Virtual Money and the SEC

It has been a while since my last post but end of year is pretty busy for attorneys.  I have been collecting items about which I want to share my views, however, and this is the first of a brief series of posts which caught my attention as matters of general interest.

Everyone reads almost daily that the SEC has shut down some virtual currency deal as involving the illegal sale of unregistered securities.  Yet Bitcoin and Ether are still around, which means they are not perceived to involve a security.  Why is that?  Both use block-chain and are distributed ledgers.  Both contemplate so-called smart contracts.  Both purport to be a currency but are highly volatile.

Let us go back to the seminal Supreme Court case defining a security, Howey, in the mid-40s.  A security is an investment utilized to finance an enterprise of some sort wherein the investor expects to make a profit from the efforts of others.  The ’33 Act has specific  examples, including stocks and notes, but Howey found a security existed in a management contract to run orange groves that the investor purchased.  (Another side-light: although the Act declares that notes are securities, court cases have decided that some notes are commercial instruments and not investments intended to be covered, for example the note you sign when you take out a house mortgage.)

Applying the common sense approach of what an investment actually is, in June the head of the SEC’s Division of Corporate Finance suggested that Ether fulfills a commercial function. There is no central “issuer” who takes the money and promises a return.  Control is decentralized.  Ether is a method of payment.

Enter the Commodity Futures Trading Commission, addressing futures contracts and options on Bitcoin and Ether.  This month the CFTC, in an effort better to understand Ether, posed the following questions:

How is ether being used?  How many transactions before we can be sure that transactions do not end up on an invalid block?  How do we know Ether can support smart contracts?  When will Ether move from  a “proof of work” standard where miners are rewarded for processing transactions to a “proof of stake” where control falls to users of the system as currency, or for contracting, or as an open ledger?  How is the network governed (is it liable to splinter apart due to disagreements)? Will there be negative impact if there is a derivative market for Ether?  What is status of cyber security?

Interestingly, the SEC is of the view that digital currency that once was marketing generally or to the public with speculative aspects might have been a security at the time but, by substantive use in real transactions, may morph out of being a security.  Implicit in this observation is the likely result that the SEC is not going backwards to punish what might once have been a violation; indeed, whom would they be punishing at this point?



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