe that they’re overreaching.
Interestingly, the SEC has always maintained that Bitcoin is not a security; it tilts towards the line of commodities instead.
In June 2018, the former SEC Chair, Jay Clayton clarified that cryptos like Bitcoin are replacements for sovereign currencies like dollar, euro or yen.
The present SEC Chair, Gary Gensler, has taken the regulatory stance a couple steps further.
Gensler, who is popular for describing cryptocurrency as a “Wild West,” has maintained that nothing about the crypto market that is incompatible with the securities law, and investor protection is just as relevant, regardless of underlying technologies.
He has also expressed the SEC’s plan to work with willing industry players, as the goal is to “extend to the crypto space the investor protections that have ensured the success of U.S securities markets.”
The growing number of regulatory settlements by cryptocurrency companies suggests that the message is starting to resonate.
Regardless, the stance remains that forceful policies could be very harmful to DeFi, but a thoughtful and well-tailored regulatory framework might open the door to new waves of global adoption and further provide a safe space for the innovation to blossom.
Ayomide Ogunsakin, the brain behind the DeFi Law Digest, is a law undergraduate at the Obafemi Awolowo University (OAU), Ile-Ife. She can be reached through email: defilawdigest@gmail.com
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