Can the SEC Regulate Bitcoin? Cryptoassets' Legal Questions (Tentatively) Answered
On Dec. 11, the Securities and Exchange Commission, one of the federal government's most fearsome financial regulators, stopped an initial coin offering in its tracks. The SEC declared the ICO an unregistered offering of securities and ordered Munchee—the "Blockchain-based incentivized restaurant review platform" in question—to return the bitcoin and ether it had raised from investors.
The news coincided with an ominous statement from SEC chair Jay Clayton, who—expressing his own opinions and not those of the agency—wrote, "just as the SEC has a sharp focus on how U.S. dollar, euro and Japanese yen transactions affect our securities markets, we have the same interests and responsibilities with respect to cryptocurrencies."
Is this the end of cryptoassets' legal and regulatory free-for-all? Yes and no, according to Matthew Gertler, senior analyst and counsel at Digital Asset Research.
Bitcoin Is "99.9%" Not a Security
"I have not seen this argument made," Gertler told me by phone following the Munchee ICO's demise, "and I don't really understand why." In his view, bitcoin is not a security (though he allows there's a 0.1% chance it is). The reason is that "all of it was mined": there was never an investment of money into the initial issuance bitcoin. What money has been invested was used to purchase bitcoin from secondary markets. If he's right, bitcoin is beyond the SEC's purview.
Gertler's argument comes down to the Howey test, a bit of language from a 1946 case in which the Supreme Court decided that an "investment contract" is "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party."
Exchanges could potentially qualify as promoters or third parties, but Gertler says they're best thought of as market makers. And the people selling bitcoin on those exchanges are "not issuing bitcoin, it's just something that they purchased already, or acquired themselves by doing work, so I strongly believe that it can't be a security."
Clayton's letter suggests Gertler could be right: "there are cryptocurrencies that do not appear to be securities," he wrote, but cautioned, "simply calling something a 'currency' or a currency-based product does not mean that it is not a security."
… But It Is Money, Property and a Commodity
Just because the SEC might lack authority over bitcoin and its exchanges, though, doesn't make them immune to government.
The Commodity Futures Trading Commission decided in 2015 that bitcoin and other "virtual currencies" are commodities, based on a broad definition that only definitively excludes motion picture box office receipts and onions.
The Financial Crimes Enforcement Network, or FinCEN, said in 2013 that cryptocurrency exchanges are money service businesses—specifically money transmitters—requiring them to comply with anti-money laundering and know your customer (AML/KYC) rules, along with reporting and record-keeping requirements.
"You can't really regulate who I'm sending bitcoin to" without tying a person to an address and tracking it, Gertler says, so "the easiest way to regulate this is by policing where fiat currency enters and exits the system." That is, the exchanges.
The real pain for exchanges comes at the state level, however. A money transmitter must obtain a license in order to transfer money to or from customers in each of 49 states, according to Gertler. He has first-hand experience of being kicked off of Bittrex for being a California resident.
He also has experience from the other side, as a former member of Venmo's legal department: "we were trying to get money transmitter licenses, and I cannot tell you how difficult it was to get them. Not only from what you have to submit and provide, but even if you do provide that, there are plenty of times where the regulator either doesn't want that and wants something else, or they just don't say what they want. So unless you actually reach out to them and try to figure out what's going on, you might not get a resolution."
All told, the process can take over a year and cost half a million dollars.
New York drew some attention with the BitLicense, the only dedicated, state-level regulation for virtual currency businesses, which went into effect in August 2015. Gertler has experience with that too.
"BitLicense basically applied New York's money transmitter statute to bitcoin companies," he says, so it was a natural enough transition from Venmo to working with cryptoassets. The regulations' applications were unclear, however, and the regulators themselves were unresponsive.
"A lot of companies, rather than try and comply with it, have just left," he says, adding that only six BitLicenses have been issued out of at least 30 applications. "So even if you want to comply, you can't really comply in New York because they're not going to get back to you in a timely fashion."
And then, of course, there are taxes. The IRS classified virtual currencies as property for tax purposes in 2014: bitcoin is subject to ordinary income, capital gains and employment taxes, depending on the situation. (It is not treated as a currency for tax purposes.)
"Historically," Gertler says, "people haven't been paying taxes." According to an affidavit filed by the IRS against Coinbase, only 802 people reported property transactions likely to relate to bitcoin in 2015. The exchange must now turn over records related to any account that conducted a transaction worth $20,000 or more from 2013 to 2015. (Coinbase might appeal.)
So bitcoin is not immune to regulation as its early cypherpunk proponents hoped, but neither is the SEC likely to pounce any time soon.
No Such Thing as a Free Munch
ICOs are a different story. It has been common knowledge for some time that the SEC considers at least some ICOs to be securities offerings. In June 2016, about a week after the hack that effectively killed the DAO, the agency released a report saying that its ICO—the largest crowdfunding campaign in history—had been a securities offering.
Perhaps it was only a matter of time before they shut one down mid-offering, but Gertler thinks there's something to be learned from their choice to target Munchee. He described his concern prior to the SEC's action: "I am a project and I have a utility token, and I do everything possible to make it a utility token"—one that does not qualify as a security—"but the consumer that's purchasing it, despite what I say, is just trying to make a profit" by selling it on the secondary market. "Would the SEC come after me?"
In other words, is it possible to distribute a token that's solely meant to power the application's ecosystem, without it qualifying as a security?
The SEC's cease and desist order suggests there's a chance. It focuses on Munchee's choice to market tokens not to users of its already-available app or to restaurant owners—the people who would in theory have use for its tokens—but to bitcoin and ICO investors. Nor did Munchee limit its promotions to the U.S., the only country where its service is available. These choices show that Munchee approached its ICO in a way that would qualify it as a securities offering rather than a utility token distribution; but the implication is that if they had targeted users rather than speculators, the token might have escaped sanction.
Emphasis on the might. "It's probably better that you market it to the right people," Gertler says, "but it's too far to jump" to say that it's definitely not a security.
The headlines sometimes give the impression that regulators act swiftly, mercilessly and without warning. And they do—in China. "They act quickly," Gertler says, but "when it comes to the U.S., we're very slow moving." Munchee's case is in line with the SEC's (and other regulators') tendency to pick an "easy win," where a rule is clearly being violated. And each one of those brings the picture a bit more into focus: "I see incremental, case-by-case things that add to our working knowledge of how this is going to be applied."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.