by Lakshmi Raj C *
Introduction
In a controversial move, the US Securities and Exchange Commission (SEC) has launched legal proceedings against crypto exchange giants, Binance and Coinbase, on grounds of an alleged contravention of the securities market regulations. The immediate response of Binance that termed the regulator’s move as “unreasonable” and a blatant misuse of the “blunt weapons of enforcement” has raised crucial questions about the extent of regulatory scrutiny required for the healthy sustenance of fair market practices in securities transactions. Against this backdrop, it is pertinent to understand the crucial implications of the impending legal battle from a regulatory and investment standpoint.
On June 5, 2023, the US SEC filed a complaint in the Manhattan Federal Court against Coinbase on grounds that the platform had, since 2019, operated as an unregistered broker for crypto transactions and unlawfully offered exchange, broker-dealer and clearinghouse functions. On the same day, crypto giant Binance was also sued by the SEC on thirteen elaborate grounds of securities law violations such as subversion of control to secretly allow US customers to trade on their platform. Allegations were also made against the founder of the company, Changpeng Zhao that he, along with the company, had misused their control over the assets of the customers on the platform to channel funds unauthorizedly. The SEC’s move had immediate impacts as it sent the shares of Coinbase crashing down to its biggest one-day percentage decline since late March. Besides this, it is feared that the crackdown could potentially impact the penetration of decentralized finance (DeFI) systems in these trading platforms, hindering their future development. The legal battle which is set to ensue has grabbed eyeballs from capital market participants across the world. On the other hand, the regulator’s action of tightening the noose over crypto assets is also being considered a solid measure to safeguard the interests of investors and improve the security of transactions when it comes to digital assets. The differing views raise a conflict about the crucial considerations that must motivate regulatory actions of such wide magnitude.
The Regulatory Conundrum : Breaking down the SEC's approach
In classifying crypto as a “security” for the purposes of regulation, the commission relied on the age-old test for “investment contracts” as devised in the US Supreme Court (US SC) decision of SEC v. W.J. Howey Co. “The Howey Test”, as it is famously known, considers that an investment contract exists if three conditions are satisfied, namely, (i) investment of money in a common enterprise, (ii) a reasonable expectation of profits from such investment, and (iii) reliance on the efforts of others for such profits. Investment contracts are included within the definition of “securities” under the securities law in the US. Interestingly, the qualification of crypto assets as securities has remained debatable for a long period of time.
The SEC’s recent tryst with digital assets’ classification began with its filing of a suit against Ripple Labs Inc. and two of its executives in 2020. The suit held the company and its officials liable on similar grounds, namely transacting with digital assets without registering them as securities. The SEC’s recent action against Binance and Coinbase comes amidst the anticipation of finality to the debate through a conclusion to the legal proceeding. Notably, one of the principal pieces of evidence raised in the case of Ripple Labs was the Hinman speech of 2018, where the former SEC Director commented that Bitcoin and Ether cannot be considered securities, given their decentralized nature of operations. Such forms of operations make it impossible to identify a set of persons whose efforts may be crucial for the success of the enterprise, thereby not satisfying the last limb of Howey’s test.. The assertions in Hinman’s speech only contributed to the existing ambiguity shrouding the classification of digital tokens.
Historically, the uncertainty surrounding the classification of digital assets has given rise to the development of numerous tests through judicial decisions. One of the prominent tests that may be considered is the 'family resemblance test’ of 1990 devised by the US SC in Reves v. Ernst & Young. The test begins with a primary analysis of the motivation of the parties in entering into the transaction, and if the same is profit-driven, it raises a strong case for classifying the asset as security. The test then proceeds to examine if the “plan of distribution” contemplated through the instrument involves a “common trading for speculation and investment”. In the next stage, the “reasonable expectations of the investing public” is considered. The final limb involves a larger public interest test to assess if there exists an alternative regulatory forum that is competent to reduce the risks from the instrument, rendering the intervention of the securities regulatory body avoidable. The multi-pronged test casts a wide net to ensure that the space does not lie unregulated. A variant of the test that tilts more in favour of safeguarding the interests of the investors was devised by the California Supreme Court in Silver Hills Country Club v. Sobieski called the “risk capital” test. The test substituted the reasonable expectation of profit limb in Howey’s test with the requirement of expectation of any significant or valuable benefit to the participants that induces them to invest in the asset. The decision in State v. Hawaii Market Center Inc., added a new dimension to the test by requiring not only risk to initial value, but also inducement to invest by the offeror through promises of tangible benefit. The tests have been used by Federal courts in multiple contexts unbiasedly, hinting that their application on crypto assets may not be far-fetched or misplaced.
Conclusion
At a normative level, the SEC’s action must be assessed based on a closer consideration of the limitations in the larger legal space governing crypto assets. The absence of legal backing for crypto assets makes the sector alarmingly vulnerable to market manipulations. The recent Internet Crime Report of the FBI in the US revealed that investment fraud complaints jumped from $ 1.45 billion in 2021 to $ 3.31 billion in 2022. Out of this, cryptocurrency investment frauds witnessed a drastic increase of 183% from 2021 to 2022. The regulatory tussle concerning the competence of the SEC can only be resolved through concrete interventions aimed at clarifying the legal nature of the digital asset. Several proposals for laying down a comprehensive legal framework for crypto regulation have been considered by the US Congress lately, including a proposal for setting up a self-regulatory body for crypto assets. However, constructive action on these proposals has largely evaded sufficient legislative attention. Against this backdrop, the SEC’s current attempt at regulation can only be considered a drastic measure to lay a safety net for the protection of investors participating in the unrestricted sector.
* Lakshmi Raj C is a fifth year student at The National University of Advanced Legal Studies, Kochi at the time of publication of this blog.
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