Why interchangeable crypto assets not securities
2023.02.09 12:44
Why interchangeable crypto assets not securities
By Tiffany Smith
Budrigannews.com – On January 30, the cryptocurrency community rejoiced as the United States Securities and Exchange Commission (SEC) acknowledged during the remedies hearing of the LBRY case that secondary sales of its LBC coin were not securities sales. John Deaton, who represents Ripple in the SEC’s case against it, was so ecstatic that he made a video that evening for his CryptoLawTV channel, which is hosted on Twitter.
A friend of the court or amicus curiae in the case, Deaton, recalled their conversation that day. Let’s not play games, now. Deaton recalled, “I brought up to him that Lewis Cohen article.” Secondary market sales are a problem.
The paper “The Ineluctable Modality of Securities Law:” Deaton was referring to Lewis Cohen, Gregory Strong, Freeman Lewin, and Sarah Chen of the DLx Law firm, which Cohen co-founded, wrote “Why Fungible Crypto Assets Are Not Securities.” In November 2022, when the paper was submitted in the Ripple case, in which Cohen is also an amicus curiae, Deaton had praised it.
The paper is getting more and more attention. On December 13, it was posted to the Social Science Research Network’s preprint repository. Cohen told Cointelegraph in mid-January that after about a month, the paper had 353 downloads, making it the most downloaded securities law article on the website. In the two weeks that followed, that number more than doubled. Podcasts related to cryptocurrency and mainstream and legal media have also covered the paper. The unusual title is a reference to Ulysses by James Joyce.
One of crypto securities law’s enduring maxims is the subject of a close examination in the Cohen paper: Oranges are not securities. This is referring to the Howey test, which was established in 1946 by the Supreme Court of the United States to identify a security. The Howey test is thoroughly examined in this paper, and an alternative to its current application is proposed.
Some people disagree with applying the Howey test to crypto assets, arguing that it is more effective at prosecuting fraud cases than at assisting with registration. In a podcast on February 3, Cohen himself agreed with this position. However, the authors of the paper do not dispute the application of the Howey test to crypto assets, which originated in a case involving orange groves.
The breadth of the paper’s analyses cannot be adequately summarized in a brief summary. In just over 100 pages and annexes, the authors discuss crypto cases, SEC policy, relevant precedents, the Securities and Exchange Acts, and blockchain technology. To arrive at their conclusions, they looked at 266 decisions from federal appellate courts and the Supreme Court—every relevant case they could find. On LexHub GitHub, they invite the general public to add any additional relevant cases to their list.
There are four parts to the Howey test, which are referred to as prongs. The test says that a transaction is a security if it is either an investment of money, an investment in a common enterprise, a transaction with the expectation of profit, or a transaction that will be derived from the efforts of others. The test can only be applied retrospectively if all four conditions are met.
1/ The @DLxLawLLP team has been debating the most important question in crypto law for almost three years: When and how are crypto assets subject to US federal securities laws?
In very simple terms, Cohen and coauthors argue that “fungible crypto assets” do not meet the definition of a security, with the rare exception of securities designed to be securities. The saying about oranges conveys this insight.
The authors of the paper go on to say that, according to Howey, a crypto asset offering on the primary market might be a security. “To date, Telegram, Kik, and LBRY are the only thoroughly briefed and decided cases relating to fundraising sales of crypto,” they write, however.
They were referring to the SEC’s lawsuit against Telegram, which was decided in favor of the SEC in 2020 and claimed that Telegram’s $1.7 billion initial coin offering was an unregistered securities offering. In 2020, the SEC won its case against Kik Interactive, which also involved token sales. In 2022, the unregistered securities sales case brought by the SEC against LBRY was also won.
The paper’s views on dealing with crypto assets on secondary markets are its most significant innovation. The authors argue that sales of crypto assets on secondary markets like Coinbase or Uniswap should be subjected to the Howey test once more. The authors jot down:
“Generally, by applying the Howey test to transactions in these assets, securities regulators in the United States have attempted to address the many issues raised from the advent of crypto assets. However, […] regulators have gone beyond current law to suggest that the majority of fungible crypto assets are themselves “securities,” which would grant them jurisdiction over virtually all activity involving these assets.
According to the authors, crypto assets won’t generally meet the Howey definition on the secondary market. A “legal relationship between the token owner and the entity that deployed the smart contract creating the token or that raised funds from other parties through sales of the tokens” is not established by the mere possession of an asset. As a result, secondary transactions fail to satisfy the second Howey prong, which calls for a third party.
Based on their comprehensive analysis of Howey-related decisions, the authors conclude:
Because an investment contract transaction is typically absent, there is currently no legal basis to classify the majority of fungible crypto assets as “securities” when transferred in secondary transactions.
The paper’s argument makes it possible to distinguish between a transaction involving a token on the secondary market and its issuance. According to the paper, subsequent trades will not necessarily be securities trades, but the creation of a token may be a securities transaction.
“I think he’s [Cohen’s] taking ownership of the fact that the issuings [of tokens] are going to be regulated and he’s trying to suggest a way to then have it [a token] trade in an unregulated manner,” Bressler, Amery & Ross principal Sean Coughlin told Budrigannews.
Christopher Vaughn, a colleague of Coughlin’s, had reservations about the paper because it was at times “disingenuous.”
He stated, “It ignores the realities that everyone who has ever traded in cryptocurrency knows, which are that these liquidity pools and decentralized exchange transactions don’t happen unless the token issuer facilitates them.”
Vaugh, on the other hand, gave the paper high marks, stating, “I would love for this to be the be-all and end-all of crypto.”
According to John Montague, an attorney at Montague Law, which focuses on digital assets, custody issues, particularly how self-custody of crypto assets affects the investment prong of Howey, might make Cohen’s argument more difficult.
Montague acknowledged the paper’s high level of scholarship, describing it as:
The “most monumental thought piece in the industry with respect to securities law perhaps ever,” “certainly since Hester Peirce’s safe harbor proposal,” is the title of this article.
SEC commissioner Peirce suggested that network developers be granted a three-year exemption from federal securities law registration requirements in order to “facilitate participation in and the development of a functional or decentralized network” in her final version of the proposal.
Cohen stated, “One thing I like about the crypto world is that it is adversarial.” He stated that he hoped the paper would “lift the level of discussion.” Public responses did not significantly oppose it. However, there have been signs of cynicism.
“You write books. You found a character best explained by law in crypto,” a network developer tweeted.
A financial services executive stated on LinkedIn that “intelligent legal opinions rarely move the needle on SEC opinions or enforcement cases.”
