On September 29, 2023, Paradigm filed an amicus brief in the ongoing lawsuit between the U.S. Securities and Exchange Commission (SEC) and Binance, a leading cryptocurrency exchange. Paradigm is not an investor in Binance and has no direct financial interest in the lawsuit’s outcome. However, the firm believes that the SEC’s actions represent a form of government overreach that could have significant implications for the broader financial and crypto markets.
The SEC initiated legal action against Binance in June 2023, accusing the exchange of multiple violations of securities laws. These include operating without the necessary licenses and registrations as an exchange, broker-dealer, or clearing agency. The SEC’s investigation into Binance began in May 2023. In its amicus brief, Paradigm argues that the SEC is attempting to change existing laws without adhering to the established rulemaking process, thereby acting outside its regulatory scope.
Paradigm’s brief raises several critical points that challenge the SEC’s interpretation of securities law. The firm argues that the SEC’s expansive interpretation of “investment contract” could bring a wide range of asset sales under the purview of securities laws. Paradigm also highlights flaws in the SEC’s application of the Howey test, a legal standard used to determine what constitutes a security.
Circle, a stablecoin services company specializing in blockchain technology, has also been brought into the legal battle between Binance and the SEC as well. Circle argues that stablecoins, a type of cryptocurrency designed to maintain a stable value, should not be treated as securities, adding another dimension to the ongoing case.
Paradigm emphasizes that regulatory gaps do exist in the crypto sector and that it is Congress’s responsibility to fill these gaps. This perspective aligns with SEC Chair Gary Gensler’s Congressional testimony, where he acknowledged the SEC’s limitations in regulating crypto secondary markets.
Paradigm’s amicus brief serves as a significant counterpoint to the SEC’s actions against Binance and other crypto exchanges. By challenging the SEC’s authority and interpretation of securities law, Paradigm adds a layer of complexity to an already intricate legal landscape. The firm’s stance could potentially influence how securities laws are applied to the crypto industry in the future.
Cryptocurrencies occupy a bizarre and gray portion of the legal landscape. This is partly due to their novelty. Quite simply, blockchain technology and its accompanying cryptocurrencies haven’t been a part of the landscape long enough for banks and regulatory agencies to make much sense of them.
This is also partly due to their anti-authoritarian nature. In the ur-example – Satoshi Nakamoto’s white paper introducing Bitcoin – one of the fundamental reasons a cryptocurrency has for existing is skirting third-party regulation.
Indeed, that’s what separates cryptocurrencies from other financial instruments. Via a distributed ledger on a blockchain, the currency provides its own internal regulation and enforcement.
That’s the ideal situation, anyway. In the real financial world, the situation is considerably more complex. The U.S. Internal Revenue Service has already clarified that trading cryptocurrencies is a taxable event.
Moreover, the U.S. Securities and Exchange Commission (SEC) has deemed that cryptocurrencies pass the Howey Test, are therefore securities, and are therefore subject to securities regulation.
Let’s take a look at the Howey Test, how it applies to cryptocurrencies, and how it impacts the market moving forward.
The Howey Test
The genesis of the Howey Test was a 1946 Supreme Court case. In the case, the titular W.J. Howey Company sold citrus grove plots to outside investors. Howey and the investors reached an arrangement whereby the buyers would immediately lease the groves back to Howey, which would harvest and sell the resulting citrus products.
The Supreme Court ruled the citrus groves, in this case, to constitute an investment contract and, thus, a security. It applied four main criteria in making this decision, which subsequently became known as the Howey Test.
In order for a financial instrument to be dubbed a security and fall under the purview of the SEC, the instrument must meet these four criteria:
It must be an investment of money
With an expectation of profit
In a common enterprise
With the profit to be generated by a third party.
The Howey Test, Image from RealEstateCE
The citrus grove in the precedent was bought with money and an expectation of profit by a pool of common investors, and its success depended on Howey’s ability to profitably make money from selling its citrus products.
Stocks are a more familiar type of security, and they also pass the Howey Test. A share in U.S. Steel is bought with money in the hopes that the share will eventually be worth at least as much as its initial purchase price. This is done in a pool with other investors, and they are at the mercy of U.S. Steel’s board of directors when it comes to profits.
That last bit is key. The hammer of securities regulation comes down when the investor can’t do much of anything to impact whether an investment turns a profit. Ostensibly, the registration and financial reporting requirements that go along with regulation are to protect investors from predatory scams.
Again, that’s how it works in an ideal world, with large companies employing the kind of high-priced attorneys and accounts needed to comply with regulation.
Cryptocurrency initial coin offerings turn that established system on its head. The developers of coins are not huge multinational corporations but small startups – sometimes, just a single person. They do not have the financial, political, or legal clout to do their own research, so to speak, on whether their initial coin offering complies with applicable security regulations.
In fact, up until 2017, it wasn’t clear whether cryptocurrencies were securities at all.
The DAO
A German group founded The DAO and held a token sale in 2016. This token was then attacked by hackers, forcing a fork in the Ethereum blockchain.
While the SEC chose not to take enforcement actions against The DAO, it issued a statement in July 2017 that clarified that henceforth, all cryptocurrencies were to be treated as securities.
“These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology,” the SEC wrote. “In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.”
The apparent blockbuster in the legalese was that unregistered crypto initial coin offerings were illegal, and so U.S. citizens are barred from participating in them. Cryptocurrency developers working in coffee shops and basements had been lumped in legally with major corporations and banks.
This provoked an immediate outburst from the cryptocurrency community, who said that bringing initial coin offerings under the aegis of the SEC risked stifling growth in the potentially explosive industry.
First of all, critics argue, it is not immediately clear that all tokens are securities. The SEC’s report was worded in such a way to deem The DAO a security, but not necessarily all cryptocurrencies. Some may fall short of the Howey Test, although the onus is on developers to prove that.
Secondly, the barriers to entry for coin developers are substantially raised if they indeed are securities. Coins often depend on an initial coin offering for an injection of liquidity to give the project a head start. If those offerings cannot be held without first diving through expensive regulatory hoops, the project risks dying on the vine.
Moving Forward
Like most aspects of the crypto sphere, it is unclear what exactly comes next. The SEC hasn’t issued any more detailed reports on cryptocurrencies, and that might be deliberate; at least some industry watchers are applauding the SEC for using a relatively light touch to allow wiggle room for the crypto community to sort out what, exactly, it is.
Moreover, by not painting all crypto coins with the same brush, the SEC has put the ball in developers’ courts to prove that they are not, in fact, operating a security.
That’s an expensive ball, indeed, and it certainly puts a damper on the Wild West atmosphere of initial coin offerings – at least in the U.S.
This might indeed work in favor of the market as a whole. Coinmarketcap.com alone lists more than 1,600 coins, some of them extremely problematic in terms of use case and even sincerity.
The word “scam” gets tossed around in the crypto sphere far more often than it should due to projects that seem to appear, pump, and disappear without a trace. Shady developers and pump-and-dump groups lurk in the nonregulated shadows.
A measure of legitimacy, and perhaps institutional money, might come with more stringent regulatory rules.
The cost, of course, is the laissez-faire development atmosphere.
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Speaking at Draper Goren Holm’s Security Token Summit on March 25, SEC commissioner Hester Peirce, also known as “Crypto Mom” warned the issuers of fractionalized non-fungible tokens and NFT index baskets that they could inadvertently be distributing investment products.
While Peirce stated that “the whole concept of an NFT is supposed to be non-fungible” — meaning that “in general, it’s less likely to be a security” — she noted that “people are being very creative in the type of NFTs they are putting out there.”
Peirce urged NFT issuers to be cautious if they decide to “sell fractional interests” in NFTs or NFT baskets, stating:
“You better be careful that you’re not creating something that’s an investment product — that is a security.”
With NFTs fetching increasingly exorbitant prices, fractionalized interests in these assets enable smaller investors to still be able to gain exposure to a small share of a high-priced NFT. Earlier this month, Cointelegraph reported on two emerging teams offering novel solutions for fractionalizing non-fungible tokens.
Peirce also criticized the use of the Howey Test to assess whether crypto assets are securities, asserting it “hasn’t worked that well” for the industry.
The Howey Test is frequently used by courts to determine whether an asset is a security, with the test being derived from a landmark 1946 court case concerning real estate contracts issued by the owner of a citrus grove to fund the business’ expansion.
Peirce said that if the test was used in the 1946 case in the same way it is applied to crypto, the courts would have been seeking to determine whether the fruit trees were securities, rather the investment contracts relating to the plants.
Peirce noted she hopes to collaborate with incoming SEC chairman Gary Gensler on developing her “safe harbor plan,” which would reduce regulatory scrutiny of emerging blockchain networks.
The safe harbor plan would allow new token issuers a three-year window in which to build a robust and decentralized network and demonstrate securities laws do not apply. The plan would also require that issuers provide detailed plans regarding the network’s roadmap, token sale, and the individuals and investors behind the project.
You have three years to develop the network so that the token is actually usable or the network is decentralized — and at that point, it’s clear the securities laws don’t apply. And everything that you say will be covered by the anti-fraud laws under the securities laws.”
Joe Hall, a former Senior Policy executive at the SEC under the Bush administration, has commented on the Securities and Exchange Commission (SEC)’s decision to sue Ripple for XRP. He, for one, thinks that cryptocurrencies are here to stay.
The lawsuit against Ripple has shook the entire crypto industry, as the outcome of the case will likely influence the way cryptocurrencies are treated in the US. Hall, who is also a partner at Davis Polk, now commented on the agency’s move and its persistence in classifying cryptocurrencies with the Howey Test. He called the SEC’s decision to sue Ripple Labs for ongoing XRP sales “remarkable on several levels.”
XRP fails to be exempted like Ethereum
He suggested that there may have been a disagreement among commissioners on whether to administer a lawsuit for XRP, as it was announced at an unlikely time – just as Jay Clayton was exiting the agency as chairman. With the lawsuit slapped on Ripple Labs, many crypto exchanges and funds have backed away from XRP, causing its market cap to drop significantly. An estimated $14.5 billion in market cap was wiped out following the SEC’s announced plan to pursue Ripple for unregistered securities through XRP.
Hall questioned why XRP did not receive a similar treatment as its fellow cryptocurrency Ethereum. He said that the former director of the SEC’s Division of Corporation Finance Bill Hinman had said that “Ether might have been born a security, but later morphed into a non-security,” and that it would have been a “fair bet” for XRP to receive a similar treatment.
Comparing apples and oranges?
Hall suggests that the SEC’s decision to regulate digital assets with the Howey Test may not be the best approach. The Howey Test essentially measures whether an asset falls under the umbrella term of security. It says that if an asset provides an investor with profit that is based on the efforts of a third party, it is ruled a security.
The Howey Test was previously applied to a citrus grove in Florida, where the oranges sold by the Florida native were deemed securities, as it complied to the test. However, Hall suggested that the Howey Test should not be used for cryptocurrencies like XRP. He said:
“It’s not obvious that the SEC’s approach to regulating crypto should be grounded in metaphors about oranges and principles articulated in a case decided three-quarters of a century ago which – take it from one who knows – is nearly impossible to apply with consistency and predictability across the digital asset class.”
The Davis Polk partner added that it may be impractical to apply securities laws to the whole cryptocurrency market despite the appeal of digital assets as a viable investment. This is due to the dynamic nature of digital assets and the fact that many are transacted on a blockchain with peer-to-peer transactions. He said:
“The regulatory obligations governing transactions in securities make it impractical to use them in many ordinary commercial or peer-to-peer transactions. Digital assets need to flow freely from user to user over a blockchain to enable the exchange of value and information.”
While Hall suggested that some aspects of securities laws could be applicable to digital currencies if they were sold as an investment contract cryptocurrency, he suggested that other aspects were not, as it would defeat the use of a cryptocurrency.
He said it remains a mystery why the SEC decided to pursue XRP as it did, as a loss in XRP’s litigation would “epically damage the SEC’s regulatory project when it comes to digital assets.”
Is the Howey Test outdated?
The SEC’s persistence in applying the Howey Test to cryptocurrencies has been criticized not only by Joe Hall, but by founder of TechCrunch Michael Arrington.
Arrington had suggested that the Howey Test was outdated, as it was “hundred-year-old test” that should therefore not be applicable anymore in a modern world.
