Unpacking the complexities of cryptoassets: Are they securities or not?

We often hear from regulators that they view most cryptoassets as securities, and as such these cryptoassets must be registered with the US Securities and Exchange Commission if they are to be offered to the public or held by more than 500 “retail” investors. This latter test in particular is likely to capture most of the large-cap cryptoassets available today on Coinbase and other leading marketplaces, even if the assets were not originally offered to the public.

So what should we do about this? Is the fact that almost no crypto assets are registered just a result of intransigence and a desire to evade the law? Or is there more to the story?

Lewis Cohen is co-founder of DLx Law. This article is part of CoinDesk’s Politics week.

We recently wrote a long article on this topic titled “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities” in which we reviewed all of the appellate case law on the subject of “investment contracts” (a unique type of security defined not by Congress, but in a famous Supreme Court case known as SEC v. WJ Howey and Co.). When cryptoassets are categorized as “securities” it is to this definition that regulators and courts generally look.

As we explain in “Ineluctable Modality,” the SEC and state regulators have won nearly every case they have brought involving fundraising transactions in which cryptoassets are sold to raise money for the development of a blockchain project. However, there have yet to be any significant court cases where the status of a crypto-asset independent of a fundraising transaction has been presented to a court.

Most cryptoassets do not create a legal relationship between an identifiable “issuer” and the owner of the asset. We would argue that cryptoassets are not in themselves “securities” under applicable law. (We also argue that characterizing cryptoassets as “temporary” securities until external factors such as “sufficient decentralization” cause them to “transform” into non-securities is not supported by current law and would be bad policy if adopted by courts. )

But suppose a court were to find a popular crypto asset a collateral, at least temporarily. What would happen next? This is where things get interesting.

Our federal securities laws are built around a basic premise – that behind every security there is an issuer. Because cryptoassets such as ETH, AVAX, ADA, DOGE and SOL do not create a legal relationship with any entity, the first task will be to determine which legal entity should be treated as the “issuer”. The first place to look would be the entity that implemented the smart contracts that started the network. However, as this is a purely administrative task, it is often delegated to an insignificant company or trust which is often dissolved after this one task is completed.

More likely, regulators will look to the entity that received the proceeds from the sale of cryptoassets and used them to develop or continue work on the related project. However, it is not unusual for several units to receive income from the sale of assets. Although there is usually one legal entity (often referred to as “[Project Name] Labs”), which receive the single largest share of sales revenue, this is not always the case. Also, projects in the future may choose to avoid an entity receiving a significant amount of revenue, further complicating the task of identifying a proxy issuer for compliance purposes.

Even if an entity has been deemed the “issuer” of a cryptoasset, that entity and the individuals acting as its managers and directors will have to assume responsibilities that will often be of little or no relevance to the owners of the cryptoasset. This is because, unlike shares in a company or debt obligations of a company, the value of a digital asset can only be very tangentially related to the issuer’s business or its financial condition.

Among other things, they must:

In addition, there are countless provisions in US securities laws that are opaque at best and nonsensical at worst when applied to crypto. This includes disclosures of where and how cryptoassets will be allowed to trade, how custody rules will be applied, whether a “transfer agent” will be required (and how that may apply), margin rules, settlement rules, broker-dealer rules, investment company and investment adviser rules, and many others.

Not only are there many practical challenges here when it comes to mapping out requirements meant for traditional businesses to be considered issuers of cryptoassets, there is the larger question of why a company or group of individuals would want to take on this responsibility when they also do not have access to all information relevant to the crypto-asset and is also not compensated for taking on these many potential liabilities. In fact, just the process of imposing these obligations and then incentivizing those responsible will fundamentally change the dynamics of the project and essentially recreate the current structure of centralized platforms.

Even imagining that an entity can be found to act as an issuer and the stakeholders involved are willing to assume all the responsibilities of an issuer of public securities, a final hurdle remains.

If a crypto-asset is treated as a security, it will only be tradable on a national stock exchange (basically the New York Stock Exchange or Nasdaq) or in an exempt alternative trading system (ATS) approved by FINRA, the securities themselves. – regulatory organisation. At least at this point, there is no possibility of crypto-assets being listed on a national stock exchange, and there are only a handful of ATSs approved by FINRA to trade digital securities.

Even more, as recognized “securities”, the assets may not be able to trade in offshore crypto-asset markets or decentralized exchanges (DEX), functionally eliminating liquidity for the asset and likely reducing its price, which ironically harms those investors for whom the securities laws were intended. to protect.

The bottom line is that without a radical overhaul of our entire securities laws, it is very difficult to see how most cryptoassets can practically function as securities and still retain their intended purpose.

Instead, a solution along the lines of Title III of the Lummis-Gillibrand Responsible Financial Innovation Act would make much more sense. That title would add a new section to the securities laws that imposes reasonable disclosure requirements on those companies that raise money through the sale of cryptoassets without attempting to treat the cryptoassets themselves as securities.