On Monday, the Competitive Enterprise Institute responded to Sen. Patrick Toomey’s (R-PA) request for proposals to clarify laws around cryptocurrency and blockchain technology. I authored the proposals, which would reduce the current confusion about these emerging technologies as they grow ever more vital to the US economy.
The proposals have two parts:
- Exclude cryptocurrency and blockchain projects from the definition of “investment contract”—collectively digital ledger technology, DLT projects—thereby removing them from Securities and Exchange Commission (SEC) jurisdiction.
From the outset, commentators have questioned whether DLT projects are securities and thus should produce disclosures and abide by other SEC investor protection mandates. The test for when unconventional offerings qualify as securities derives from a 1946 Supreme Court case, SEC v. W.J. Howey. In the now familiar Howey test, the Court derived a four-part test for whether an ‘investment contract’ was an SEC-regulated security. These are:
- “an investment of money;”
- “in a common enterprise;”
- with the expectation of profits;
- based solely on the efforts of others.
Even in its original form, the Howey test was unworkable for DLT projects, given its incompatibilities with their business models and economic realities. But the current test is worse because the SEC and courts have stretched its prongs beyond any limiting principles that the original case imposed.
For example, the Howey test requires “an investment of money in a common enterprise.” But the SEC now interprets this prong to include “bounty programs” where people receive tokens for finding software bugs or posting positive stories or tweets about the platform. It also includes “air drops” where the platform creators supply unsolicited tokens to digital-] wallet holders hoping to increase circulation.
The courts and SEC have also diluted the requirement that investors rely “solely on the efforts others.” The SEC now avers this prong is satisfied if third-party managerial actions are anything more than “ministerial” or “routine.”
The SEC has also added prongs not in the original test, for instance, the existence of secondary markets, and if the project is decentralized. (The SEC has since disavowed “decentralization” in the SEC v. Ripple et al litigation.).
The Howey test is now unworkable for DLT projects. It does not conform to the economic realities of DLT projects and further subjugation to Howey demands will have disastrous repercussions for the coming tokenized economy.
If Congress insists on keeping investment contract analysis through Howey, it should loosen rules in Regulation A and Regulation Crowdfunding to make DLT viable.
If Congress does not remove DLT projects from Howey analysis, it should improve the private exemptions to make them viable within the current framework. The Jumpstart Our Business Startups (JOBS) Act of 2012 provides two exemptions that could make DLT project funding easier.
Regulation A (Reg A+) provides advantages for DLT projects. These include retail investor access, high offering limits, and instant tradability.
Unfortunately, Reg A+ is hampered by limited securities, discordant state notice and fee structures, and state restrictions on secondary trading.
Congress could remove these barriers by allowing all security types and fully preempting Reg A+ from state-level (Blue Sky) laws that thwart the development of DLT projects using this exemption, especially secondary trading.
Congress should also insert language allowing Reg A+ DLT projects to declare themselves fully decentralized after a certain period, perhaps three years. Then put the onus on the SEC to justify why ongoing reporting and disclosures should continue.
Similarly, Regulation Crowdfunding (Reg CF), also part of the JOBS Act, could act as a vehicle for smaller DLT projects. But Congress must also modify it. Changes would include:
- Removing the one-year holding period;
- Preempting Blue Sky laws for notice, fees, and secondary trading; and
- Removing the requirement issuers sell through FINRA-regulated portals.
Sen. Toomey’s call for DLT legislative proposals is prescient given the SEC’s increasingly strident stance toward DLT projects. These proposals would ease regulatory burdens for crypto entrepreneurs.
Read the full proposal here.