Not your lawyer, not legal advice.

Following my post Whether Ether is a Security, in which I agreed with Gary Gensler’s assessment that Ether is probably a security, and Ether was (probably) a security, in which the WSJ leaked that regulators did in fact consider Ether to be a security, SEC director William Hinman announced today that it is his view that Ethereum is likely not a security – although it may have been one in the past.

This has been received by the market as semi-official opinion of the agency, as it should be. In practice, I suspect this means that some might expect a great many unregistered investment schemes – no matter how harebrained or illegal – dating back to the 2014 era will get a free pass.

Although I’m an English lawyer, my personal view that this interpretation of what was and continues to be an ICO-funded scheme doesn’t gybe well with the purpose or substance of U.S. securities law.

Just about everyone appears to agree that Ethereum was a security when it was first issued. “Promoters,” Hinman said in his speech, “in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing… [where] Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases… it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey.” In other words, very much what happened with Ethereum four years ago.

Hinman suggests, however, that the wide adoption of secondary market transactions have caused the Ether instrument to lose its qualities as a security. Or more to the point, that the transactions in Ether are not sales of a security. “Putting aside the fundraising that accompanied the creation of Ether,” he continues, “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.” (Emphasis mine.)

This is because, he argues, “if the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”

Except it totally is

I join Chairman Clayton and Director Hinman in thinking that a “decentralized” scheme – which I define as

“a (1) cryptocurrency scheme, (2) in relation to which neither an originator nor promoter has sold or distributed tokens for value to third parties, and (3) which utilizes a consensus algorithm that ensures the process of adding blocks or transactions to the shared transaction history is not controllable or censorable by one person or a reasonably foreseeable cartel”

is not an investment contract and should not be subject to securities regulation.

Where I struggle is in understanding how tokens issued by a scheme start life as investment contracts, and then, despite openly flouting the law for years and seemingly only because the scheme has successfully evaded enforcement action during that time, despite being part of and enabling what former SEC Commissioner Joseph Grundfest called “the most pervasive, open and notorious violation of federal securities laws since the Code of Hammurabi,” the tokens issued by such a scheme could conceivably lose their status as investment contracts.

With such a scheme it is the instrument, aka the token, which is the investment contract. It is the mode of that investment contract’s issuance which should determine the character of the entire scheme. As Chairman Clayton made clear when he carved out Bitcoin from the SEC’s purview, we are concerned with the initial sale of the token for value with an expectation of profits etc., not the secondary market transactions in such a token, when determining the token-qua-instrument’s character and whether the securities laws apply to it. Tokens are the thing that the public values; they are the evidence of the share in the scheme, “it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” Howey.

The property that backs the token and of which it is a proportional share, if any, is the goodwill of the underlying chain ecosystem to which that token relates, which can be and is quantified as a “market cap” on websites like Coinmarketcap, calculated as the spot price of the token multiplied by the total tokens outstanding.

Secondary trading of the token-qua-investment-contract ought not to change the investment contract into a cryptocurrency, any more than a secondary trading of, say, a private company share doesn’t transmogrify the share into money. If there’s a precedent that supports the SEC’s current proposed approach, I’m not aware of it.

Anyway. I don’t think it should be terribly difficult for the SEC to get on board with that approach once they get some skeptical input to counter some of the input I know they’ve had from the lobbyists (I’m easy to get hold of, guys). Especially since, towards the end of Director Hinman’s speech, he rattled off a list of criteria, one of which refers to a token as an “instrument:”

I will leave it to you, dear reader, how you might have applied these factors in 2014. If we assume for the sake of argument that the Howey criteria are met, and if we pay very close attention to the word “scheme” in Howey’s “contract, transaction, or scheme,” it seems clear that later decentralization should not save a cryptocurrency scheme from earlier transgressions; where the later-mined tokens are part of the same scheme as the presale coins and facilitate its objectives, and it was an investment contract at inception, then as a practical matter the Ether sold in the presale and the Ether today are all part of the same scheme, albeit one that has achieved completely its promoters’ original goals.

Indeed, decentralization does not terminate the initial investment contract; it is the purpose and objective of the initial investment contract. Funding marketing efforts and becoming a decentralized cryptocurrency is the point of the exercise.

To think otherwise is to effectively allow crypto-token systems to outrun regulation even if at their genesis they violated the laws. It does not take long for a cryptocurrency system to grow beyond the immediate control of its creators; even with Ethereum, it would have been very difficult, as a practical matter, for the system to be unilaterally controlled by the Ethereum Foundation or the core team mere days after the system launched (ignoring the DAO hard fork, which was the result of an at-the-time-unforeseeable cartel of most of the major economic interests in Eth trying to extricate themselves from a plainly absurd $150 million unregistered investment scheme, which also escaped scrutiny despite being a flagrant violation of U.S. securities laws and, presumably, the public offering rules in every jurisdiction in which DAO Tokens were sold).

“Decentralization” is, accordingly, not a good measure for deciding whether securities laws should apply to a scheme, as a scheme can become functionally decentralized fairly quickly merely by choosing an appropriately decentralized consensus algorithm. Today, that means proof-of-work.

Why have we now changed the subject to be about secondary market transactions in Ether instead of the thing that is possibly the investment contract and may have been all along, Ether itself? Lord only knows. But in my view, coins, when sold to obtain investment capital, should be treated as an investment contract of a kind, no matter how “decentralized” the system eventually becomes. (Note, whether Ethereum is decentralized – or will be after the transition to Proof of Stake, where its largest holders will have a meaningful input on consensus – is an open question.)

Speaking of which,

“Decentralization” is legally meaningless

The term “decentralization” has no legal meaning, at least not yet. It could mean that a scheme uses POW consensus even if the supply of the cryptocurrency was pre-sold to a handful of large promoters who funded its early development (purely hypothetically). It could mean that the cryptocurrency has a hard-cap and is reliant in practice, if not in theory, on one company’s contributions to the network, as with Ripple. It could mean many investors hold the coins but consensus is determined by a cartel, like Eos. It could mean that, as with Bitcoin, three major mining pools and a small group of “core” devs have outsize influence over the currency.

If “decentralization” is a defense, all of the schemes outlined above will plead it. All of them will be both right and wrong to varying degrees.

Put another way, “decentralization” is a buzzword, not a term of art. We should therefore avoid entirely use of the term and look to processes the law understands – issuance and sale – to inform our regulatory approaches. Relying on this amorphous, non-legal, coin-specific concept of “decentralization,” as Coin Center argues we should, muddies the waters completely unnecessarily, introduces a huge amount of legal uncertainty, has no basis in existing law and will result only in further confusion in the marketplace, exposing retail investors to more risk.

I have a pretty simple way of looking at tokens, one which squares the circle nicely when we’re trying to ask why Bitcoin shouldn’t be a security where something like Ether should. The most important question, the threshold issue, is whether the issuer or creator of the chain sells any of the tokens/coins.

This way of thinking about token transactions is elegant in its simplicity; e.g., it is hard to argue that a mined coin on a chain where no tokens have ever been sold or distributed by the issuer to the public is an investment contract, as there is no valuable consideration moving between the user and the blockchain’s creator, ergo no investment of money, ergo no investment contract. Tokens that are not sold are made, through mining or similar processes. Last time I checked, cryptocurrency mining was perfectly legal.

This means, given current market dynamics, from the perspective of a scheme promoter, assuming a scheme is “decentralized” per my definition given above,

If you’re selling/distributing tokens, and especially if you’re pre-selling them, to US persons, you probably have an investment contract on your hands.

If, like Satoshi Nakamoto, you’re not selling or distributing tokens to US persons, you probably don’t.

Again, none of that is legal advice, but more a point for discussing whether the SEC’s proposed regulatory approach could benefit from revisions.

To conclude

Anyhoo. Whatever people think of today’s statement of policy, it hints towards a liberal approach to cryptocurrency structuring. I don’t like that it hints towards that approach, as I think cryptocurrencies are economically extremely dangerous, but I have to concede that’s where it points.

I still think industry-specific regulation is now due. We will almost certainly not get it for at least half a decade or more. But its absence should not be interpreted by entrepreneurs as a free-for-all; remain mindful that this is the first round of a regulatory boxing match in what promises to be a decades-long bout. Remember also that securities regulation is fast-moving field where what worked yesterday might well not work tomorrow. See, e.g., U.S. v. Newman, where the Second Circuit Court of Appeals, overturning itself, criticised the government’s “overreliance on our prior dicta” to inform “the doctrinal novelty of its recent insider trading prosecutions.” Judicial gaslighting par excellence.

“Doctrinal Novelty” – these are two words all lawyers in blockchain should keep in mind as we advise on and unravel these new and interesting technologies.

Entrepreneurs, on the other hand, should not commence a coin issuance free-for-all in response to today’s semi-official statement from the SEC, although I fear now that many of you will. If your behavior gets too out of line, you will ruin the party for everyone.

To sum up, compliance is a long game. Plan accordingly.