The purpose of this article will not be to give the news that the SEC revealed that they would not deem Ethereum to be a security.
That has already been well-established by multiple outlets.
Instead, however, the purpose of this news will be to dissect the SEC’s decision and try to make an educated deduction, based on what they have stated, on how they might rule on other cryptocurrencies in the near future.
This article will also look at other factors/facets of the SEC in order to gauge the likelihood that expansive, drastic/blackswan-like measures could/will be implemented any time in the near or distant-future (wow, that was a mouthful!).
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So, let’s get started:
As stated in the preface, the SEC recently came to the conclusion that Ethereum would not be considered a security by the commission — this decision came on June 14th.
I won’t dig too much into the after-shock that this had on the market (it looks like this exuberance has already died, however).
Instead, I’d like to get a little bit more into the actual language of the decision itself as well as the individual that made the statement.
You can find the actual text of the statement that was made by William Hinman, the Director of the Division of Corporate Finance for the SEC:
Now, let’s clarify a couple of things before we deep dive into this press release/statement/remark made by Director Hinman.
What is the Role of the Director of Division of Corporation Finance?
Fortunately, the SEC was kind enough to grant a full description for the purpose of this branch of their agency here:
- The “Division of Corporation Finance seeks to ensure that investors are provided with material information in order to make informed investment decisions, both when a company initially offers its securities to the public and on an ongoing basis as it continues to give information to the marketplace.”
- “Through the Division’s filing review process, we selectively review filings made under Securities Act of 1933 and Securities Exchange Act of 1934 both to monitor and to enhance compliance with disclosure and accounting requirements.”
So, in a nutshell, it appears that this division has the authority to speak on what will be deemed a security or not. I just wanted to provide this clarification so that we could remove any potential anxiety that people may have if they were under the impression that Jay Clayton (chairman of the SEC), or another ‘higher-up’ in the entire department could overrule/reverse the decision at whim.
Digging into the Remarks Made by Director Hinman on June 14th, 2018
The following remarks that we are going to dissect in this article were given by Director Hinman at the “Yahoo! Finance All Markets Summit: Crypto”. This event took place on June 14th, 2018, in San Francisco, California (United States).
So, naturally, as a member of the SEC, securities was a major part of the conversation that day.
I’m going to comb through the entire speech from top to bottom to give us a better idea of what was being said here.
Initial Question Posited by Director Hinman
From the outset, Director Hinman asked a question about something that has been on the minds of many in the crypto community (myself included).
That is: “Whether a digital asset offered as a security can, over time, become something other than a security.”
Director Hinman’s response to this rhetorical question that he posed in his speech was that, “We should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold.”
In These Statements, Director Hinman Outlined Two Major Criteria That the SEC Will Be Using
That gives us two criteria that the SEC will be looking at when they are evaluating whether a cryptocurrency is a security or not.
The following statements by Director Hinman provide even more insight on the SEC’s opinion.
Director Hinman further states,
“To that end, a better line of inquiry is: ‘Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?’ “
In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ‘no’.”
These statements have now helped us identify a third criteria for how the SEC will determine whether a cryptocurrency is a security or not.
Now, to analyze that statement, “In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ‘no’.”
This statement is a bit vague to me, in my opinion. What makes this more confusing is that even the fact that Ethereum wasn’t deemed a security doesn’t really help us to decipher this statement because U.S. law and legal decisions/determinants typically are contingent upon all criteria being satisfied, rather than just one.
What I mean by that above statement is that a cryptocurrency could fail this third criteria and still pass the first two and it would meet the ‘clear’ for not being deemed a security.
Director Hinman goes on to briefly state criteria that will exempt a token from being considered a ‘security’ by the SEC. He does this when he asks,
‘What about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created?’
He then states, “I believe in these cases the answer is a qualified ‘yes’.”
The Answer is ‘Yes’ to What Again?
Remember, this entire line of conversation began with the question:
‘Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?’
So, he’s stating that a cryptocurrency/token that adheres to that exemption criteria that he gave can be sold in a manner that does not constitute an offering of a security.
This stands in pretty direct conflict with some earlier released statements by other senior members of the SEC that contend that “every ICO = security”, but we’ll jump into that a bit later.
What We Know Now Though is That Director Hinman is Asserting That a Token/Crypto is NOT a Security if:
a) There is “no longer” any central enterprise being invested in
OR (major keyword; big difference between ‘or’ and the word ‘and’ — take note)
b) Where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.
Let’s Break Down This Exemption Criteria That Director Hinman Gave
In the first-half of this exemption criteria, I noticed that Director Hinman stated that a token/crypto could/would avoid being labeled a security if there was “no longer” any central enterprise.
He did not say “never” and he also did not stipulate that there could not be a central enterprise at all. Director Hinman merely stated that there could no longer be a central enterprise being invested in.
In my opinion, this strongly implies that:
- Projects will be screwed if they are apprehended while in the ICO phase. I believe that Director Hinman is stating this in the most subtle way possible in order to avoid having this news spread to all sectors of the space, triggering super quick ICO sales to avoid falling under the purview of U.S. regulations.
- Projects can probably exonerate themselves if they do not have a majority stake in the digital asset (i.e., a major pre-mine of 25%+ ; not sure what the threshold would be here that the SEC would use to determine that the token is ‘enriching’ its owners). Perhaps the SEC would want proof that the majority of the team’s funds were coming from a source other than the token itself and that any amount of the token that they did possess was a percentage of the total token supply that one could expect a reasonable investor to possess.
Director Hinman also stated that a cryptocurrency/token would not meet the criteria for being deemed a security if it was
“Sold only to be used to purchase a good or service available through the network on which it was created”
- This more than likely was the criteria that exonerated Ethereum, because it can easily be argued that Ether is purchased for the sole purpose (or its generally intended purpose) to gain access to the ‘services’ of Ethereum (i.e., dAPP development) and not merely to ‘invest in’ or enrich the founders of Ethereum.
- Other platform/dAPP/currency-based tokens that are designed with a very specific and fixed use case that mandates the purchase of said tokens would (or should) fall under this criteria for exemption as well. So, this protects a pretty decent amount of the space if the SEC adheres strictly to Director Hinman’s statements at this summit (remember, he has the authority to make such statements and the SEC largely delegates the responsibility/role of determining what is/isn’t a security to these individuals).
Director Hinman’s Enthusiasm on Cryptocurrency in General
After breaking down this preliminary criteria for determining whether a cryptocurrency is or isn’t a security, Director Hinman then goes on to explain that he is excited, in general, about cryptocurrency.
This is important because it reflects that the individual making these decisions has a favorable outlook on this space, in general.
This is reflected in the following statements when he says that,
“What I believe may be most excited about distributed technology…is, the potential share information, transfer value,and record transactions in a decentralized digital environment. Potential applications include supply chain management, intellectual property rights licensing, stock ownership transfers and countless others. There is real value in creating applications that can be accessed and executed electronically with a public, immutable record and without the need for a trusted third party to verify transactions. Some people believe that this technology will transform e-commerce as we know it. There is excitement and a great deal of speculative interest around this new technology. Unfortunately, there also are cases of fraud. In many regards, it is still ‘early days’.”
From those statements above, it is hard to pedal the narrative that the SEC is somehow anti-crypto or that they have an agenda to destroy the space and undermine those within, despite the claims of John McAfee:
Back to Initial Coin Offerings
As I iterated above, the primary focus of the SEC appears to be on securities offerings — and that is exactly what Director Hinman turned back to after remarking on the potential applications and revolutionary nature of blockchain technology.
Director Hinman went on to state,
“ Promoters, in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument — usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”
What he described above is essential an Initial Coin Offering, to a tee. However, I noticed that they did not call it that and that was probably to stop certain projects in the space from labeling these token sales as something else under the hopes that giving it a different name will allow them to escape from the SEC’s purview.
Director Hinman more or less confirms this theory for me later in the speech when he states that,
“ As an aside, you might ask, given that these token sales often look like securities offerings, why are the promoters choosing to package the investment as a coin or token offering? This is an especially good question if the network on which the token or coin will function is not yet operational. I think there can be a number of reasons. For a while, some believed such labeling might, by itself, remove the transaction from the securities laws. I think people now realize labeling an investment opportunity as a coin or token does not achieve that result.”
Director Hinman states that the above process (which essentially amounts to an ICO) can easily be determined to be a security, per the Howey Test.
Specifically, Director Hinman mentioned that ICOs fail the criteria which stipulates that “An investment of money in a common enterprise with an expectation of profit derived from the efforts of others” would be one of the elements that constitutes an offering/financial instrument or asset as a security, per the SEC’s standards.
This next statement by Director Hinman is important as well:
“ And it is important to reflect on the facts of Howey. A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc. for a return.”
When looking at this, one could interpret it a number of ways. In the above example/case study that Director Hinman gave, it appears that the cultivation of the orchard itself by the main hotel owner is what ended up being the defining feature that made his selling of interests in the citrus grove to his guests a security, rather than a selling of real estate.
Despite the fact that the ‘customers’ of this grove could do things that would help enhance the value of the grove, it was determined that they widely relied upon the hotel owner.
I take this to mean that a cryptocurrency that folks invest in where the utility/benefit of that cryptocurrency is pushed forth primarily by a centralized team, must be deem to be a security.
So, How Does Ethereum Escape This Definition?
My assumption is that, by using the same sort of community-based development model that Bitcoin was birthed on (i.e., any and everyone has the ability to create code/suggestions for the coin and the vast majority of improvements have been sourced by the community rather than a fixed entity or team), Ethereum was able to escape being labeled squarely as a security.
However, if there were some sort of central team running Ethereum and also receiving a profit, then the SEC’s opinion may have been different.
Now, I get that Vitalik and others that are notable members of the community are considered to be the leaders and core developers (literally) of the coin and that may make some folks read this and think, “How the hell is Ethereum not a security?”
However, I think it’s important to note that the SEC is not saying that a core team cannot exist, they just can’t be some sort of pre-defined, immutable structure.
While many may argue that the core team for Ethereum is exactly that, one aspect that must also be considered is whether the purchase of Ethereum could be considered an investment in such efforts.
In other words, when you buy Ethereum, are you making Vitalik comparatively richer, and is that what is enabling him to be able to continue and move development forward on the coin?
Ethereum argued in the negative to the above question, claiming that they had such a small total allocation of the coin, that it could not be construed that a purchase of Ethereum was an investment in a defined security.
Perhaps this argument is what ultimately swayed the SEC.
Director Hinman Mentions That Token Sales Are Also Too Broad in Nature
Director Hinman goes on to state that,
“ Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey — where interests in the groves were sold to hotel guests, not farmers — tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.”
So, given the fact that there is no discrimination in the investors that purchase a given token during a token sale, that, in itself, is one of the proofs the SEC uses to determine that a crypto is a security.
To break this down in a more coherent way — imagine that you go to an arcade. In 2018, most arcades will require that you buy their arcade ‘tokens’ before you can play any of the games there, right? You can’t use your fiat cash or anything else if you wish to play games at the arcade itself.
Per the SEC’s logic, the thing that makes this immune to be considering a securities offering is the fact that the only people buying tokens are the ones that would be attending that arcade to play games that day. You wouldn’t expect individuals to be buying tokens that have absolutely no intentions on attending the arcade.
Conversely, in crypto — the fact that the tokens are purchased by the vast majority of individuals that have absolutely no intentions of using the crypto for the platform in which it was created and the makers of the coin have not directed their token sale in such a way where only the users of that platform would be seeking out the crypto itself.
This assumption I made above is corroborated by the following statements;
“In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”
Most Important Piece of the Entire Speech that Director Hinman Gave
For some reason, this portion of the speech that Director Hinman gave was entirely skipped over by crypto journalists and “mainstream” journalists alike, where he states:
“Returning to the ICOs I am seeing, strictly speaking, the token — or coin or whatever the digital information packet is called — all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security. But under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, if the housing unit is offered with a management contract or other services, it can be a security.”
This is critical because the Director is conveying the fact that these tokens/cryptocurrencies, by themselves, are not necessarily securities — but the offering of said tokens/cryptos via an ICO/crowdfund offering/etc., is a security offering.
This provides substantial credence to my earlier statements that the SEC is not looking to make a sweeping judgment of any and all cryptocurrencies that are in existence at this very moment.
On the contrary, it appears as though they are implicitly suggesting that the cryptocurrencies/tokens that are in circulation now are in the clear entirely, but ICOs themselves are not permissible.
So, essentially, if one wishes to issue a token, that’s no problem.
If one wants to raise funds for said token though, then it falls under the purview of the SEC.
This is a very simple concept that has held consistent with other statements made by the SEC/CFTC and other governing bodies in recent months regarding this matter.
Director Hinman also states why the SEC is adamant about cracking down on ICOs as well:
“The digital asset itself is simply code. But the way it is sold — as part of an investment; to non-users; by promoters to develop the enterprise — can be, and, in that context, most often is, a security — because it evidences an investment contract. And regulating these transactions as securities transactions makes sense. The impetus of the Securities Act is to remove the information asymmetry between promoters and investors. In a public distribution, the Securities Act prescribes the information investors need to make an informed investment decision, and the promoter is liable for material misstatements in the offering materials.
These are important safeguards, and they are appropriate for most ICOs. The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise — and the ability to realize a profit on the investment — turns on the efforts of the third party. So learning material information about the third party — its background, financing, plans, financial stake and so forth — is a prerequisite to making an informed investment decision. Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk.”
To summarize, this is essentially the SEC continuing to crackdown on any and all ICO scams in an attempt to ensure that investors have all necessary background information before investing in certain projects.
And given the slew of bullshit and fraud that has polluted the space in the last two years via ICO, its hard to argue that the government is really overstepping their bounds here in attempting to regulate/filter this content out.
To assume that the government(s) was/were going to sit by idly and watch as hundreds of millions, if not billions, are being scammed from investors and not do anything is wishful thinking at best. If that were the case, then the issues we’re facing are much greater than the potential utility of cryptocurrency.
Society must be governed by some extent of law and order and governments, by their very nature, must be expected to adhere to those same laws and orders.
Director Hinman States Why He Believes Bitcoin is Not a Security
Toward the end of the speech, Director Hinman provides his logic for why he believes that Bitcoin is not a security when he states,
“ And so, when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
So, to summarize, the director’s reasoning for why he did not feel that Bitcoin was a security was:
- No Central, Third-Party whose efforts are a “key determining factor” in the enterprise.
- The network on which Bitcoin functions on is operational and “appears to have been decentralized for some time”.
- “Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
The third and last statement is critical, in my opinion. That’s the SEC basically admitting that the inability to enforce securities laws is, in itself, a reason why they would not impose securities laws (essentially, they’re saving face in that regard).
Director Hinman States Why He Believes Ethereum is Not a Security
The Director was pretty explicit in his statement on Ethereum, stating that,
“ And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”
To break this down, Director Hinman’s reason for stating that Ethereum is not a considered were predicated upon the following points:
- “Putting aside the fundraising of Ether” = I don’t want this statement to be misconstrued as a tacit endorsement of the ICO that Ether launched, but since they are no longer in the fundraising phase, I will not consider this in my verdict (which establishes that the SEC must look at coins in their present state).
- The Ethereum network and its decentralized structure, current sales of Ether are not securities transactions.
For the second point — I think it’s important to note that the decentralized structure appears to be a major facet of what precludes Ethereum from continuing to be labeled as a security. Thus, if Ethereum is not a security — then no exchange that is selling Ethereum can be considered to be in danger.
Once again, this drills home the point that tokens that are not in ICOs will more than likely widely be considered to be ‘safe’. However, if a token is in an ICO phase, it is more than likely to be labeled as a security.
This is just part 1 of the article, as there is another aspect of this decision that I want to get to, but this should serve as a pretty thorough overview of the SEC’s decision for the time being.
Please do not consider this to be the conclusion statements of this statements and stay tuned for the follow-up to this piece, coming soon!