Are cryptocurrencies securities? 5 things to consider

The US Securities and Exchange Commission (SEC)'s assault on the cryptocurrency marketplace continues with their recently filed complaint against Terraform Labs Pte. Ltd and a founder Do Kwon. The complaint, filed in the US District Court for the Southern District of New York, charges the defendants with violating the registration and anti-fraud provisions of US securities.  In that complaint the SEC alleges that the stablecoin Terra and 4 other tokens should be classified as securities for US securities law purposes and that the defendants engaged in the illegal issuance of unregistered securities and other violations of the US securities laws.  Assuming that the SEC prevails in its position and all cryptocurrencies other than Bitcoin are securities, this article explores five possible ramifications of such characterization.

1. Cryptocurrency exchanges

Only marketplaces (exchanges) registered with the SEC as a securities exchange under the Securities Exchange Act of 1934 (34 Act) can list and trade securities.  To date, no US based cryptocurrency exchange has been registered as such; we understand that at least one US exchange has approached the SEC seeking to be registered, but its overtures were rebuffed. Accordingly, to the extent that cryptocurrency tokens are alleged to be “securities” by the SEC, the US based exchanges will likely decide to halt trading of those tokens.  This would likely lead to the tokens only being traded on non-US based exchanges, many of which prohibit US persons from opening accounts.  The practical implication of classifying cryptocurrency tokens as securities will be to deny US persons the opportunity to participate in the continually growing cryptocurrency marketplace. 

In this regard, the SEC's efforts are less aimed at investor protection and more focused on denying US persons access to financial products and markets available to people in the rest of the world. For example, certain centralized exchanges may well be able to qualify for registration as a 34 Act exchange or alternative trading system (or "ATS"), and, for example, meet the compliance requirements of registered exchanges, including as to KYC, AML, data privacy and security, record retention, and equity capital.  However, it is unclear whether decentralized exchanges would be able to satisfy all of these requirements without significant effort and investment. More fundamentally, though, recent statements and actions by the SEC indicate that it is unwilling to register any existing US cryptocurrency exchange, decentralized or centralized, even if they qualify as an exchange or ATS. Again, the clear upshot from the SEC's saber rattling and enforcement efforts is that it is moving to deny US persons access to digital assets other than Bitcoin and possibly Ether.

2. Reporting issuers

Many companies that issue cryptocurrency tokens to US investors rely on one or more exemptions from registering their tokens with the SEC; that allows them to legally issue securities in the US. However, these exemptions only apply to the initial issuance of securities under the Securities Act of 1933 (33 Act).  What many token issuers may not be aware of is that issuers with more than $10 million in assets and equity securities held by more than 2,000 persons (or more than 500 non-accredited investors), likely have become a “reporting issuer”. See, Section 13 or 15(d) of the 33 Act. The issue of whether tokens are “equity securities” is unresolved, though as between debt and equity the SEC has forcefully argued that tokens are closer to “equity.”  If it meets those criteria, a token issuer can be a "reporting issuer" even if it considers itself otherwise privately held.  In addition, token issuers also must become a "reporting issuer" if their tokens are listed on a securities exchange.  As a reporting issuer it would have to register with the SEC and file a number of forms, including annual Form 10K, and quarterly Form 10Q.  Detailed financial statements are required, among other information and disclosures; given the recent issues with FTX and other large cryptocurrency exchanges, finding an accounting firm that is willing to provide accounting advice or perform a financial statement audit will be very challenging for most token issuers.

3. Investors - rescission rights

If a court concludes that tokens targeted by the SEC are securities for US securities law purposes and the issuance was not exempt under the 33 Act and state securities laws, then initial US investors in those tokens may have rescission rights allowing them to request that the token issuer refund their initial investment.  We understand that many token issuances have not been structured to qualify as a “exempt” offering, and none have been registered under the 33 Act.  There are of course practical requirements and implications to consider before bringing a rescission claim – who is the issuer (especially in the case of an unincorporated or decentralized token issuer); who are responsible directors and officers (or equivalent); how do you get jurisdiction over the token issuer; can a class action lawsuit be brought with respect to rescission claims; under the token terms and conditions, did the investors waive their right to sue or become limited to arbitration of their claims; and perhaps most importantly does the token issuer have the funds to repay the disgruntled investors?  Regardless, the fact that a right to rescission may exist for investors in tokens determined by a court to be US securities means that targeted issuers face a real risk of double punishment through SEC penalties and investor / token holder lawsuits. 

4. Non-US token issuers

The fact that the token issuer is not a US person does not prevent US securities laws in applying to tokens issued to US persons.  Many foreign issuers have disclaimers on their website or other documents stating that US investors are not permitted to invest or purchase their tokens. Many do not; Terraform Labs, Telegram and others have found out to their chagrin that they can be sued in the US for violations of US securities laws.

5. Token resales

Many token issuers initially offer their tokens to insiders, developers, influencers, high net worth persons, and VC and other crypto-targeted funds, relying on an exemption from the securities registration requirements with such initial investors qualifying as “accredited investors” and completing a subscription agreement attesting to that status. At some later date, such initial investor may resell part or all of their token holding on a cryptocurrency exchange in a direct sale or otherwise.  It is possible that such resale is not covered by an exemption from the securities registration requirement, in which case both the seller and the token issuer may have liability; the initial purchaser may be liable for an unregistered trade and the token issuer for failure to have adequate safeguards in place to prevent unlawful resales and for other violations of the 34 Act.

Depending upon the facts of the transaction, the initial purchaser may also be liable to the secondary purchaser for violations of applicable state “blue sky” law or other applicable laws. Such violations may give the secondary purchaser rescission rights with respect to the VC or other fund.

Executives and other "insiders" who receive tokens that are classified as securities are also subject to similar risks if the tokens were not sold in connection with a previously adopted 10(b)(5)(1) plan; in most cases such a plan will not have been in place at the time of the sale of the tokens subjecting the executives to claims under Section 10(b) of the 34 Act.

Concluding thoughts

It is well known that many or even most token issuers have been resistant to undertaking a 33 Act registration, as doing so may cause them to be delisted by one or more cryptocurrency exchanges, and they would become subject to SEC filing requirements. The fault does not lie entirely with the cryptocurrency market participants.  Regulation by enforcement fails to provide a solid mechanism for market participants to innovate. Market participants should be able to look to actual SEC issued rules and guidance instead of having to decide if their circumstances are different than those of other issuers in an enforcement action. Relying on laws, for example, based on cases from the 1930s such as the Howey case has failed to establish clear rules of engagement for the innovations that set cryptocurrencies apart from other instruments.  

More than five years after the DAO report, the SEC has utterly failed to make an effort to enable registration of cryptocurrency tokens even after widely proclaiming them to be securities, albeit ones that do not fall within the traditional corporate structures. In so doing, the SEC has failed to fully consider its statutory duties, in addition, to providing protection to investors, and to promoting efficiency, competition and capital formation.

The recent enforcement actions, along with published statements by SEC officials and others, suggest that the US SEC and other regulators would prefer to have the US market participants voluntarily move offshore or cease operating so that they would not have to actually engage in thoughtful regulations.