Is crypto a security? The simple answer is, it depends. Below we will be reviewing the question: when is crypto a security?
Whether you are a seasoned crypto pro or new to the exciting world of crypto trading, it is important to understand these concepts.
The U.S. Security and Exchange Commission (“SEC”) said “If you are considering … engaging in the offer, sale, or distribution of a digital asset, you need to consider whether the U.S. federal securities laws apply. A threshold issue is whether the digital asset is a ‘security’ under those laws.”
Essentially, the SEC is warning everyone who owns, sells, or distributes crypto that security laws may apply.
So why does it matter whether a particular crypto is a security? Well, it is illegal to
sell (or offer to sell) securities that are not registered with the SEC. Violations of this law are
punishable by fines of up to $10,000 and federal prison sentences of up to five years. In addition, violators may be subject to financially devastating civil penalties and potential lawsuits from the investors involved (AKA you might get sued).
However, because registering a security with the SEC can take years and cost hundreds of
thousands of dollars in legal and accounting fees, most folks (including the purveyors of most
cryptocurrencies) would rather not do it – so they don’t. Their (ignorant) justification for that position is that their coin is not a security.
As detailed in my previous article there is a three-part test called the “Howey Test” (named after
the Supreme Court case that created it) to determine whether a particular investment is a security.
An investment is a security if:
“An investment of money” is exactly what it sounds like. Money (value) is exchanged for an asset, investment, or item. For example, you give me 100 of your new coins and in return, I give you $20.
According to the SEC, the first prong of the Howey Test is typically met in the sale of any
cryptocurrency: “because the digital asset is purchased or otherwise acquired in exchange for
value, whether in the form of real (or fiat) currency, another digital asset, or other type of
consideration.”
On the second prong of the Howey Test, most federal courts define a “common enterprise” as
one that is horizontal, meaning that an investor’s return on their money is dependent on the success of the project. (This is why Gold is not a security, a return on the investment is not dependent on the ‘success’ of a project).
The SEC is pretty blunt. Their statement on the subject is: “In evaluating digital assets,
we have found that a ‘common enterprise’ typically exists.”
Although this may appear to be the same thing as “in a common enterprise”, there are important distinctions. The most simple way to think of it is, the only thing the investor is contributing to the project is their money. They are not participating (providing effort) in running the business in order for the project to see a profit.
Typically, when it comes to the Howey Test (for all types of investments – not just crypto), the third prong of the test is the determining factor between a security and a non-security. When it comes to cryptocurrency, an investor may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.
According to the SEC: “When a promoter, sponsor, or other third-party (or affiliated group of
third parties) (each, an ‘Active Participant’ or ‘AP’) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those
efforts, then this prong of the test is met.
Be sure to read the second to last section titled “Economic Reality” as this is a relevant aspect of this prong of the Howey test.
You may think it’s overboard, but the third prong of the Howey test is typically the defining difference between a security. That is why it’s important to understand how the SEC breaks it down:
For the SEC, the inquiry into whether an investor is relying on the efforts of others focuses on
two key issues:
Below is a list of factors the SEC has indicated it will look at. While none of these factors
are necessarily determinative, the more of these factors that apply to a situation (and the
stronger their presence), the more likely it is that an investor is relying on the efforts of
others:
An easy way to visualize this concept is thinking of it as the following formula:
Money/Investment + Active Participants Efforts = Profits
Money (provided by non-participating investors) + Active Participant’s Effort (Founders making efforts to grow the project using the funds provided by the investor) = Profits
When considering this concept using the above ‘formula’, it seems quite obvious. If someone took your money and did a bunch of work to build something with that money, you, who contributed the money should expect something in return (profits).
Profits are typically things like capital appreciation resulting from the development of the initial
investment or business enterprise or a participation in earnings resulting from the use of
investors’ funds.
The SEC clarifies that “price appreciation resulting solely from external market
forces (such as general inflationary trends or the economy) impacting the supply and demand for
an underlying asset generally is not considered ‘profit’ under the Howey test.”
Here is a list of factors the SEC has indicated it will look at on the topic of “Reasonable Expectation of Profits”. Once again, none of these factors are necessarily determinative, but the more of these factors that apply to a situation (and the stronger their presence) the more likely it is that a purchaser of a digital asset has a reasonable expectation of profits:
The SEC also looks at the “economic reality” of a transaction. Specifically, they look at whether
the asset is offered and sold for use or consumption by purchasers (Think, purchasing a Tesla to drive vs Purchasing Tesla Stock). If it is purchased for consumption, then it is less likely that the Howey Test is met.
On this topic, the SEC considers the following questions. In this case, the more of these factors that apply and the stronger their presence, the less likely it is the crypto is a security:
So, is the new crypto you want to create (or invest in) a security? As you can tell, the
response is not a simple “yes or no.” Given the complexities of the situation, is the best course
of action to “shoot now and ask questions later?” absolutely not! A good securities attorney
(while unable to make guarantees) will be able to take a look at your situation within the context
of the SEC’s regulatory framework and make recommendations as to things to do (and not to do)
to strengthen your argument that your crypto is not a security.
If you can’t definitively answer the question “is this crypto a security?”, it might be time to contact a professional. Your attorney can walk you through the various securities registration exemptions that may be available to help you bring on investor capital without risking time in federal prison.
Real-life examples are always helpful and instructive. So, next, we will look at how the SEC is
dealing with three major cryptocurrencies: Bitcoin, Ether, and XRP.
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Podcast “Main Street Business Podcast” and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions, 2nd Edition”. the “8 Steps to Start and Grow Your Business Workbook”, and “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You”. He is also a senior partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP.