ATTORNEY: SAMUEL J. ADAMS
POMERANTZ MONITOR JULY/AUGUST 2018
A recent spike in interest surrounding cryptocurrencies has left investors wondering whether or not the federal securities laws apply to transactions involving digital currency such as Bitcoin and Ether. As noted in previous Monitor articles, broadly speaking, cryptocurrency is a form of payment that can be exchanged online, with digital “tokens,” for goods and services. Unlike traditional currency, cryptocurrency exists solely in the digital realm and is not backed by any government or central banking entity. Interest in cryptocurrency reached a fever pitch in 2017, as cryptocurrencies, such as Bitcoin, experienced dramatic increases in value. By way of example, one Bitcoin traded for approximately $1,000 in January 2017 and reached a high of $19,500 in December 2017. In July 2018, the currency dipped below $6,000 per Bitcoin, and the price continues to fluctuate. Given such volatility, speculators have started purchasing cryptocurrencies as investments. In determining whether the federal securities laws apply to these purchases and sales, the salient question is whether purchasers are investing in the currencies themselves or in the network or platform on which they run. The backbone of the cryptocurrency ecosystem is a decentralized technology known as blockchain, which is spread across many computers that manage and record transactions in cryptocurrency. Bitcoin, the original cryptocurrency, was developed as a “peer-to-peer electronic cash system” and allows online Bitcoin payments to be sent directly to a party without the involvement of any financial institution or other third party. Similar, but slightly different, is the Ethereum blockchain, for which Ether is the underlying token. Although Ether is traded on public markets, it was not intended to be a unit of currency on a peer-to-peer payment network; rather, it is a necessary input, often called the “native asset,” used to pay the Ethereum platform, a decentralized world computer upon which users can build and run applications, to perform certain tasks. For this reason, Ether is sometimes characterized as a cryptocommodity rather than a cryptocurrency, but it can and does function like a cryptocurrency in many respects. In terms of market value, Ether and Bitcoin are the two largest cryptocurrencies or tokens currently available to investors. In an effort to clear up confusion, William Hinman, director of the SEC’s division of corporation finance, recently stated that transactions in Bitcoin and Ether are not subject to federal securities laws, calming concerns that the SEC may seek to regulate these transactions. In prepared remarks delivered on June 14, 2018, Hinman noted that, in determining whether a cryptocurrency is a security, a central consideration is how the cryptocurrency is being sold and the “reasonable expectations of purchasers.” For example, where cryptocurrency is being sold chiefly as an investment in an enterprise or cryptocurrency platform, as is the case in some Initial Coin Offerings (“ICO”), the SEC takes the position that the transaction is a securities offering subject to the federal securities laws and should be registered. Conversely, once a sufficiently decentralized network for the exchange of a cryptocurrency has been established, such that it would be difficult to even identify an issuer or promoter to make the requisite disclosures to investors, sales of the cryptocurrencies will not be subject to the federal securities laws. Hinman noted that “the network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception.” Hinman added that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” Finally, Hinman left the door open to other digital currencies escaping SEC scrutiny, stating that “over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” The price of Bitcoin and Ether both increased on this news. Hinman also laid out a roadmap of sorts for establishing a cryptocurrency exchange and insuring that investors have clear expectations regarding their cryptocurrency transactions. In order to get an exchange off the ground, Himan suggested raising initial funding through a registered or exempt equity or debt offering, rather than an ICO. After the network has already been established and is sufficiently decentralized, tokens or cryptocurrency can then be offered in a manner whereby it is evident that purchasers are not making an investment in the development of the cryptocurrency network, but rather are purchasing an asset used to purchase a good or service. While the current state of play for Bitcoin and Ether appears to be settled, at least from the perspective of the SEC, there is sure to be confusion going forward as additional forms of cryptocurrency proliferate and new exchanges lure additional investment.