Why Ether and Ethereum Is Not a Security
(Originally written in August 2019)
Recently, news has been surfacing of blockchain and cryptocurrency related companies conducting unregistered securities offerings and being shut down by the Securities and Exchange Commission (SEC). For many companies, the viability of their business model is completely dependent on whether the blockchain-based service or product they offer is considered a security. In a recently given statement, SEC Chairman Jay Clayton affirmed SEC Division of Corporate Finance Director William Hinman’s opinion that the Ethereum network and Ether are not a security. Although the opinions made by both the Chairman and the Director are not contained in official opinion letters of the SEC, they do indicate the general stance of the SEC and how it would rule once it decides to do so. To understand how the SEC came to this conclusion, we first must understand how the Ethereum network works.
The Ethereum Network
Ethereum is a blockchain-based platform on which the cryptocurrency known as Ether is spent and transacted. Ethereum is a bit like a web-hosting service, a programming language and a payment processing system all amalgamated into one system.
By creating a network of “miners” (computers around the world which store and compute data in exchange for Ether), the Ethereum network is able to provide hosting and computing services which do not exist just on one server and instead are portioned out to hundreds or thousands of computers across the world. Because the computing data is not in one location under one person’s or entity’s control, Ethereum is able to offer a higher level of security and assurance, especially for financial transactions. Although Ethereum likely could host any type of application of its services, the per-computation Ether cost discourages users from clogging up the network with trivial computations.
Ethereum is also like a programming language in that any person who is willing to learn how to use the Ethereum network may build their own application on the network. Many times, these applications may be a mix of half off-network website and half on-network Ethereum transactions, reducing the Ether spend when compared to a full on-network application. The current applications programmed and hosted on the Ethereum network are weighted heavily towards the field of fundraising. Most companies use Ethereum to create an application that creates and issues the company’s private token. Since Ethereum simplifies and lowers the cost of maintaining and recording a ledger of transactions, many unsophisticated parties have erroneously utilized Ethereum to implement a sale of tokens which are considered unregistered securities by the SEC.
When a company creates a new token on the Ethereum network, it has complete control over the new token created, including producing, trading and exchange. However, the new token has no miners, it is still on the Ethereum network and the operator of the new token still must purchase Ether from the market to pay miners to compute and host the transactions of the new token. Thus, Ether acts as an intermediary currency between the offeror of computing and hosting services and the offeree seeking to host the new token and the application. As a side note, it is also possible to create an application which transacts in Ether rather than a self-created new token, and many programmers do that as well.
The Howey Test
The definition of a security according to the SEC includes stocks, bonds and investment contracts, among others. This definition is extremely important to many blockchain companies because if their new token is considered a security, then they will need to follow much stricter guidelines when offering their tokens for sale to the public. Although some companies create tokens which grant stock ownership in the company, most eschew granting equity to their token holders. Thus, most tokens must be analyzed under the definition of investment contract which is also considered a security. The case SEC v. Howey Co. defines an investment contract as a contract, transaction or scheme whereby a person: 1) invests his or her money, 2) in a common enterprise, 3) is led to expect profits, 4) solely from the efforts of the promoter or a third party. Whether a contract or scheme is considered a security is analyzed on a per offering basis. In other words, something that may be a security in this offering may not be considered a security in another offering if the surrounding circumstances change.
The Common Enterprise
Currently, there is a three-way circuit split of decisions among the Federal courts as to the definition of “common enterprise.” First, the Horizontal Approach considers whether there is a “pooling” of investor’s money such that the individual investors share all of the risks and benefits of the business enterprise. This approach is currently used by the District of Columbia and the First, Second, Third, Fourth, Sixth and Seventh Circuits. Second, the Narrow Vertical Approach considers whether the fortunes of any single investor are interwoven with and dependent upon the efforts and success of those seeking the investment. This approach is used solely by the Ninth Circuit. Third, the Broad Vertical Approach only requires that the investors are dependent upon the expertise or efforts of the investment promoter for their returns. This approach is currently used by the Fifth and Eleventh Circuits. Thus, the Horizontal Approach frequently fails whereas the Broad Vertical Approach rarely does. The SEC has stated that for tokens, this element is usually met.
Efforts of the Promoter or Third Party
The main issue in analyzing whether a digital asset is considered a security is whether there is a reliance on the efforts of others. The inquiry focuses on two key issues: 1) does the purchaser reasonably expect to rely on the efforts of the active participant (promoter or other related party); and 2) are the efforts “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature? Generally, if the token sale occurs before the platform or product is built, then that token will be considered to have been sold to investors in reliance on the efforts of others.
Ether During its Presale Phase
When Ether was first sold, it was offered in a presale which netted the non-profit Ethereum owning entity approximately $18 million. At the time, the platform was not fully built and the Ethereum team was collaborating in developing the platform. Thus, each purchaser of Ether at the presale phase invested money in a common enterprise (all of the purchasers of Ether pooled their money to Ethereum to build the platform) and the direct managerial efforts of the founders were required for Ethereum to exist. However, there exists a question as to whether the purchasers were led to reasonably expect profits. Ether has no dividends, and the entity owning Ethereum is a non-profit entity. As long as the purchaser’s expectations were curbed by Ethereum during the presale coin offering phase regarding the asset appreciation value, it may be argued that Ethereum did not lead purchasers to expect profits. In another sense, Ethereum can state that the sale of Ether at the presale phase was simply a prepayment for its future services. Whether those prepaid services are worth more at a future date is simply market fluctuations. This argument currently has not been validated by the SEC. Although the SEC recently has stated that Ether is not a security, it is still investigating whether or not to consider the original presale of Ether to be a security. Certain factors—such as if there is a secondary market, if purchasers reasonably would expect appreciation of Ether, if Ether was offered broadly beyond the market of its users, if Ether was purchased in larger quantities than a general user would ever need or if the founder will benefit from its efforts as a holder of Ether, all may be considered by the SEC in later declaring the presale to be an unregistered offering.
Recent Statements Made by SEC Officials
Director William Hinman, in his address at the Yahoo Finance All Markets Summit, stated that some digital assets considered a security when first offered can, over time, become something other than a security. A digital asset originally considered a security may become so automated as to require no efforts on the part of the founders in order for it to function. Even if the founders and their agents were to completely remove themselves from any participation, the digital asset would function unabated. It is also possible, in decentralized systems, for control of the digital asset to be removed from the original founder and divided among the market participants. In such a system, one purchaser of a token must rely on the efforts of all the platform participants in order for their token to grow in value.
For Ether, if there were another offering today of the token, the analysis may change greatly. It is not clear if Ethereum may rely on a lack of reasonable expectation of profits going forward. Although Ethereum may state in the offering documents that no investor should expect profits, there is also an active trading market which shows an appreciation of the asset in a way similar to any stock or bond. The disclaimer may no longer be reasonable. However, Ethereum currently does not participate in the transactions that occur on its platform. Programmers that create their own applications to be hosted on the Ethereum network transact directly with their clients and purchasers as well as with the computers and hosting owners. Ethereum charges no middleman fees and has no way of changing transactions that already have occurred. Ethereum cannot unplug or stop the network from existing. Ethereum’s current participation is to create code updates for the system and to be a global advocate for the Ethereum platform. At this stage, there is no pooling of money between purchasers of Ether, and the purchaser’s fortunes are not related to the seller’s fortunes, as third-party creators’ actions are immensely more integral to the Ether market. Additionally, it may be argued that the code updates Ethereum provides are just ministerial for the system instead of managerial. All decisions made that affect the Ethereum network must be made by a plurality of its actors instead of by Ethereum itself. Thus, there are no efforts of the promoter or third party, and it may be argued that there is also no common enterprise. Ether then is not an investment contract and, consequently, not a security.
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