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Regulation and Compliance > Federal Regulation > SEC

Gensler's SEC Can Bring Regulatory Clarity to Digital Assets

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What You Need to Know

  • Market participants need clearer guidance on when and whether digital tokens are securities.
  • Regulatory oversight is indispensable in creating a safe digital assets market.
  • Regulatory clarity is equally important to allowing this nascent market to reach its potential.

Gary Gensler’s confirmation Wednesday, April 14, as chairman of the Securities and Exchange Commission marks a significant moment in the development of the digital assets and blockchain industry. Digital assets and blockchain technology hold significant potential for human advancement.

As now-Chairman Gensler acknowledged in his March 2 hearing before the Senate Banking, Housing, and Urban Affairs Committee, powerful use cases exist — including financial resources for the unbanked, increased and more immediate access to medical records, and reduction in the costs of international transactions between small-business owners in the developing world and consumers worldwide.

Of course, these are just a few of the unlimited theoretical applications of this technology. Because of its massive potential to transform the economy and meaningfully shape our collective future, investors to date have poured billions of dollars into the development of digital assets.

But the U.S. legal landscape in which these assets operate is still largely emerging and is in a constant state of change.

As the U.S. market has a significant influence on the overall economic potential of these assets, this ever-changing legal landscape creates substantial market uncertainty for industry participants.

To be clear, regulatory oversight plays an indispensable role in creating a safe market for mainstream market participants, as evidenced by the countless security breaches and hacks and criminal misuse of this technology over the years. However, equally critical for allowing this nascent industry to reach its potential is regulatory clarity.

The truth of this principle is no more apparent than in the SEC’s recent enforcement action filed against Ripple Labs, the primary promoter of the digital asset XRP. On Dec. 22, 2020, the commission filed a complaint against Ripple Labs, alleging a continuous securities offering from 2013 through the present of over 14.6 billion units of XRP tokens.

Ripple contends that XRP is a medium of exchange and not a security. Since the complaint was filed, XRP has experienced significant price volatility and trading has largely been halted. If there is one takeaway from this story, it is this: Regulatory clarity matters.

Clarity from SEC

Of pivotal importance is regulatory clarity from the commission, which is responsible for overseeing U.S. market activity involving securities.  Specifically, as we discuss below, the Commission should build on the breadcrumbs of clarity SEC leadership has offered in prior speeches in which they have recognized that bitcoin is not a security.

Building on this foundation, the SEC has the opportunity to offer meaningful clarity to the industry by making clear that a digital asset does not qualify as a security if it operates as a currency equivalent with an existing marketplace for everyday transactions and is distributed by a mining network responsible for validating transactions.

Presently, there is no categorical classification for all digital assets as either commodities or securities under U.S. law. Depending on the digital asset, it may be deemed either a commodity or a security.

If a digital asset meets the definition of a security under U.S. law, it is subject to all requirements under the U.S. securities law regime. For example, digital assets that are securities must be sold only in offerings that comply with the registration and disclosure requirements of Section 5 of the Securities Act of 1933, unless the assets or sale qualify for an exemption.

Further, exchanges that allow trading in securities must likewise follow registration and disclosure requirements under the Securities Exchange Act of 1934. Failure to comply can result in stiff penalties.

The Howey Test

In determining whether a given instrument qualifies as an investment contract — and therefore a security — U.S. courts apply a test developed by the Supreme Court known as the Howey test.

Under this test, a transaction or series of transactions may qualify as an “investment contract” when the following elements are present: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profits (iv) based on the entrepreneurial or managerial efforts of a third party. The Howey test was first applied to digital assets by the SEC in its July 2017 Section 21(a) report concerning tokens issued by The DAO.

Since then, the SEC has provided significant guidance to market participants on how it evaluates digital assets under Howey. Namely, in 2019, the Strategic Hub for Innovation and Technology (FinHUB) in the Division of Corporate Finance provided the most extensive guidance to date to market participants in its Framework for “Investment Contract” Analysis of Digital Assets (the Framework).

The Framework identifies 38 separate considerations, listing sub-points under many of them. However, the Framework is not an official commission rule, does not qualify as formal guidance, and is not binding on the SEC or its divisions. Moreover, the Framework stresses that “[w]hether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances.”

The fact-specific nature of the Howey test, coupled with the SEC’s lack of binding guidance on what kinds of digital assets do not qualify as securities, has created enormous uncertainty in the market. This has a very consequential impact in the real world. It hinders innovation.

This problem, of course, is solvable. There is hope that with the change in administration, new FinHUB leadership will provide clearer guidance to the digital asset and blockchain industry. In this article, we propose one modest form of guidance that could go a long way toward providing that much-needed clarity.

Not a Security

The SEC leadership has already made clear their view that Bitcoin is not a security. In April 2018, in a hearing before the House Appropriations Committee, then-SEC Chairman Jay Clayton stated that Bitcoin does not qualify as a security. He reasoned that Bitcoin functions as a replacement for currency.

Clayton later added in a media interview that digital assets that “are replacements for sovereign currencies, [which] replace the dollar, the euro, the yen … [are] not a security.” In other words, he reasoned that any digital currency whose primary function is to serve as a substitute for fiat currency would not qualify as a security.

Subsequently, in a July 2018 speech, William Hinman, then director of the Division of Corporation Finance, likewise opined that Bitcoin is not a security under Howey. He reasoned that there no longer seemed to be “a central third party whose efforts are a key determining factor in the enterprise.”

Importantly, now-SEC Chairman Gensler similarly recognized in his Senate confirmation hearing that Bitcoin “has been deemed” a commodity. Further, in a 2018 speech before an MIT blockchain conference, he distinguished Bitcoin from tokens accompanied by initial coin offerings and/or pre-mined coins, explaining that “bitcoin came into existence as mining began as an incentive in validating a distributed platform.”

Two Significant Issues

Two key features highlighted by the commission’s leadership merit further comment. First, SEC leaders have flagged the importance of a digital asset functioning as a currency equivalent. This, of course, makes perfect sense.

Those who acquire digital assets that can readily be used as a currency equivalent in the existing marketplace may reasonably be assumed to have acquired those assets with the intent to spend them, rather than to hold them for their investment potential. Such a showing defeats the required element of an expectation of profits.

Second, SEC leadership has likewise highlighted the importance of a digital asset with a diversified control structure, so that the success of the enterprise does not hinge principally on one private operator alone. Many have misconstrued this emphasis on “decentralization” to suggest the misplaced notion that a digital asset cannot have a central entity or coordinated group responsible for maintaining the blockchain code.

Such an expectation would create an impossible and counterproductive standard. At a minimum, blockchain code — as with any software code — requires constant maintenance to protect it from hackers and other security risks. Such maintenance cannot be achieved effectively and efficiently without centralized leadership guiding that effort.

A more intuitive reading of these comments leads to the obvious conclusion that decentralization does not require the absence of centralized maintenance of a digital asset’s blockchain, but rather a structure that places responsibility for the success of the enterprise across a diverse array of market participants.

Bitcoin does this by design. Specifically, a central and defining aspect of Bitcoin — that transactions must be processed by a network of miners —distinguishes Bitcoin from a vast array of other digital assets whose distributions are controlled directly by the issuer. Indeed, Gensler himself highlighted the importance of mining as a distinguishing feature of Bitcoin in his 2018 speech at MIT.

The Mining Structure

Among other reasons, the mining structure is important because it naturally defeats the required showing under the Howey test that investors’ reasonable expectation of profits turn principally on the managerial or entrepreneurial efforts of a central third party. Indeed, without miners willing to operate nodes and process transactions, the Bitcoin network could not function.

Accordingly, these services, provided by a diverse array of unrelated entities central to the success of the network, are undeniably significant.

Thus, the commission’s leaders can provide meaningful and much-needed clarity to the digital asset industry by building on their prior remarks and formalizing those remarks into binding guidance.

Specifically, the SEC should, through its rulemaking authority, make clear that a digital asset does not qualify as a security if it operates currently (or from inception) as a currency equivalent with an existing marketplace for everyday transactions and is distributed by a mining network responsible for processing and validating transactions.

Such clarity would significantly reduce the investment risk for market participants to make the costly upfront investment in powerful and innovative technology that builds on those digital assets that have these critical attributes.

Indeed, these modest assurances have the power to unleash unlimited, large-scale innovation that can transform our everyday lives. The Biden administration has a unique opportunity to provide the foundation for this transformational technology. We hope it won’t miss the moment.

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The views expressed in this commentary piece are those of the authors and do not reflect the view of Cozen O’Connor or the firm’s clients.


Chris Bellini is a member of Cozen O’Connor and is based in Minneapolis. Chris concentrates his practice on securities and compliance issues, mergers and acquisitions and private equity transactions. 

Kara Kapp is a member in Cozen O’Connor’s White Collar Practice and is based in Washington, D.C., and Chicago. Kara provides clients with proactive compliance advice and represents clients before federal regulators in white-collar matters, including those related to the cryptocurrency and financial industries.