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The head of the Securities and Exchange Commission (SEC) has reiterated his view that most crypto-assets are securities, adding that crypto-related firms should focus on compliance sooner rather than later.
Speaking at an SEC lecture series, chairman Gary Gensler said that of the ten of thousands of crypto-assets in circulation, he believes the “vast majority” are securities.
“Offers and sales of these thousands of crypto security tokens are covered under the securities laws,” he said.
And while some tokens may not meet the definition of a security, “these likely represent only a small number of tokens, even though they may represent a significant portion of the crypto market’s aggregate value.”
Bitcoin, the first and largest crypto-asset, is the most important non-security token in Gensler’s view, and ought to be regulated as a commodity rather than a security.
For Gensler, interpretation comes down to how the crypto-asset was conceived and how it is marketed to others.
The notable difference in bitcoin’s case — versus most crypto-assets — is that its founder has remained anonymous and that he described his invention as a “peer-to-peer electronic cash system” rather than an investment product.
The Howey Test
Exploring the historical scope of US securities laws, Gensler referred to two key Supreme Court cases that have guided his thinking on crypto-assets.
The first is the 1946 case of SEC v. Howey Co. that gave birth to the Howey Test, a measure of what constitutes a security under the 1934 Securities Exchange Act.
The Howey Test is named after William John Howey, a Florida politician and citrus farmer who was sued by the SEC for selling small strips of citrus grove to investors.
Each investor signed a contract with Howey that detailed plans for the cultivation, marketing and remitting of net profits from each plot of land.
The SEC pursued an injunction against Howey, arguing that his citrus grove contracts constituted the sale of unregistered securities.
The complaint was upheld by the Supreme Court, and has been instructive in US securities law ever since.
Broadly speaking, the case established that a security is a document that provides proof of a monetary investment in a common enterprise, with the profits from the investment earned exclusively through the effort of others.
“In general,” said Gensler, tying the case back to crypto, “the investing public is buying or selling crypto security tokens because they’re expecting profits derived from the efforts of others in a common enterprise.”
Even in 1946, Gensler said the Supreme Court made clear that US securities laws were designed “to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Gensler added: “Investors are following crypto projects on social media and scouring online posts about them.
“These tokens have promotional websites, featuring profiles of the entrepreneurs working on the projects.”
“These are not laundromat tokens: promoters are marketing and the investing public is buying most of these tokens, touting or anticipating profits based on the efforts of others.”
Since 1946, the Supreme Court has reaffirmed the validity of the Howey Test in numerous other cases, including as recently as 2019.
Gensler also pointed out that his predecessor, Jay Clayton, also took the same view of crypto-assets as securities under the Howey Test.
From payable on demand notes to crypto-assets
The second case raised by Gensler was the 1990 case of Reves v. Ernst & Young. The case established that, under the 1934 Securities Exchange Act, payable on demand notes offered by businesses to support their operations are securities.
The case centred on the Farmer's Cooperative of Arkansas and Oklahoma and its sale of payable on demand notes to both Co-Op members and non-members.
The notes, which were marketed as an "Investment Program", paid a variable interest rate higher than that of local financial institutions.
But when the Co-Op went bankrupt, investors sued on the grounds that it had violated the anti-fraud provisions of the 1934 Securities Exchange Act.
The Supreme Court upheld the complaint, with Justice Thurgood Marshall writing that “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”
As Gensler argued, it logically follows that Congress should “paint with a broad brush” when considering the scope of securities laws in light of new technologies.
In the crypto world, an issuer’s own token serves the same purpose as a payable on demand note.
Usually through multiple fundraising rounds prior to a public launch, investors are enticed to purchase new tokens to support the development, marketing and ultimately the financial success of the project.
Often, tokens purchased by early investors are subject to vesting schedules, which prevents these investors from cashing out early.
When sold under a vesting schedule, a crypto-asset token is more akin to a fixed term promissory note — a type of commercial paper that can only be redeemed at the end of its stated term.
Either way, both types of commercial paper — fixed term and notes payable on demand — are deemed securities under US law.
‘Come in, talk to us’
Gensler’s view is that the securities question is now settled with regard to crypto-assets, and he dismissed calls for further “guidance” on the issue as unnecessary.
“Not liking the message isn’t the same thing as not receiving it,” he said, referring to those companies that would still like to argue the point.
Going forward, Gensler said that crypto companies should focus on compliance with securities laws sooner rather than later.
“For those who are starting up in this space now — either from traditional finance or as crypto-native companies — work with us on compliance from the beginning,” he said. “It’s far less costly to do so from the outset.
“I can only say that true cooperation benefits everybody here. Meaningful engagement is always welcome.”
He added that he has asked the SEC staff to work directly with entrepreneurs to get their tokens registered and regulated, where appropriate, as securities.
However, he noted that so far only a “handful” of crypto security tokens have registered under the existing regime.
