NEW YORK (Reuters Breakingviews) - Investors in crypto-currencies may be in for a surprise. To hear the U.S. Securities and Exchange Commission and other regulators tell it, many initial coin offerings – or ICOs – of digital tokens like bitcoin are actually securities, and subject to rigorous rules. That’s far from clear, though, judging from a handful of cases making their way through the courts. A ruling against the government could add to the confusion.
ICOs clearly befuddle legal experts as much as they do many seasoned investors. They’re an increasingly popular way to finance projects by issuing virtual coins conferring purchasers some value, or right, with respect to the project. ICOs raised some $6.5 billion last year, according to research firm Token Report. They are on pace to triple that this year.
They are, unfortunately, a magnet for fraudsters. The SEC has so far slapped at least four companies with charges of offering unregistered securities and lying about their operations or expected financial returns. A fifth company, Overstock.com, disclosed this month that the watchdog was investigating its planned $250 million ICO, one of dozens of similar probes.
The fate of these and other cases – and of the ICO industry itself – could come down to an issue of orange trees. More than seven decades ago, the SEC sued W.J. Howey Co for peddling plots of Florida citrus groves that the company would tend and share the profits from pursuant to a services contract. Howey said it was just selling land and services, but the Supreme Court ruled that it was actually offering securities through an investment contract. The test: The property buyers invested money in a common enterprise and expected to profit solely from someone else’s efforts. Failing to register the contracts was illegal, the justices concluded.
ICOs meet the test, the SEC argues, because they typically involve selling digital tokens as investments in some third-party endeavor expected to make a profit. Like many judge-created standards, though, this one is fuzzy enough to generate plenty of uncertainty.
Take the cases playing out in Brooklyn federal court against Maksim Zaslavskiy and his companies, REcoin Group Foundation and Diamond Reserve Club World, or DRC. The SEC and criminal prosecutors claim the businessman promised potential purchasers in two ICOs that they would profit from non-existent real estate or diamond investments and from the demand-driven increase in the value of the crypto-currencies being offered. Zaslavskiy is charged with conspiracy to commit securities fraud and, by the SEC, of illegally offering unregistered securities.
Earlier this month, though, Zaslavskiy moved to dismiss the criminal charges, arguing that crypto-currencies aren’t securities. They are, he says, simply a currency – a store of value or medium of exchange used to buy things – and explicitly exempt from the securities laws.
What’s more, he contends, the REcoin and DRC ICOs didn’t meet the Supreme Court’s Howey test. First, there was no investment involved, only the exchange of one currency for another that happened to be backed by real estate or diamonds, just as the dollar was once backed by gold. Second, there was no common enterprise, because one buyer’s fortunes weren’t tied to those of another. And finally, the value of the digital currency depended not on the efforts of Zaslavskiy or his businesses but on the willingness of each buyer to use the tokens as a medium of exchange. The more they were used, the more they would be worth.
The arguments are clever, if a bit of a stretch. Prospective purchasers were supposedly led to expect a profit if the real-estate and diamond investments panned out, suggesting a common enterprise dependent on Zaslavskiy’s acumen, and, in any event, the allegedly fraudulent aspects of the scheme undermine his case. He seems correct, though, that no federal court has ruled that crypto-currencies are securities. The court in Brooklyn could be the first, after prosecutors get a chance to respond on Monday to Zaslavskiy’s dismissal motion. And there’s enough wiggle room in the law for the judge to go either way.
That’s a problem in itself, as Zaslavskiy also points out. Enacted in the 1930s, the federal securities laws were never a model of precision, but at least they list what qualifies as a security. Crypto-currencies are, naturally, not mentioned, and hundreds of variations have been issued in the past decade without being registered. Whether any should have been registered “depends on the facts,” SEC Commissioner Jay Clayton said last December. That’s cold comfort for issuers attempting to navigate new legal territory.
It seems almost futile to expect a fractious Congress to accomplish much. The Senate Banking Committee held hearings on virtual currencies last month, however, so lawmakers may be interested enough in the topic to enact rules allowing regulators to say what is and isn’t permitted. A useful start would be a sharper definition of “investment contract,” which would stop courts from concocting their own versions of the Howey test.
Despite these legal gaps, bitcoin and its ilk are subject to at least some regulation. A federal judge in Brooklyn confirmed this month, for example, they are commodities within the remit of the Commodity Futures Trading Commission. The SEC is, however, the lead enforcer in American financial markets and needs clearer laws to do its job properly. Maybe a federal judge can help supply them. But with the jury still out, Congress has its chance to step in.