What Do Crypto Asset Securities Mean?
A frustrated judge, a misguided investor alert and the interplay between money and the law
On December 15, the SEC denied a Petition for Rulemaking filed on behalf of Coinbase Global, Inc. Here is the statement by SEC Chair Gary Gensler.
In Chair Gensler’s statement, the phrase “crypto asset securities” features prominently. Including the footnotes, it has been mentioned a whopping 21 times.
What does the phrase “crypto asset securities” mean, though? The pro-crypto Xverse has been busy burying the term, suggesting that the term has no legal meaning, and the SEC is just using it to influence the perception. Here are a couple of examples:
Are they right?
The answer is nuanced. If you are coming into this discussion without an agenda and truly want to understand what’s going on, this post is for you.
A Frustrated Judge
The phrase “crypto asset securities” has already left at least one judge frustrated. As you may recall, the SEC sued Binance on June 5, 2023. A hearing was held about a week later, on June 13, 2023. You can find the transcript (PDF) here. We’ve included various relevant excerpts below and followed up with our commentary:
THE COURT: Okay. Well, that will be fun. All right. The memorandum says, at multiple points, including on pages 16 and 19, that the defendant, particularly the U.S. entity BAM Trading offers the ability to buy and sell, quote, crypto assets, including crypto asset securities. That's your formulation. At various points in the memorandum you refer to "crypto assets," but in others you use the term "crypto asset securities."
It’s perfectly normal to wonder what the distinction is, isn’t it?
THE COURT: Okay. All right. And we'll get to that in a minute, but it would help me if, first, you would walk me through what differentiates crypto assets from crypto asset securities, and then I'm going to ask you to tell me which assets in particular referred to in the memo and in the complaint, other than the Binance coin, are the securities that are the predicate for your complaint.
It’s a legitimate question, but a satisfactory answer was not coming, so Judge Amy Berman Jackson tried again:
THE COURT: All right. But when you talk generally about the companies and their businesses, you say they deal both in crypto assets and crypto asset securities. Does the complaint allege any other specific coins are securities, besides the BNB or the Binance coin?
After some back and forth, Judge Amy Berman Jackson was still not satisfied, so she tried again. Some progress was made in this exchange:
THE COURT: When you use the formulation crypto asset versus crypto asset securities, can you tell me, what are the differentiating factors?
MR. SCARLATO: Whether they meet the Howey test.
THE COURT: That's it? The Howey test for each one --
MR. SCARLATO: Yes.
The Howey test, indeed, but not as originally conceived. A modified Howey test is needed. We laid the groundwork for it in our Binance amicus brief, it remains to be seen at what point the legal community will recognize that the Howey test is ultimately about finance, and when finance changes, so should the test.
THE COURT: -- in --
MR. SCARLATO: I'm sorry, Your Honor. Yes, that's how a security is defined, and we give 14 specific representatives. We're not saying that's exclusive, Your Honor. Our complaint, we feel like, was long enough, so we gave a bunch that we thought satisfied that test and reserve our right in discovery to, you know, conform our complaint to the pleadings or whatever is necessary before trial.
THE COURT: All right. Are the other crypto assets that you're not labeling as securities, commodities?
Good question. The best answer would have been that securities and commodities are not mutually exclusive. That they are is a myth, one that is happily perpetuated by the pro-crypto community.
MR. SCARLATO: The other -- that aren't alleged in our complaint, Your Honor?
THE COURT: The others that you say they're trading in that you're not saying are securities, because you're not saying all of the ones they're trading in are securities, correct?
MR. SCARLATO: We -- at this time, Your Honor, we're reserving our rights, just given we're at the pleading stage we have to get into discovery where we can make a full assessment. But our position, Your Honor, is that if one of these coins are a security, we've won.
Sure, but that seems to be a lost opportunity to bust the security “or” commodity myth. Chair Gensler had a similar opportunity, but he also passed.
THE COURT: I heard that.
MR. SCARLATO: Okay.
THE COURT: But you have said all over the complaint crypto assets -- and you differentiate that specifically from crypto asset securities, and you make it clear that one category is larger than the other category and that both categories are on the Binance.com platform and the Binance.US platform, correct?
MR. SCARLATO: Yes.
THE COURT: So I'm asking you, the ones that you are not putting in the securities category, what are they? Are they commodities?
An opportunity presented itself again. Yet…
MR. SCARLATO: We are not -- thank you, Your Honor. We are not taking a position at this time. We're at the pleading stage. We are trying to get past, you know, any potential motion to dismiss and satisfying our burden under the rules. So we have, we think, way more than is required under Rule 8. We gave the Court and the parties notice as to -- I think the number is 14 total coins, including BNB, which is at issue in the TRO.
…the SEC passed again. The unfortunate reality is the SEC’s unwillingness to take a firm position on this plays right into crypto’s hand; another lost opportunity.
THE COURT: All right. You argue in your memo that the Binance coin, at least by the time it was available to be purchased through BAM Trading on the Binance. US platform was not a security. So what was it? Was it a commodity?
Not satisfied with the answer, Judge Amy Berman Jackson was now seeking an answer from Defendant’s (BAM) counsel:
MR. MERTENS: It was a crypto asset.
At this point, one can feel the frustration boiling…
THE COURT: What is a crypto asset that is different from a crypto security? No one wants to tell me.
MR. MERTENS: Well, the crypto asset security, as I understand it, is they're adding the word "security" to bring it within the scope of the federal securities laws. And whether it's section -- I believe it's section 2 of the Securities Act or section 3 of the Exchange Act, defines a security as, among other things, an investment contract, as the Court has heard, and that is what the government is relying on.
This position seems reasonable. “Security” is a legal conclusion. SEC’s word choice seems to assume the conclusion that they want. To be clear, we agree with that conclusion, though we take a different path to get there.
An investment contract requires a contract. The language about a scheme, as I understand, it was dicta. There was not a scheme at issue in Howey, it was a contract. And as I understand the case law, all of the cases under Howey and all of the cases under the Blue Sky laws prior to Howey under which was the origin of the securities laws, involved a contract. We are not aware of any case that's found a security without a contract. And that is --
We disagree. An investment contract does not require a contract. Please see our reasoning in our Coinbase amicus brief.
THE COURT: Even since Howey? I mean, what about the government's citing cases where actually crypto assets were found to be securities?
MR. MERTENS: So my understanding is that those other cases did have a contract in place, and there is not a contract here. And that's our dispute. You can't have an investment contract without a contract. You also can't have an investment contract without some expectation of profit. And here there's -- no one has talked, explained at all what the obligation -- what the contractual obligations or the contractual benefits are from supposedly buying one of these assets.
And, you know, there's lots of other language used by the SEC when they were speaking about it that, you know, people hoped to earn a return. That's not -- that doesn't equal an investment contract. It's a long way from investing in an orange grove in Howey and expecting to earn returns when the oranges were picked from the trees and sold. There's no contract here --
Again, we beg to differ. Under the modified Howey test, hoping for a return if that’s the predominant behavior, actually does imply an investment contract.
The SEC is indeed incorporating a legal conclusion into the language that is far from established. That said, their conclusion is correct. To understand why, we have to first take a step back and remember the basic principles of finance.
A Misguided Investor Alert
This investor alert, titled Exercise Caution with Crypto Asset Securities, is actually from March 2023, but the SEC recently reiterated its stance:
Let’s see, the phrase “crypto asset securities” clocks in at 20 times in this investor alert. There is a pattern here; the phrase seems to get around 20-21 touches per statement, not unlike a heavily-used running back. It does indeed seem that the SEC is pushing for a touchdown.
Similarly, the word investment or investing gets many touches in the investor alert (too many to count). For example:
The SEC’s Office of Investor Education and Advocacy continues to urge investors to be cautious if considering an investment involving crypto asset securities.
And:
Investments in crypto asset securities can be exceptionally volatile and speculative, and the platforms where investors buy, sell, borrow, or lend these securities may lack important protections for investors.
And:
Investments in crypto asset securities can be exceptionally risky, and are often volatile.
And:
In sum, investors in crypto asset securities should understand they may be deprived of key information and other important protections in connection with their investment.
Curious how we reached the same legal conclusion as the SEC but got there via a different path? It’s quite intuitive, actually. Our position is that the most important piece of information being withheld from crypto purchasers is that one cannot invest in crypto.
The Interplay Between Money and The Law
Can there be true justice when the law and finance don’t work in unison? Our starting point in both the Coinbase and Binance amicus briefs was the need to acknowledge that there are not one but two questions that need to be answered. In our Coinbase amicus brief, we said:
[T]his case can be conceptually represented through a straightforward two-by-two table, guided by two key yes-or-no questions. First, the finance question: Is it an investment? Second, the legal question: Is it an investment contract? Answering each of these questions with a ‘yes’ or ‘no’ results in four potential outcomes (yes/yes, yes/no, no/yes and no/no). NFI contends that a comprehensive resolution of this case necessitates the simultaneous examination of both the finance and legal questions. A common-sense approach underscores the importance of viewing the issues represented by this case as an application of the law through the lens of finance: determining the boundaries of investor protection, after all, would be a difficult task unless a consensus can simultaneously be established on the definition of the term investing.
It should not be controversial that a multidisciplinary lens is needed to properly resolve legal questions related to money. So what is the problem? Even when this principle can be agreed upon, one giant obstacle remains: The discipline of finance has forgotten what investing really means. As a result, we truly live in an alternate reality of finance.
Other than us, practically nobody else is talking about this. In our minds, what is happening is quite clear:
It all starts with the definitions. Investing is all about cash flows.
Over time, crypto morphed into something that it wasn’t originally designed to be. Perhaps it was a decoy all along, or maybe Satoshi and early adopters truly did envision a new currency. In any event, crypto started to be seen as an investment opportunity.
Very few people pushed back. Warren Buffett and Charlie Munger come to mind. Aswath Damodaran has been vocal. So has Jamie Dimon. As influential as these voices are, their opinions got lost in the cacophony.
Critically, the SEC took the position that one can invest in crypto. We disagree. Their investor alert should have read like this.
The alarm bells should have gone off. If the regulator whose mission is investor protection (SEC) and the person who amassed a 12-figure net worth by doing nothing more than good old investing (Warren Buffett) had such a fundamental disagreement, it was time to take a step back and examine why.
That didn’t happen. Proponents of speculation still happily sell crypto as investing. Speculators keep buying it, perhaps because fancying themselves as investors makes them feel better. Meanwhile, regulators, Congress, and the courts continue to miss the fact that this is the most significant issue of our lifetime with at least a trillion dollars at stake, and it all hinges on a single word: investing.
Can the SEC still win the case against Coinbase? Yes, but how you win is just as important as winning itself, if not more so. A win for the wrong reasons will all but ensure that the win will be rather short-lived from a legal perspective. “Investors”? They are already losing, because they are being deprived of the most important thing they need to know. Disguised as a matter of personal choice and generational opportunity, the concept of “investing in crypto” only makes people more vulnerable. Can there be a real choice without full information? That’s a non-starter, but amazingly, that’s precisely what is happening.
We are convinced of one thing. Unless and until there is a true partnership between money and the law, one that is devoid of all misconceptions, myths, and dead-end narratives, the American dream will continue to slip away from all of us.
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