Jan 22nd 2023

Regulators are in no hurry to write rules for crypto. The Securities and Exchange Commission and Commodity Futures Trading Commission have brought a combined total of more than 100 enforcement actions against crypto-asset market participants. Yet, neither agency has issued a single crypto-specific rule, and it is unlikely that they will change course any time soon. But what if the agencies decided to do so? What sorts of rules could they write using their existing regulatory authorities?

The SEC

Federal securities laws are principally designed to reduce information asymmetries between the issuers of securities and the investing public. When a firm elects to raise capital from investors by selling a security, the laws require the firm to make investor disclosures to minimize the informational disadvantage of outside investors. Additionally, the laws require exchanges, brokers, dealers and investment advisers who provide access to securities or securities-related advice to register with the SEC and adopt policies and procedures designed to protect investors.

Michael Selig is counsel at Willkie Farr & Gallagher.

The framers of the federal securities laws didn't have programmable crypto assets in mind when they drafted the laws. But the SEC has the statutory authority to issue rules that would make it possible for crypto assets and crypto intermediaries to operate within the contours of federal securities laws. The agency could start by writing rules to establish a workable framework for crypto-asset security issuances and exchanges.

Issuances

Crypto assets are network assets. Unlike firms, networks are generative. The value of a network derives from the applications, organizations and projects built on the network by its users. The developer of a network may opt to issue the network’s native crypto asset when publicly available information about the network is scarce to encourage users to join the network. Once a critical mass of users has joined and is participating in a network, the developer may no longer have an informational advantage relative to the users. At this point, investors in the crypto asset may not require the protections of federal securities laws.

It is unlawful to offer or sell a security without registering the offering or sale with the SEC, absent an exemption. The definition of the term “security” includes a list of financial instruments, such as stocks, bonds, notes and investment contracts. Crypto assets most typically come within scope of federal securities laws when sold as part of an investment contract.

The term investment contract originates from “blue sky” laws designed to govern offerings of written contracts under which a person invests money with a promoter who promises to use the money to generate profits for the investor. In a 1946 opinion (giving rise to the so-called Howey Test), the U.S. Supreme Court defined the term “investment contract” for purposes of federal securities laws as a contract, transaction or scheme whereby an investor invests money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

There is little mention of investment contracts in the SEC rules because before crypto assets came along, nobody knowingly intended to issue them. For decades, the SEC has brought lawsuits asserting that a contract, transaction or scheme should remedially be classified as an investment contract because it has the economic substance of a security. After the SEC started to bring these lawsuits against crypto-asset issuers, some crypto projects embraced the investment contract designation and attempted to issue these instruments in compliance with federal securities laws.