The government of Gibraltar issued a proposal for the regulation of digital token sales, secondary digital token market platforms, and investment services relating to non-security and non-virtual currency digital tokens that also expressed a narrow view of what constitutes a security token. According to Gibraltar Finance, most digital tokens are not securities because they are not structured as such – meaning they afford no equity interest or right to distributions (e.g., of profits or in the event of a firm’s insolvency). They more often represent “the advance sale of products that entitle holders to access future networks or consume financial services” – and thus represent “commercial products,” or have the characteristics of virtual currencies. Holders of the digital tokens, said Gibraltar Finance, expect a return once a project is complete and successful, which is “similar to early acquisition and holding of commodities with a view to trading them later at a higher price.” Under Gibraltar law, digital tokens that are akin to securities are already subject to existing securities regulation. Its proposed new regulatory regime will solely address tokens that are commonly referred to as “utility” or “access” tokens and will deal with primary market promotion, sale and distribution. Generally, Gibraltar proposes to implement disclosure rules and financial crimes provisions, require authorization and supervision of token sale sponsors, require authorized sponsors to implement and follow a self-created code of conduct, and regulate the conduct of secondary market platforms. Gibraltar hopes to complete its implementation of a regulatory scheme by October 2018. Gibraltar Finance, a Gibraltar goverment initiative, attempts to promote Gibraltar as a center for financial services within the European Union.
Unrelatedly, the Joint Economic Committee of Congress presented its 2018 Economic Report of the President. In it, the Committee provided an overview of the growth of cryptocurrencies and initial coin offerings in 2017 and acknowledged the disparate regulatory treatment of digital tokens in the United States. Among other things, the Committee recommended that “[r]egulators should continue to coordinate among each other to guarantee coherent policy frameworks, definitions, and jurisdiction” going forward not to inhibit the development of blockchain technology. (Click here to access a copy of the Committee’s report; see pages 201-227.)
My View: The SEC takes a very broad view of what constitutes a security. This view is principally premised on the agency’s interpretation of the landmark 1946 Supreme Court decision of SEC v. W.J. Howey (click here to access) that labeled as an investment contract (and thus, as a security) any (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. The SEC argues that an investment contract could also exist when persons invest money in a project and expect profits through the appreciation in value of their investment attributable to the entrepreneurial or managerial efforts of others, even if such “profits” can be realized solely by investors reselling their investments. As a result, the SEC argues that an investment contract could include instruments that convey no traditional ownership rights on its holders or any direct rights to revenue – such as many digital tokens issued as part of ICOs. (Click herefor background on the SEC’s views in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)
However, under this approach, privately issued gold coins promoted by their issuers could potentially be deemed investment contracts by the SEC, as could special edition collectible automobiles hyped by their manufacturers. In these instances, purchasers would reasonably expect to realize a premium to ordinary market value if they resell their asset because of the entrepreneurial or managerial efforts of others designed to create buzz around their asset. This seems like an attenuated view of what should be considered a security. For example, under the SEC’s interpretation, persons who pre-purchased a first generation Tesla Roadster in 2008 prior to its rollout – expecting it would rise in value because of hype and promotional efforts of Elon Musk on behalf of Tesla electric cars generally – would likely also be driving a security. However, this outcome makes no sense. The SEC’s view could also potentially capture some virtual currencies within the definition of a security as well.
Gibraltar’s definition of a security is far more narrow and appropriate and commonsensical. According to Gibraltar Finance, “[m]ost often, [digital] tokens do not qualify as securities under Gibraltar or EU legislation.” This is because “they represent the advance sale of products that entitle holders to access future networks or consume future services.” There is no direct or indirect tie to an underlying project’s income stream, and there are no distribution rights in case of a project’s insolvency.
According to Gibraltar Finance, digital tokens are “representations of something else, whether tangible or intangible.” As such, they are analogous to derivatives, as “trading tokens is not necessarily the same activity as treading its underlying asset (where one exists).”
This analysis makes sense and provides a roadmap for a rational allocation of regulatory oversight in the United States over cryptocurrencies. Digital tokens that are directly or indirectly tied principally to the income flow of a project or accord the holders rights in insolvency are securities that, along with their offer and sale, implicate federal and state securities laws. Cryptocurrencies that are not securities and do not serve principally as a medium of exchange are a derivative instrument (perhaps a privilege) on commodities, potentially implicating the exclusive jurisdiction of the Commodity Futures Trading Commission – although applicable law and CFTC regulations may have to be amended to make this unequivocal. When digital tokens are designed to serve principally as a medium of exchange and serve as such, they are virtual currencies and should be treated analogously to fiat currencies under law. (Click here for an overview of the current regulation of cryptocurrencies in the US in the testimony of Mike Lempres, Chief Legal and Risk Officer of Coinbase, on March 13 before the House Committee on Financial Services, Subcommittee on Capital Markets, Securities, and Investment.)