On February 7, 2024, Prometheum, a crypto company boasting approval from FINRA to manage digital asset securities, announced its plan to offer custodial services for Ether (ETH) as provided under the Ethereum network. This move is controversial because Ether is not presently classified as a security under current SEC guidelines. Rather, the SEC has long treated Ether and other crypto assets as commodities. Prometheum’s move, has prompted the SEC to take another look at Ether. In this article, we take a look at the SEC’s treatment of cryptocurrencies, analyze the present standing of Ether, and look at the potential consequences of a ruling by the SEC that Ether is a security.
Background:
To best understand the repercussions of Ether potentially being classified as a security, it is important to distinguish between the separate asset classes of securities versus commodities. At present, cryptocurrencies are considered commodities falling under the responsibility of the Commodity Futures Trading Commission (CFTC). Commodities are goods with physical qualities that may be used as inputs in the manufacturing process, such as natural gas, and are typically traded on commodity exchanges as futures contracts. In December 2022, the CFTC emphasized in a complaint against individuals for commodities fraud that Ether, like Bitcoin, is a commodity in interstate commerce, as defined under Section 1a(9) of the Commodity Exchange Act, 7 U.S.C. § 1a(9).
The Securities and Exchange Commission (SEC) contends that a number of cryptocurrencies are more accurately described as unregistered securities. Securities are investment instruments that hold monetary value including equity, debt, and related hybrids. Securities are purchased and sold by investors through stock brokers who must register with the SEC and abide by strict rules. The SEC has clear regulations surrounding securities and how they can be purchased, sold, and what information must be reported to the agency. The SEC has brought various charges against top cryptocurrency exchanges for trading crypto asset securities, but they have refused to comment on the exact classification of Ether.
While the SEC has refused to share its view on whether it sees Ether as potentially constituting a security, its recent probing of various companies regarding its dealings with the Ethereum Foundation has sparked speculation that the SEC may be leaning towards labeling Ether as a security.
In order to determine whether a product could be classified as a security, the SEC uses the Howey test, a legal framework outlined by the U.S. Supreme Court in the case of SEC v. W.J. Howey Co. This test determines whether a transaction qualifies as an investment contract and security, and thus if it should be regulated as such. According to the test, “an ‘investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” It is irrelevant whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
Credit: QuoteInspector.com
Howey Test’s Four Criteria:
The Howey Test can be broken down into four main elements:
(1) there must be monetary investment in the transaction or another form of consideration passing from one party to the other. For example, an individual purchasing corporate bonds with funds from their brokerage account would satisfy this factor. On the other hand, earning shares in a startup without having invested any money into it, does not meet this criteria.
(2) The investor expects the investment to accrue profits as the enterprise succeeds, such as when one invests in real estate property with the expectation that it will appreciate in value, yielding profit. On the contrary, buying a home with the objective of personal use without expecting to utilize it for profit, would not fit this criteria.
(3) There is a common enterprise, meaning that the investors and enterprise behind the transaction, asset, or product are tied by a financial relationship, and the fortunes of the investors are connected to the enterprise’s success. Accumulating funds with other investors in a mutual fund managed by a fund manager is a good example of such a relationship. However, a stand-alone contract where the financial return does not correlate to the success of a larger entity (for example a lease agreement between a landlord and tenant), would not suffice.
(4) Success of the investment relies mostly on the efforts of individuals rather than the investor. For example, investing in a startup where the financial return is dependent on the skills and efforts of the team would fulfill this element while investing in an art piece where the potential appreciation is not based on the efforts of others would not suffice.
Applying the Howey Test to Ether:
By using the SEC’s provided framework for digital assets, we can apply the Howey Test to Ether:
A. The Investment of Money:
The offer and sale of a digital asset satisfies this part of the test because “the digital asset is purchased or otherwise acquired in exchange for value.” The test does not require that the value is real currency. Any type of consideration will suffice.
Ether easily satisfies this portion of the test: it is a digital asset which is acquired by trading real currency or other digital assets for it.
B. Common Enterprise:
In order to satisfy the “common enterprise” aspect of the Howey test, federal courts require that there be either “horizontal commonality” or “vertical commonality.” Under the horizontal commonality test, a common enterprise exists if investors pool funds in an investment and the profits of each investor correlate with those of the other investors. Under the vertical commonality test, a common enterprise exists when the investors rely on the promoter to make money and their profits are tied to the profits of the promoter.
The SEC is not likely to establish that Ether is a common enterprise. On the issue of horizontal commonality, people who purchase ETH are not “pooling their funds”; rather, they are acquiring an asset. The fact the price of ETH fluctuates with demand makes it more similar to a commodity like oil, rather than a security.
This may change, however. In 2022, Ether transitioned from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) consensus mechanism. Staking allows participants to tie up their coins and earn rewards for contributing to the network. It is unclear whether this would be considered “pooling” of funds. On one hand, some investors are opting to tie their ETH to the project and get compensated for it with more ETH. The perception that their funds are being held and that the value of their compensation depends on the success of ETH is inevitable. On the other hand, however, these ETH holders are merely providing a service to improve the functionality and efficiency of the network–that this service is carried through lending their digital assets is merely incidental. So is the mode of compensation.
On the issue of vertical commonality, Ethereum’s “promoter” is not easily identifiable. While some may claim that Vitalik Buterin is the face of Ethereum and therefore its promoter, Ethereum does not rely on Mr. Buterin or anyone else to succeed. Ethereum is sufficiently decentralized to be completely independent of any headfigure. Former SEC director, William Hinman, made this clear in his 2018 speech addressing cryptocurrencies.
C. Reasonable Expectation of Profits
Profits can be capital appreciation from the development of the initial investment, or earnings resulting from the use of the investors’ funds. Whether a purchaser of ETH has a reasonable expectation of profits depends on the evaluation of several factors, which include, among others: 1) the digital asset grants its holder the right to profit sharing or capital gains; 2) the digital asset is transferable on a secondary market; 3) the digital asset is offered broadly to potential purchasers rather than to people who seek to rely on the functionality of the network; 4) the lack of correlation between the price of the digital asset and the goods or services one may trade for it; and 5) how the asset is marketed.
There is little doubt that ETH investors have a reasonable expectation of profits based on the above factors. The digital asset grants its holder the possibility of capital gains; it is transferable on the secondary market; it is bought primarily by people who seek to purchase the asset itself rather than people who seek to use the network; there is little correlation between the price of ETH and the price of the goods or services it can buy; and while it is not marketed as an investment by the Ethereum Foundation, it is treated as an investment by everyone else.
D. Derived from Efforts of Others:
Whether a purchaser of ETH is relying on the efforts of others is a two-prong test: 1) Does the purchaser reasonably expect to rely on the efforts of an active participant?; and 2) Are those efforts managerial (driving success) as opposed to ministerial (keeping things running)?
The SEC’s framework provides guidelines for analyzing whether the purchaser of ETH reasonably expects to rely on the efforts of an active participant. On this point, Ether is sufficiently decentralized. There is no active participant supporting the market for Ether or the price of Ether. Further, no active participant plays a major role in the governance of Ether because Ethereum does not have a formal governance structure. Thus, there is no need to consider the second prong.
In sum, based on our analysis guided by the SEC framework, it appears unlikely that Ether will be classified as a security.
What Happens if Ether is a Security?
In the unlikely case that the SEC was to classify Ether as a security, there would be a number of overarching consequences regarding its issuance, trading regulations, and investment trends throughout the cryptocurrency market. First, in accordance with SEC securities regulations, Ether would be much more difficult to trade as a whole. It would not be as easy to buy and sell, and since centralized cryptocurrency exchanges are unregistered with the SEC, Ether would likely have to be delisted and no longer offered as a token. Since Ether makes up practically 20% of the overall market, the ceasing of all activity and deleting the cryptocurrency from the exchange platform would devastate investors.
Additionally, existing projects and NFT markets built on the Ethereum blockchain would also be put in jeopardy. A registered security could not be used for gas fees and payments currently being met with Ether in its commodity form. Securities as an asset class do not function in the same way, which would likely lead to an influx in alternative cryptocurrency investments and ultimate losses for holders of ETH. Although the likelihood that Ether will be classified as a security in the near future remains low, such implications highlight just how risky investing in crypto can be overall.
Conclusion
The classification of Ether as either a security or a commodity carries significant implications for the cryptocurrency market. Despite recent scrutiny, analysis indicates that Ether is unlikely to meet the criteria for classification as a security, given its decentralized nature and multifaceted utility beyond simply being an investment vehicle.
However, if Ether were to be classified as a security by the SEC, it would result in tightened trading regulations, potentially leading to delisting from exchanges and disrupting the broader cryptocurrency market. Additionally, existing projects and markets on the Ethereum blockchain could face uncertainty, impacting their functionality.
Although the likelihood of Ether being labeled a security is small, the discussion highlights the inherent risks of cryptocurrency investment. As regulatory bodies continue to adapt to the evolving digital asset landscape, investors must remain vigilant and prepared for potential regulatory changes that could affect their investments.
*The views expressed in this article do not represent the views of Santa Clara University.
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