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3 December 2021

Dear frens,

I hope you all had a great Thanksgiving holiday and I hope you're having a happy Hanukkah. Today, I want to ruminate on a claim I often see on social media: that SEC Chairman Gary Gensler has said that ETH is a security, and that as a result we may see him repudiate the policy outlined in the famous 2018 speech by then-Director of the Division of Corporate Finance William Hinman. I want to explain why I’m not convinced by these claims.

Let’s begin by understanding what exactly Hinman said in his speech. I find that there’s a lot of confusion about what he was communicating even though to me the speech is incredibly clear.

Sales, not tokens

One key message of the Hinman speech is that the proper question to ask is not whether a particular digital asset is a security or not, but whether a particular sale of an asset is a security. He says it once:

To start, we should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold. To that end, a better line of inquiry is: “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”

And twice:

The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract. And regulating these transactions as securities transactions makes sense.

What he is saying here is pretty clear. He is just applying the Howey test to digital assets. In the Howey case a guy sold people land along with promises related to the management of the orange groves on the land, and the Supreme Court found those sales to be investment contracts (a kind of security). That is, the Court found the sales, the transactions with its associated promises, to be securities, not the land.

The land that was the subject of the sale was never and will never be a security. That land is still in Florida and has likely been bought and sold many times since Howey, and we don’t say that at some point it “transformed” from a security into real estate. The land itself was never a security; it was always just real estate. In the same way, token sales can be securities yet tokens themselves cannot; at most they can simply represent or control a security interest.

So what are the kind of things that would have to accompany the sale of an otherwise-commodity token in order to make that transaction an investment contract? Again the answer to that comes from the Howey: There has to be (1) an investment of money in a (2) common enterprise with an (3) expectation of profits (4) reliant on the managerial or entrepreneurial efforts of a third party or promoter.

In the Howey case, Mr. Howey didn’t market the land to farmers who wanted to tend orange groves, but instead to tourists. And these tourists bought the land not because they wanted to tend the groves, but as an investment in the agricultural enterprise that Mr. Howey was managing. Most importantly, the buyers of the land relied on those managerial efforts for their expectation of profits. To apply this to a token, you just need to substitute token for land and token network for agricultural enterprise.

When tokens are just tokens

This brings us to the second key point in the Hinman speech. He was trying to answer the question: when can we say that a token that was once part of an investment contract is no longer a part and is now being sold just as a commodity? As he put it:

[W]hat about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created?

In the events of Howey, I imagine it’s probably the case that between the time the scheme began and the time of the SEC enforcement action there were some investors who bought land from Howey and sold it to other investors—investors who also relied on Howey’s efforts. Those secondary sales, of course, were also the sales of investment contracts, not just land. But at some point after the Howey decision there was a sale of the land by itself, to a farmer or a developer, who was not relying on anyone else’s efforts for their returns. The land was just land; there was no longer an orange grove enterprise managed by Howey that the purchaser was buying into.

So, the same should hold for a token that was sold at some point as part of an investment contract, but later sold without any reliance on third-party efforts. Analogizing to Howey, Hinman says that if buyers of a token are no longer relying on anyone else’s efforts (even if the token was at some point in the past part of an investment contract), then it sales won’t be investment contracts.

But how can we tell if there is reliance on a third-party or not? As the SEC is fond of saying, that’s a matter of “facts and circumstances” specific to each case, but in general we should be able to say that if “there is no longer any central enterprise being invested in”—that is, there is no longer any Howey Orange Grove Management, Inc. that manages the scheme—then there is no reliance because there is no one on whom one on whom one could be said to rely.

In the case of ICOs, investors are almost certainly relying on the ICO’s issuers to build and launch the network or application. Any secondary sales of tokens while people are still relying on the efforts of the issuer to build and launch the network are also going to be sales of securities. But at some point, if they indeed build and launch the network, and it becomes decentralized (in the sense that the issuer can get hit by a bus and the network would continue to function and others in the community could continue to develop it via open source means), then there is no one person or entity on whom investors can be said to rely. After that, token sales are just sales of commodities. In Hinman’s words:

If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.

The rationale he gives is important. The securities laws exist to mitigate the information asymmetry that exists between issuer/promoter/manager and investor. In the case where a network no longer has a central developer or manager, and all development and management is done open and transparently via open source and open blockchain means, there is no longer any information asymmetry to mitigate. Indeed, it’s not clear who the SEC would even require to make disclosures in such a case.

So when do we have sufficient decentralization to be able to say that there’s no one person or group that investors are relying on? Well, it’s not a bright line. It’s very much like pornography: you know it when you see it. That said, Hinman did offer a list of indicia. Subsequently the SEC made available a further list of factors it considers. I imagine a court would consider a similar set of factors.

Many folks in our space don’t like that it’s not a bright line. As a fan of the common law and flexible tests, it doesn’t bother me too much. The real problem is that the SEC doesn’t often take cases to court, so we don’t get much development of where the lines are, but that’s a topic for another missive. The important thing is that at one end of the spectrum we have clearly a security and at the other we have something that is not, and it’s possible to start life as part of an investment contract and end up not being related to any such contract and be just a commodity token.

ETH

Which brings us to Ethereum. Here’s what Hinman had to say about it in the speech:

And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

People focus on the last clause of that sentence (“current offers and sales of Ether are not securities transactions”), but just as important are the first two clauses. First he says, “putting aside the fundraising that accompanied the creation of Ether”. What he’s doing there is going out of his way to say that he is not talking about the Ethereum presale. By implication he is saying that the Ethereum presale may well have been a securities offering, no doubt because at the time of the sale investors relied on the efforts of the promoters to build and launch the network.

The second clause in the sentence is another big caveat: “based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure”. What he’s saying there is that he’s only talking about Ether as it existed at the time of his speech. Not at the time of the presale, not a month before the speech, and (this will become important in a bit) not in the future. He’s saying that his assessment that there’s no central party on whom investors rely depends on the facts and circumstances of the network as he understands them to be at that moment in time in June of 2018.

When Gary Met “When Gary Met Howey”

In 2019. Rep. Ted Budd (probably the next senator from the great state of North Carolina, BTW) sent a letter to then SEC Chairman Jay Clayton asking him if he agreed with Hinman’s speech, and Clayton answered that he did. It would be neat to have a similar letter sent to Gensler, but until then we have to rely on his past public statements to get a sense of his thinking.

I’ve looked for as many such statements as I could find. (It’s been funny because in a couple of the ones that are often cited I’m actually either a co-panelist with Gensler or testifying before a committee he chaired.) What I’ve concluded after looking at all these statements is that in every one Gensler seems to be agreeing (or at least not disagreeing) with Hinman’s analysis. It’s often reported that Gensler has said that Ether is a security, but in every statement that’s cited for that proposition it turns out that he’s referring to the Ethereum presale, not ETH itself today. Here are some examples:

→ MIT Bitcoin Expo (March 2018). He agrees it’s more or less settled that Bitcoin is not a security, but raises doubts about other tokens. He suggests he thinks ETH could be a security, but then adds “maybe not ether because it’s established, but then what do you do [about the others]?” {Twitter Clip} {Entirety on YouTube}

→ MIT Tech Review Business of Blockchain Conference (April 23, 2018). He makes clear his analysis is only about the initial Ethereum offering in 2014. {Clip on Twitter} {Entirety on YouTube}

→ Maryland Financial Consumer Protection Commission Hearing (June 2018). He explains his view that the ETH presale was a securities offering. This hearing took place ten days before the Hinman speech and Gensler bring up the open question about whether “something once being a security can transform to be something else” but doesn’t take a position. {Twitter Clip} {Source Video}

→ Congressional Testimony (July 2018). He discusses what the obligations of the ETH presale organizers should have been. {Twitter Clip} In his written testimony he acknowledges ETH is a commodity like Bitcoin when he says, “While the CFTC has general anti-fraud and anti-manipulation authorities with regard to spot transactions in crypto cash commodities, such as Bitcoin or Ether, the agency does not currently have express registration or plenary rule writing authorities with regard to cash commodities.” (Emphasis mine.) He also quotes the Hinman speech at length to explain that the SEC has taken the position that ETH is not now a security and he expresses no objection to this position.

→ Bloomberg Institutional Investor Conference (2018). He makes clear his analysis is about the initial Ethereum offering in 2014. Literally says “I think Ether when it was done in 2014 would pass [the Howey] test.” in the past tense. He then acknowledges Hinman speech saying that “subsequently the SEC has said that by 2018 is decentralized enough and they’ve said we’ll let it go the other way.” He states no objection to that. {YouTube}

→ MIT Class Lecture (Fall 2018). He makes clear his analysis is about the initial Ethereum offering in 2014. {Clip from Twitter} {Entirety on YouTube} In a previous lecture in the same court he also acknowledges that the SEC’s position was that ETH is not now a security and he doesn’t not express disagreement with that. {Twitter Clip}

Bottom line: I have not been able to find anywhere where Gensler says ETH is a security in the present tense. As far as I can tell, he’s only ever said the presale was a securities offering. On the question of whether a commodity that was once part of a securities offering can later be sold outside, he seems to demur giving a definite answer in the statements he made before the Hinman speech, and after the speech he acknowledges the SEC’s position and doesn’t express disagreement with it.

If you’re aware of some other statement I’ve missed where he says something beyond this, please send it my way as I’d love to be corrected. Additionally, it may be that his public statements don’t completely reflect the entirety of his thinking, or that his views may have changed. But, going on what I have, Gensler’s statements have always been consistent with the Hinman speech.

Now, does any of this preclude any SEC action on Ethereum in the future? No.

Remember that Hinman went out of his way to say that his determination was dependent on the network’s structure at the time of his speech. If there were to be ETH sales in the future where buyers in some way are relying on a person or group for their expectation of profits, then you can certainly imagine the SEC taking the position that those are sales of securities. This would be similar to the ongoing SEC action against Ripple Labs where the SEC’s charge that particular sales of XRP are securities can be made even if one grants that the XRP token itself is not a security.

Any such determination would be consistent with the Hinman speech. After all, it’s just a pretty straightforward application of the Howey test, so I don’t see what rationale there would be for repudiating it.

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That’s all I got today. I certainly would love to hear your thoughts. Please forward it to anyone you think might enjoy it and encourage them to subscribe. I’m not making these available on the web so the only way to get them is via email.

Finally, I took part in a panel discussion about D.C.-based crypto advocacy on the Bankless Podcast recently. You should check it out. {Audio} {Video} This was in conjunction with a new round of Gitcoin fundraising for Coin Center and other advocacy groups. Because of the quadratic funding mechanism Gitcoin employs, one dollar you give to Coin Center today will be matched to the tune of another $3,000 or so, so you really have no excuse to kick in a buck or two! You can do so here. Thanks!

All the best,

JB