Could a Class-Action Lawsuit Determine if Cryptocurrencies Are Securities?

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11 months ago

Earlier this week, a bi-partisan bill addressing the nature of cryptocurrencies seeking to define individual coins and tokens as either securities or commodities entered the national discussion on cryptocurrencies. The National Law Review has made some interesting observations regarding the legislation. Among those observations include:

  • Would not apply to incorporated DAOs. However, DAOs that are licensed by Wyoming and Tennessee under their pioneering DAO legislation may be impacted.

  • Gains or losses of $200 or less could be exempt from federal income taxes.

  • The bill introduces an “ancillary asset” classification that would be regulated by the Commodity Futures Trading Commission (CFTC).

  • Crypto asset exchanges that deal with spot trades would also report to the CFTC.

  • Defines who is cryptocurrency broker.

  • Clarifies that staking and mining gains would not be considered a part of gross income until a taxpayer “exercises dominion” over those assets.

  • Requires payment stablecoin issuers to maintain liquid assets equal to 100 percent of face value of all outstanding payment stablecoins.

Those are just some of the provisions in the bill, which will likely die in committee given the makeup of the current House of Representatives and the inability of the two major parties to agree on much of anything. Still, the fact that there is legislation means that Congress has cryptocurrencies on its radar.

Will a Class-Action Lawsuit Determine How Crypto Is Classified?

Far more interesting is a class-action lawsuit filed against Coinbase in March. Brought by three Coinbase customers who claim the crypto exchange didn’t warn them of the risks of purchasing cryptocurrencies, the parties seek a return of fees paid on the exchange and nullification of their transactions under the guise that Coinbase is trading unregulated securities as defined by the Securities Act of 1933. The plaintiffs assume that all of the cryptocurrencies listed on Coinbase are securities despite no court ever ruling that is the case.

In an ongoing lawsuit between the Securities and Exchange Commission (SEC) and Ripple Labs, the SEC claims that XRP, the cryptocurrency created by Ripple Labs, is a security because it looks and acts like one. However, Ripple CEO Brad Garlinghouse disagrees. He says XRP is not a security because it exists independent of Ripple Labs. According to Garlinghouse,

If Ripple the company is shut down tomorrow, the XRP ecosystem will continue to exist. It’s an independent open-source technology.

Such reasoning flies in the face of the Howey Test.

In the 1946 Supreme Court case SEC v. W.J. Howey Co., the Supreme Court defined a 4-part test to determine whether an investment contract is a security. That determination is predicated upon:

  1. An investment involving money

  2. In a common enterprise

  3. With an expectation of profit

  4. Derived from the efforts of others (emphasis mine)

The bold text above indicates where Garlinghouse’s statement and the SEC’s provocations meet. If XRP is independent of Ripple Labs and will continue to exist, leading to potential profits for XRP holders, even if Ripple Labs ceased to exist, then Garlinghouse is 100 percent correct. In that case, the expectation of profit would not be derived from the efforts of others, but from the perpetuation of a technology.

On the other hand, that technology was created by humans. The technology would not exist were it not for Ripple Labs, so the court could side with the SEC on those grounds.

What I find interesting about the Coinbase lawsuit is that plaintiffs assume that all 79 cryptocurrencies listed on Coinbase are securities when there has been no legal determination on that matter. Their arguments hinge on comments made by SEC Chair Gary Gensler, but Gensler doesn’t make the law. His authority extends only to enforcing law that already exists.

It is for that reason that Congress should write legislation that addresses how cryptocurrencies should be classified. I believe Coinbase CEO Brian Armstrong was correct when he said

Treating every cryptocurrency under the same regulations would not make sense. Some cryptocurrencies, such as Bitcoin and Ethereum, might be a commodity, and Stablecoins may be a currency.

And, yes, some may very well be securities. But it isn’t Gensler who should make that determination. It’s the legislative body that creates the laws of the land with the presidents signatory approval as the head of the executive branch.

How Should Congress Decide Which Cryptocurrencies Constitute Securities?

Utility tokens are not securities. Governance tokens are not securities. No cryptocurrency should be classified as a security unless it is used as an ownership interest in an underlying asset and its value is derived solely and directly from the actions of managers of the project or executives of a parent organization. In XRP’s case, the value of the cryptocurrency is derived from its ability to allow individuals and institutions to move money quickly in a more cost efficient way.

The only real way Ripple has any influence on the value of XRP from day to day is when it releases new XRP into the circulating supply. While that certainly can impact the value of XRP, it’s not the only factor that impact’s XRP’s value.

In the age of cryptocurrencies, I believe the Howey Test should be modified to include a fifth criteria. Is there anything other than the direct efforts of others that can impact the value of the digital asset? In most cases, the answer is yes - the technology itself.

The only way to determine whether Coinbase is peddling securities is to take each cryptocurrency listed at the exchange and examine how it works independently of the other cryptocurrencies. If the court does this, I believe it will find that most of the cryptocurrencies listed at the exchange do not meet the definition of security even without the fifth criteria. What do you think? Leave me a comment below and let me know.

Cryptocracy is a decentralized newsletter published 4 times a week. I curate the latest news and crypto analysis from some of the brightest minds in crypto, and sometimes offer a little insightful and snarky commentary. Always fresh, always interesting, and always crypto.

First published at Cryptocracy. Not to be construed as financial advice.

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