Chalk and Cheese: When Crypto Assets Meet the Securities Laws

We frequently hear from regulators that they view most crypto assets as securities and, as such, those crypto assets need to be registered with the U.S. Securities and Exchange Commission if they are to be offered to the general public or held by more than 500 “retail” investors. This latter test, in particular, would likely ensnare most large-cap crypto assets available today on Coinbase and other leading marketplaces, even if the assets were not originally offered to the public.

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

Lewis Cohen is the co-founder of DLx Law. This article is part of CoinDesk’s Policy Week.

When are crypto assets securities?

We recently wrote a lengthy paper on this topic entitled “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities” for which we reviewed the entire body of 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. W.J. Howey and Co.). When crypto assets 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 almost all cases they have brought involving fundraising transactions in which crypto assets are sold to raise money for the development of a blockchain project. However, there have been no significant court cases yet in which the status of a crypto asset independent of a fundraising transaction has been presented to a court.

See also: Are Crypto Assets Securities? / Opinion

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

Compliance conundrum

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

Our federal securities laws are built around a fundamental premise – that behind every security, there lies an issuer. Because crypto assets like ETH, AVAX, ADA, DOGE and SOL do not create a legal relationship with any entity, the first task would be to determine which legal entity to treat as the “issuer.” The first place to look would be to the entity that deployed the smart contracts that initiated the network. However, as this is a purely administrative task it is often delegated to an inconsequential company or trust that is frequently dissolved after this one task has been completed.

See also: After FTX: How Congress Is Gearing Up to Regulate Crypto

More likely, regulators would look to the entity that received the proceeds of the sales of the crypto asset and used them to develop or continue work on the related project. However, it is not uncommon for multiple entities to receive proceeds from the asset sale. Although there is commonly one legal entity (frequently referred to as “[Project Name] Labs”) that receives the single largest portion of the sale proceeds, this is not always the case. Moreover, in the future projects may choose to avoid having any one entity receive a significant amount of proceeds, further complicating the task of identifying a proxy issuer for compliance purposes.

Who’s responsible here?

Even if an entity has been deemed the “issuer” of a crypto asset, that entity and the individuals who act as its officers and directors will have to take on responsibilities that will frequently either be of little or no relevance to owners of the crypto asset. This is because, unlike with shares in a company or debt obligations of a company, the value of a digital asset may only be very tangentially related to the issuer’s operations or its financial condition.

Among other things, they will need to:

• Prepare audited financial statements (as well as “internal controls over financial reporting”)
• File CEO and chief financial officer (CFO) certifications
• Hire a compliance team to prepare and file quarterly and annual reports as well as current reports required when unexpected developments occur
• Comply with Regulation FD, which addresses the problem of “selective disclosure” of company information (and presumes that this information is relevant to an issued security)
• Hold annual meetings of its “security holders” and prepare proxy statement disclosure in advance

Additionally, there are myriad provisions in U.S. securities laws that are at best opaque and at worst nonsensical, when applied to crypto. This includes disclosures for where and how crypto assets would be allowed to trade, how custody rules would be applied, whether a “transfer agent” would be needed (and how that could possible apply), margin rules, settlement rules, broker-dealer rules, investment company and investment advisor rules and many others.

Not only are there numerous practical challenges here in mapping requirements intended for traditional businesses to deemed issuers of crypto assets, there is the larger question of why any company or group of individuals would want to take on these responsibilities when they neither have access to all information relevant to the crypto asset nor are being compensated for taking on these many potential liabilities. In fact, the mere process of imposing these liabilities and then incentivizing those responsible will fundamentally change the dynamics of the project and essentially replicate the current structure of centralized platforms.

Looking for Mr. Goodmarket

Even imaging that an entity can be found to act as issuer and the stakeholders involved are willing to take on all of 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 able to be traded on a national securities exchange (basically, New York Stock Exchange or Nasdaq) or in an exempt alternative trading system (ATS) approved by FINRA, the securities self-regulatory organization. At least at this time there is no possibility of crypto assets being listed on a national securities exchange and there are only a handful of ATSs approved by FINRA to deal in digital asset securities.

See also: What If Regulators Wrote Rules for Crypto? / Opinion

Even more, as acknowledged “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 tanking the price, ironically hurting the very investors the securities laws were intended to protect.

Practically function

The bottom line is that, without a radical re-imagining of the entirety of our securities laws, it is very difficult to see how most crypto assets can practically function as securities and still keep 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 sensible disclosure requirements on those companies that fundraise through the sale of crypto assets without attempting to treat the crypto assets themselves as securities.