Securities Law in Crypto: It’s Everywhere! It’s Everywhere!

Suppose you have become a believer in crypto, crypto currencies, blockchain technology and crypto concepts such as non-fungible tokens (“NFTs”). You believe that crypto-based assets (existing now and probably soon to be invented) present opportunities for profitable new businesses. But what do these opportunities look like under the Securities and Exchange Commission (“SEC”) laws?

Opportunity #1: Sell some of your NFTs and manage them for the new owners.

You decide to sell some of your assets to friends and others who are not as knowledgeable in crypto and offer to manage those NFTs for your purchasers.

But your reading of crypto literature has turned up concerning mentions by the SEC that cryptocurrency and crypto-assets are “securities,” like stocks and bonds, and are – or will be – regulated by the securities laws. And some state securities commissions are also making similarly uncertain statements.

Your further research shows that the statutes and the courts define a “security” to be any interest, contract, or transaction involving:

• An investment of money or valuable property,
• In a common enterprise,
• With the expectation that profits will be derived from the efforts of the promoter/seller of the interest or a third party(s).

I.e., the Howey test, named after the Supreme Court case of SEC v. Howey.

The dominant factor in this definition is that of profits expected to be generated by the efforts of persons other than the purchaser/holder of the interest. You realize that your offer to manage the NFTs calls for your efforts to generate profits and may call the Howey definition into play. (We will perhaps discuss the equally uncertain concept of “common enterprise” in a later discussion.)

Opportunity #2: Manage a pool of NFTs.

So, now you figure, “I will just avoid that complication by coming up with another business plan.” Your company, owning a large inventory of varied NFTs and/or other crypto-assets, will continue to own a large inventory of varied NFTs, but will increase the value of that inventory by selling, buying, and managing those and other crypto-assets. It also will sell passive memberships in your company to friends and other persons interested in crypto but without your level of crypto and NFT sophistication.

Unfortunately, that will not work, either. You have not sold the assets to your customers, but you have sold to them the equivalent of shares in your company, which are securities. And further your company has become a mutual fund, technically named an “investment company,” requiring registration as such under the Investment Company Act of 1940. Also, sales transactions to the new members will require registration (or an exemption) under the Securities Act of 1933 and under most state securities laws. (Note: If you sell individual or numerous NFTs or other assets to buyers who will themselves own and manage them, the interests sold would not be securities and the securities laws would not apply to them or to the sales transactions.)

Opportunity #3: Borrowing the assets then lending them.

Another idea you have is for investors to lend their crypto-assets to your company/platform in exchange for monthly interest payments to them generated by your company’s lending and investment activities. (This is commonly called block financing or “blockfi”). This does not work either: Your agreements with the lenders of the relevant crypto-assets, like most promissory notes, are securities.

Opportunity #4: Establish a trading platform for digital asset owners.

Your friends note that they would like to find a place or platform on which they can buy, sell, or otherwise trade their NFTs and crypto-assets so you have the idea to would provide them with that platform. You would provide no management leading to an expectation of generation of profits. Rather, you would charge your clients/customers for you and your employees’ efforts in administering the trading transactions. The Howey requirements do not seem to be met.

But this too probably would not work. In January 2022, the SEC proposed to expand the definition of “securities exchange” under the Securities Exchange Act of 1934 to include “communication protocol systems,” which language could “capture” certain digital asset platforms and secondary trading platforms. Such “communication protocol systems” are loosely described to mean systems that “offer the use of protocols and indications of interest in trading” to bring together buyers and sellers of securities.

No case has yet been decided, but the chairman of the SEC, Gary Gensler, has commented that crypto trading and lending platforms are probably trading securities, playing roles similar to those of traditional regulated exchanges (e.g., the New York and American stock exchanges). According to Gensler, security holders trading crypto-based investments should be protected in the same way as traditional securities, requiring registration and regulation of such “protocols” as securities exchanges.

Is there any opportunity for a business?

It is difficult to predict precisely the circumstances under which a court or the SEC or a state agency would define when expected profits arise “from the efforts of others.”

However, the interest in getting into a crypto business should begin with analysis of whether an objective of any parties to the relevant transaction includes the obtaining of profits – that is, “investments.”

Also, I should note that these laws have exceptions, most relating to the size of the relevant transaction or facts unique to the parties. But they are complicated and not obvious and require careful analysis for compliance.

And my first above conclusion – respecting the sale and consequent management of the assets – is based on some pretty clear rulings by the SEC.

However, my conclusions about the other crypto-base businesses are based largely on less clear statements by the SEC and the courts and on analogy to the law historically applicable to traditional securities.

A similar analysis should be made about whether the business will involve a “common enterprise.” But that is grist for a different mill.

Published in the July 2022 St. Louis Small Business Monthly.

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