Lawbitrage

Why Cryptoequity May Not Be Securities

The year is 1941 and the place is Lake County, Florida, a town just outside of Orlando with a population of about 30,000. The W.J. Howey Company, then operated by Dodge Taylor, is selling plots of a citrus grove along with the right to share in any profits from crop sales. The investment-like nature of Howey's sales eventually landed the company before the United States Supreme Court and resulted in a decision that still has important ramifications for securities law practice.

Fast forward to the present. Cryptocurrency technologies of the sort underlying Bitcoin are beginning to be used to sell software services and access to decentralized ledger platforms. These types of so-called "cryptoequity" have the potential to change how businesses operate, from raising funds to using automated contracts to giving stakeholders a unique voice.

Over the summer, Ethereum reportedly pre-sold over $12 million worth of cryptoequity tokens to fund the operation of its "distributed application software platform." The Ethereum tokens are required for developers to implement software on its platform. Another platform, Swarm, is selling tokens that allow entrepreneurs to use its decentralized crowdfunding technology to raise funds with their own programmable cryptoequities. As of July 2014, Swarm had reportedly sold about $750,000 worth of tokens.

Because of their innovative and somewhat malleable nature, cryptoequities are also operating in a legal gray area.

In 1946, Howey's scheme was blocked when the Supreme Court ruled in SEC v. Howey that the interests being sold qualified as "investment contracts" and hence were subject to regulation by the Securities and Exchange Commission (SEC). The Howey test for qualifying as a regulated investment contract, now canon in the field of securities regulation, requires an agreement to involve an investment of money, a common enterprise, and an expectation of profits from the efforts of a promoter.

The Howey test is broad and captures a wide variety of interests not commonly understood to be securities. Over the years, it has led courts to find earthworm farm interests, a seat on the New York Stock Exchange, and virtual shares in a fantasy investment game as deserving securities regulation.

If cryptoequity is treated by the law as securities, the organizations that obtained funds by selling them would have to register with the SEC and comply with its disclosure requirements and broader regulatory regime. Yet despite the breadth of the Howey test and being labeled as a type of "equity," the tokens may not qualify as federally regulated investment contracts.

Under Howey, it doesn't matter whether the investment capital comes in the form of legal tender, digital currency, or some other valuable asset. Bitcoin ponzi schemer Trendon Shavers found that out the hard way. However, a contract must subject the buyer to a financial loss for it to be regulated. While cryptoequity in the form of software rights and memberships may fall in value, it would be difficult to characterize them as regulated investment contracts without also including a wide variety of other non-financial, commercial agreements and ordinary product sales. Funds obtained from selling memberships to use an existing facility do not provide "risk capital" as is the case with securities. To the extent Ethereum and Swarm sold tokens after they were operational, the funds they raised don't qualify as risk capital. However, Ethereum's continued platform development after its token pre-sale makes the sale at least somewhat like a regulated offering.

Cryptoequity may not meet the common enterprise requirement, either. Courts have interpreted a common enterprise to exist when an investor's gain is tied directly to the success of the promoter (or a third party), or at least generally dependent on the promoter's efforts. Applying this "vertical commonality" requirement to cryptoequities, however, indicates they are not securities due to the potentially massive gap between the success of a platform (i.e., the promoter) and an individual token holder.

Individual developers and entrepreneurs may fail using an otherwise successful platform. The converse may be true as well. Tokens may be interoperable so that holders can use them on multiple platforms, or export their underlying applications or projects to other platforms. The fact that Ethereum's platform was recreated on the Bitcoin platform suggests that very little intrinsic relationship exists between the success of a token holder and any particular platform, and certainly not something like a passive investor's relationship to a single company's management. And depending on how they develop their applications, individual token holders may find their purchase to be worthwhile or a waste of money. This potentially different payoff undermines the common enterprise in the "horizontal" sense (i.e., among token holders). 

Likewise, what cryptoequity holders actually purchase with their funds may undermine the sale from being classified as a securities offering. The expectation of profits requirement does not exist when a buyer receives a good, service, or property. This is why crowdfunding platforms like Kickstarter are not subject to federal regulation. It is also why courts, including the U.S. Supreme Court, hold that shares in housing cooperatives or condos are not securities, even when they come with a reduction in rent or income from renting common areas. If cryptoequity is viewed as conferring a right to use "real estate" on a ledger, then, like housing shares, they may not qualify as regulated agreements.

The active involvement of cryptoequity holders--either as developers or entrepreneurs--may limit the applicability of federal law as well. Passive parties that rely on managers to generate a profit are the hallmark of securities investors. On the opposite extreme are partners that equally manage a business: the law presumes that partnership interests are not securities. This is because a partner, as opposed to a mere investor, does not rely on the efforts of others and does not need to be protected by the securities laws in doing so. (The same approach applies to LLCs managed by its members.) Buyers of Ethereum's tokens may be viewed as active participants because they promised their purchase was to use and develop on its software platform (and not as an investment). According to Howey, a purchase motivated to actively "develop" property is not a securities investment.

Finally, based on the 1990 Supreme Court case of Reves v. Ernst & Young, cryptoequities may not be regulated because they closely resemble commercial contracts that are obviously not securities. The Reves court held that promissory notes secured by home mortgages or business assets were obviously not securities, and neither were agreements that resembled them. The commercial nature of cryptoequity tokens in providing access to software and fundraising platforms may lead a court to hold the same.

Securities regulation is not meant to guard all types of agreements against fraud and manipulative behavior. So while it remains to be seen how the SEC will approach cryptoequities, there is good reason to believe that at least some types of cryptoequity are too commercial in nature to fall under its regulatory orbit. 

Updated with additional analysis on January 17, 2015.

Cutting Through the Noise About High-Frequency Trading

One might expect that the impact of high-speed, computerized securities trading would not be a controversial subject because the relevant information can be quantified, measured, and assessed.

But one would be wrong.

When it comes to the impact of high-frequency trading (HFT) on securities markets, limited data and inconsistent measures of its impact only fuel a controversy in which there seems to be little ground between those who seem to know that HFT has ruined markets and those believing that investors have never had it better.

Adding to the controversy about the impact of HFT is today's publication of Flash Boys: A Wall Street Revolt by famed author Michael Lewis. While the book no doubt does a great job of explaining the complexities of modern financial markets to non-experts, based on excerpts, reviews, and interviews describing the stock market as being "rigged," those wanting a more nuanced view should look elsewhere. 

To cut through the noise surrounding HFT, it's helpful to look at empirical studies on the subject. 

And indeed, there's lots of empirical studies finding that HFT in various forms undermines the quality of markets and increases costs to investors. Perhaps the best review of evidence-based studies in this regard is a December 2013 publication by R. T. Leuchtkafer. It reviews numerous academic, industry, and government studies with conclusions such as "HFT can be highly destabilizing as it propagates shocks across markets at very high speed," "high frequency traders do not as a rule engage in the provision of liquidity like traditional market makers," and there is "strong evidence that HFT increases the trading costs of institutional investors."

But the usefulness of Leuchtkafer's review is limited: it only includes negative findings (and opinions, for that matter).

In March 2014, staff of the U.S Securities and Exchange Commission (SEC) conducted its own review of empirical studies on the impact of HFT. While certainly not comprehensive, the SEC's review includes several studies not included in Leuchtkafer's review. And many of these additional studies find that HFT has a positive impact on markets and investors.

Among other things, these studies found that HFT "was associated with a 15% decline in effective spreads and a 23% reduction in the adverse selection costs of posted prices," that "price efficiency as measured by [order imbalance and price delay] is significantly higher on days of high HFT aggressiveness," and that for investors "trading costs did not change significantly" following a fee change that reduced HFT. 

The SEC's review is hardly an endorsement of HFT. Overall, it finds the impact mixed. In any case, the SEC's review recognizes its own limitations, noting that the HFT "picture remains unfinished" due to the limited availability of data. 

So while empirical studies of HFT"s impact hardly paint a conclusive picture, they do help to cut through the noise of HFT's most vocal critics and proponents. Hopefully, a balanced view of the empirical record will have the most influence over any reforms undertaken by regulators or market participants.

It's the Comparability, Stupid: What Really Matters for Overseas Derivatives Regulation

As financial market regulators seek to coordinate their post-financial crisis reforms, a contentious question is to what extent one nation's regulations apply to companies in other countries. The general principle under the Dodd-Frank Act is that U.S. derivatives (swaps) regulation only applies to transactions that have a significant connection or effect on the U.S.

Much of the debate surrounding the Commodity Futures Trading Commission's (CFTC) regulation of cross-border swaps transactions has centered around which firms are subject to U.S. regulation either because they fall under the definition of a "U.S. person" or because they engage in transactions with U.S. firms. The key worries underlying these debates are subjecting foreign firms to onerous and duplicative U.S. regulation, and whether doing so will undermine the ability of U.S. firms to do business internationally.

But there's a good possibility that the content of U.S. regulation and concerns about who is ensnared by U.S. regulation will eventually become irrelevant to overseas firms.

This is because CFTC regulations do not apply to foreign firms if the CFTC determines that the foreign country's regulations are comparable to its own. On December 20, 2013, the CFTC determined that the swaps regulations of six non-U.S. jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) were comparable. This means that firms in those six jurisdictions that would otherwise be subject to U.S. law because of their trades with U.S. firms are now exempt. 

The only thing preventing non-U.S. firms in those six jurisdictions from never having to worry about compliance with U.S. regulation is that the CFTC limited its comparability assessments to only a portion of its derivatives regime. As the law firm Sullivan and Cromwell observed, "[i]t is notable that the CFTC has not made any comparability determinations with respect to the CFTC’s mandatory clearing...trade-execution requirements...[and] margining for uncleared swaps."

The reason that the CFTC's failure to make comparability determinations in those areas is notable is because doing so would likely result in the vast majority of non-U.S. firms not being required to comply with the core requirements of U.S. derivatives regulation; namely, mandatory clearing and trade-execution for all swaps transactions, and lots of collateral for any exempted (uncleared) swaps. 

The possibility that the CFTC will ultimately make comparability assessments in the areas it has not done so is a good one. Right now, the CFTC's approach is piecemeal and fails to comport with the approach widely agreed upon by international financial regulators, including the Securities and Exchange Commission.

Over time, market participants will likely convince regulators to remove duplicative regulations among otherwise equivalent regulatory regimes. When that happens, the more important issue will be what derivatives regimes are considered comparable to those that are already recognized as a comparable to one another, and not the specific rules of any regime or the risk of being subject to a foreign jurisdiction's regulations.

SEC Levels Playing Field for Retail Investors With Crowdfunding Rules

Yesterday, the Securities and Exchange Commission (SEC) provided a major public service by proposing new regulations that, when enacted, will for the first time give ordinary retail investors the broad-based ability to purchase the stock of private companies. The SEC posted a short summary and the full-length proposal.

The rules contemplate startups raising small amounts of capital from lots of retail investors, a practice known as crowdfunding. But unlike Kickstarter and other popular crowdfunding platforms that cater to creative endeavors, investors will be able to directly share in a company's profits by receiving stock or other securities in return for their capital contribution, as opposed to just the work of art or other product made by the crowdfunded entity.

The new rules allow retail investors worth less than $100,000 to invest up to the greater of $2,000 or 5 percent of their annual income or net worth in private companies in any given 12-month period. Retail investors worth at least $100,000 are likewise permitted to invest up to the greater of 10 percent of their annual income or net worth.

In permitting retail investors to invest at least a portion of their savings in private companies, the SEC is helping to level the playing field between ordinary and wealthy investors. Since the passage of the securities statutes in the early 1930s, ordinary investors have effectively been shut out of investments accessible only to wealthy individuals and institutions. This is because the securities laws permit companies to stay private and avoid costly regulation if they refrain from raising capital from retail investors.

One downside of being shut out of private capital markets is that retail investors may be missing out on ways to diversify their portfolios. In a 2008 article for the NYU Journal of Legislation and Public Policy, I noted that shutting retail investors out of private securities markets deprives them of the opportunity to invest in hedge funds, which are often found to help diversify a traditional portfolio of stock and bonds.

A second downside of keeping retail investors cordoned off to public markets is that their options are limited to more costly or poorer performing copycats of private investments. For example, retail investors seeking to diversify their savings could invest in a publicly traded exchange traded fund (ETF) that tracks the returns of equity investments in private companies. However, in doing so retail investors would have to pay the price in the form of fees they would not have to pay if they could access the underlying private investment directly.

The new SEC rules contemplate retail investors crowdfunding companies through newly regulated web-based funding portals. That structure certainly makes sense, given that wealthy investors for years have been able to fund and trade private securities through portals such as those operated by Second Market and the Portal Alliance. 

Equity crowdfunding will certianly expose retail investors to new sources of losses, including from fraud. But given that retail investors can already taken on virtually any risk imaginable, from ETFs that track short-term financial volatility to trading foreign company stocks in local currency outside of the purview of U.S. regulators, opening the door of equity crowdfunding is unlikely expose investors to new types of risk.

In Contrast to CFTC, SEC Cross-Border Derivatives Proposal Takes an Outcome-Based Approach

Today, the Securities and Exchange Commission (SEC) announced that it will be proposing new rules relating to how U.S. regulation under Title VII of the Dodd-Frank Act will apply to cross-border derivatives transactions.

In so doing, a significant difference seems to have emerged between how the SEC and the the Commodity Futures Trading Commission (CFTC) will go about regulating cross-border derivatives.

A major component of the SEC's and CFTC's rules is to allow certain foreign firms that trade swaps in the U.S. to be exempt from the agencies' respective regulations. The basic reason being that foreign firms may already be subject to comparable regulation in their home country such that compliance with U.S. rules would be unnecessary to protect U.S. participants or markets.

In other words, the SEC and CFTC will permit foreign firms to substitute compliance with their home country's regulation for their own.

Importantly, the SEC's analysis of foreign regulation will focus on "regulatory outcomes" as opposed actual rules and requirements. As the press release describing the SEC's proposed cross-border rules explains:

Under substituted compliance, a foreign market participant would be permitted to comply with the requirements imposed by its own home country, so long as those requirements achieve regulatory outcomes comparable with the regulatory outcomes of the relevant provisions of Title VII....the Commission would take a holistic approach... rather than basing the ultimate determination on a rule-by-rule comparison.

The SEC should be applauded for focusing on comparable regulatory outcomes instead of comparable rules and requirements. It means the SEC understands that there is more than one way to protect investors and markets. An outcome-based approach will permit foreign jurisdictions to experiment with different approaches to regulation without necessarily undermining their domestic participants' access to U.S. markets. Focusing on outcomes will also help prevent foreign firms from being subject to duplicative regulation and keep U.S. capital markets competitive.

Indeed, in a 2009 article published in the NYU Journal of International Law and Politics, Jerry Ellig and I called for an outcome-based approach towards substituted compliance with securities regulation. Using very similar language, we argued that

the SEC should permit substituted compliance with a foreign regulatory regime so long as that regime achieves investor-protection outcomes similar to the investor protection outcomes achieved by the SEC....Compliance with a regime having comparable regulatory outcomes would thereby serve as a substitute for standard registration and oversight by the SEC.

Notably, however, the SEC's outcome-based approach towards substituted compliance seems very different than the approach taken by the CFTC, which focuses more on rules and requirements in making a foreign regime comparability assessment. Instead of focusing on regulatory outcomes, the CFTC will focus on the following aspects of a foreign regime in determining whether the regime is comparable:

the scope and objectives of the regulatory requirement(s), the comprehensiveness of such requirements, the comprehensiveness of the foreign regulator’s supervisory compliance program; and the foreign regulator’s authority to support and enforce its oversight of the non-U.S. swap dealer or non-U.S. major swap participant.

There thus seems to be a fundamental difference in how the SEC and CFTC will go about determining whether a foreign regulatory regime is comparable to their own. Although differences between the two approaches may matter little in practice, the differences could ultimately impact which foreign jurisdictions are considered comparable to the U.S. and lead to regulatory arbitrage.