New Scholarship Sheds Light During Crypto Winter

Separate and apart from the unfolding FTX debacle, the last few days marked several pivotal moments in the crypto law world around the heated debate about whether crypto assets are securities.

First was a decision in SEC v. LBRY, where a Federal District Court agreed with the SEC that LBRY blockchain had issued its token, LBC, as a security and in doing so violated U.S. securities laws. In contrast, another blockchain project, Web 3 Foundation, announced that the crypto asset, DOT, native to the polkadot blockchain developed by the Web 3 Foundation, had successfully “morphed” from a security to a non-security. These developments are one illustration of the gap between the SEC’s position that most cryptoassets are securities and that of the industry.

In these dark days of crypto winter, sometimes the brightest light can come from the least expected of places, like a really long law article with an inscrutable name that considers 276 appellate opinions of Howey precedent which made its appearance last week.

But, before considering each of these items, it is helpful to consider the political and regulatory crypto scrum that is the backdrop for these occurrences.

We begin with what has become a mantra of the Securities and Exchange Commission (SEC) – that most fungible crypto tokens are securities. This maxim didn’t start with SEC Chairman Gary Gensler – although he consistently amplifies the message. It began with his predecessor, Jay Clayton, and was supported and expanded upon by Bill Hinman, the former Director of the SEC’s Division of Corporation Finance.

Hinman articulated that somehow unlike the oranges that were the subject of the famous Howey case, fungible crypto tokens could be securities because they “evidence the investment contract.” He also asserted that a token might become a non-security if the “network on which the token or coin is to function is sufficiently decentralized.” And thus, since that time, blockchain companies have sought to decentralize their operations in order to satisfy the SEC’s guidance on digital assets, so that their tokens might be, or become, non-securities.

Thus, the question of how one determines whether a token is a security has largely been left to SEC enforcement actions, including prominently the ongoing SEC v. Ripple, where amicus briefs have been filed on both sides of the “v.”

SEC v. LBRY is just the latest in a line of cases to consider the same question. In that case, the District Court for the District of New Hampshire, this past week, granted the SEC’s motion for summary judgment and determined that the LBC tokens issued by the LBRY project were “offered as securities.”

According to Jason Gottlieb, Partner, Chair of White Collar and Regulatory Enforcement Group, Morrison Cohen LLP, “it is important for courts to distinguish between the investment contract which is a security and the token itself which is not. Was that done here? I’m not sure.” (Notably, Gottleib filed an amicus brief in the Ripple case on behalf of the Blockchain Association.)

Still others find fault in the fact that the SEC failed to bring in all of the relevant parties as defendants in the LBRY enforcement action.

“In LBRY, the SEC went after a relatively small operation, but failed to go after the exchanges that listed LBRY’s native token and allowed it to trade,” said Donna Redel, Adjunct Professor, Fordham Law. “This is part of a pattern that means these key cases are rarely fully litigated.”

And prior to the LBRY decision came a major announcement (albeit one not accompanied by analysis) that a fungible token associated with blockchain project had successfully “morphed,” taking it out of the sphere of securities and all that that entails, and into the realm of non-securities. Web3 Foundation asserts in their Medium article, “the Polkadot
blockchain’s native digital asset (DOT) has morphed and is no longer a security. It is software.” This is interesting as a unilateral announcement by the project, and it is not clear whether and if the SEC agrees.

“The SEC’s theory on when crypto assets are securities has caused a lot of problems because it has made it hard for the test to be applied repeatedly with consistent results. In that sense, it is no longer a “test,” which should have predictable and logical results no matter who applies it. We are now in a place where the SEC applies the test to say almost all crypto assets are securities, while the industry applies the same test to say that nothing is a security,” says Jai Massari, Co-founder and CLO of Lightspark.

How to solve for this disconnect?

Enter Lewis Cohen and his DLx colleagues, Greg Strong, Freeman Lewin, and Sarah Chen, with their discussion draft of a scholarly paper on the nature of crypto assets entitled, “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets are Not Securities” published last week via Tweet and on the firm’s website. It’s hefty – 107 pages, not including the many annexes that list, analyze and discuss the 276 federal appellate and Supreme Court opinions that consider the Howey question of what constitutes an investment contract

Cohen, in his tweet thread (which I have condensed here) shared:

“For almost three years, the @DLxLawLLP team has pondered the most consequential of questions in all of crypto law: When and how do the US federal securities laws apply to crypto assets? As lawyers out there will know, the answer to this question turns on a rule set out in a 1946 Supreme Court case, SEC v. W.J. Howey Co. — what has become known as the ‘Howey test’. But the Howey test is and remains one of the most confusing and misunderstood rules in all of the law. Countless hours of lawyer time, and untold sums of money, have been spent seeking to reveal its secrets. . . . We needed to ingest the whole of the law – every single Howey appellate case there ever has been (and many more besides).”

And ingest they did!

The result is scholarship that explains why fungible crypto tokens, generally the object of blockchain fundraising schemes, should not be treated as securities under our current set of laws and precedent. The theory and discussion which underlie this paper are complex and, at times, difficult. Yet this piece of compelling writing could offer the roadmap to establishing a much needed crypto regulatory framework by our courts and legislatures.

“Balancing the need to provide information and protection to crypto asset purchasers with a regulatory regime that allows this technology to continue to develop in the United States was the starting point for our analysis and thinking,” says Strong. “Requiring disclosure and securities law compliance when crypto assets are sold in investment contract transactions is critical. Just as critical is recognizing that those transactions do not transform such crypto assets themselves into securities under Howey.”

Significantly, the article was developed with the input from many well known blockchain attorneys.

“They did the necessary work to look at the appellate case law precedent to see if there is a legal basis for the SEC’s morphing theory, that a token can morph from a non-security to a security. They found that the answer is ‘no,’” says Massari.

“Lewis and his colleagues have produced a monumental piece of research,” says Gottlieb. “It delves into the appellate decisions interpreting Howey case law to show why a token itself is not a security, nor does the case law support the notion that it could be.”

David Adlerstein, Counsel at Wachtell, Lipton, praises the article as a “thoughtful and timely exegesis of existing Howey jurisprudence.”

“It is a landmark piece of legal scholarship for the industry,” says Kayvan Sadeghi, Partner at Jenner & Block. Sadeghi and Cohen recently led a team of attorneys that filed an amicus brief on behalf of Paradigm in the Ripple case, borrowing heavily from the Howey jurisprudence explored in the DLx article.

The brief argues that “extending Howey to classify crypto assets, themselves as “securities,” would bypass the role of Congress and violate the major questions doctrine.” (This was first discussed in a article that I wrote following the U.S. Supreme Court’s EPA decision that limited the agency’s authority to regulate carbon emissions.)

Moreover, the brief explains that not all applications of securities laws to crypto assets implicates the major questions doctrine, only those that, “attempt to mutate analysis of the transaction into a conclusion about the asset itself.” That is, the major questions doctrine is only implicated where the crypto token which is the object of the fundraising transaction is found to be a security, under Howey analysis.

The brief continues:

“It is in that leap that the SEC departs from the authority granted by Congress and all appellate precedent. [T]hat novel argument would not only grant authority over the crypto asset secondary market not authorized by Congress, but create the first class of issuer-independent securities – a concept entirely foreign to the laws enacted by Congress.”

Heady stuff, but important. Very important. A lot hangs in the balance, namely the future of crypto regulation and innovation in the U.S.

The DLx article can provide the jurisprudential gravitas for U.S. courts, lawmakers, regulatory agencies to get behind a regulatory framework for fungible crypto assets, one that is consistent with U.S. securities law, the Howey test and related jurisprudence. So block out the chaos of FTX for a moment, put on the kettle, and give it a read.

Author’s Note: The opinions herein are my own and do not reflect the opinions or position of the Global Blockchain Business Council.

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