The debate on whether cryptocurrencies are considered securities is still ongoing. Being that this is a more than $1.6 trillion dollar industry, of course the Securities and Exchange Commission (“SEC”) has an interest in protecting users and investors alike. Similar to most discussions surrounding what is and what is not a security, the answer is not as straightforward as one would like.
A cryptocurrency (“crypto”) is a digital form of currency that people can use to buy goods or services. There are more than 6,700 cryptocurrencies that are publicly traded. Interestingly, senior SEC officials have made statements concluding that Bitcoin is not considered a security—at least for now. The reason being is that Bitcoin does not constitute an investment contract per the Howey test analysis. When determining whether or not a cryptocurrency is a security, the SEC applies the infamous Howey test. If a crypto asset meets the three prongs of the Howey test, then it will need to follow the disclosure and regulatory requirements issued by the SEC.
Bitcoin is one of the largest and most notable cryptocurrencies. One Bitcoin is currently valued at $59,941. Bitcoin, much like many other cryptocurrencies, is operated by a decentralized authority. Unlike traditional financial and governmental systems where there is a central authority that governs, in the crypto space power is spread amongst multiple points, not a single authority. This has made cryptocurrency so appealing. It is traded, distributed, and stored using blockchain technology. Blockchain supports Bitcoin and other cryptocurrencies by storing and recording transactions between parties in a verifiable way. This ensures transparency and protects against deletion or tampering.
Unlike Bitcoin, however, other cryptocurrencies may be found to be a security under federal securities laws. Just because something is labeled as a “virtual currency,” “cryptocurrency,” or “digital asset,” it is not determinative of whether or not it is in fact a security. Obviously traditional debt or equity securities that happen to be digitized are still securities, i.e. investment contracts. What matters is the substance of the cryptocurrency. This is where the application of the Howey test comes into play.
In the infamous SEC v. W.J. Howey case, the Supreme Court determined that investors who purchased interests in an orange grove, although passive, relied on the developer’s best efforts to service the groves and as such, these interests were deemed as an investment contract, i.e. a security. In the context of cryptocurrencies, a transaction is an investment contract or a security if all three of the following prongs are met: (1) there is an investment of money; (2) in a common enterprise; (3) with an expectation of profits predominantly from the efforts of others. A Howey test analysis can be extremely complex and daunting. One should consult with a securities lawyer to help determine whether a cryptocurrency is a security in need of registration or an exemption from registration with the SEC through the application of the Howey test.
In contrast, the SEC has addressed initial coin offerings (“ICOs”) as being most likely a securities offering. Based on the structure of an ICO, which generally involves a promotion of an offer and sale of securities, the SEC reasons that it requires regulatory oversight in order to to protect investors. An ICO is used to raise money for a startup company interested in creating a new coin, token, or service in the crypto space. When investors buy into the offering they are able to receive a cryptocurrency token from that company. (Read more about tokens, specifically NFTs in our blog “The Intersection Between NFTs, Cryptocurrencies, and Securities”) Sounds familiar doesn’t it? This is similar to an initial public offering commonly known as an IPO.
The SEC warns investors to be careful when getting involved in ICOs. If there is an offer to invest in a startup crypto company, then the offering must be registered with the SEC or meet an exemption from registration per SEC guidelines. It is important to consult with an experienced securities attorney before issuing an ICO to verify you are following federal laws and regulations. Because there have been instances of fraudulent ICOs and manipulation, it is imperative that you do not mislead investors. In August 2020, the SEC filed charges against Boon.Tech, a virginia-based crypto company and its CEO Rajesh Pavithran, for issuing a fraudulent ICO and failing to follow federal registration requirements. Boon.Tech led investors to believe that it had innovative patent-pending technology to leverage Boon Coins against the U.S. dollar, when in fact it did not.
In addition to misleading investors, individuals were buying and selling Boon Coins as an investment contract, but the company did not register the offering with the SEC. Boon.Tech had to return the $5 million raised, plus $600,334 interest, and destroy all Boon Coins in their possession. Pavithran was fined a hefty $150,000 and is prohibited from being an officer or board member of a public company. The Boon.Tech case is one example of many, about how crucial it is to seek guidance from a securities attorney if you are interested in getting involved in this crypto space. To learn more about your options and how to protect your business in cryptocurrencies offerings schedule a consultation with us today.
*co-authored by Elizabeth L. Carter. Esq., , Managing Attorney