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Is cryptocurrency like stocks and bonds? The courts are getting closer to an answer.
For more than a decade, cryptocurrency industry pioneers have envisioned digital currencies as an alternative branch of finance, a renegade sector that would operate beyond the reach of big banks and government regulators.
But as digital currencies like Bitcoin and Ether became increasingly widespread, the cryptocurrency industry ran afoul of a 1946 Supreme Court decision that created what’s known as Howey’s testa legal analysis that determines when a financial product becomes subject to the same strict rules as stocks and bonds.
In recent years, regulators have seized on this legal precedent to argue that cryptocurrencies are just another stock, like Apple or General Motors stock. The cryptocurrency industry fought back, leaving it in a legal gray area with an uncertain future in the United States.
Now the long-running dispute is moving closer to a resolution, as federal judges begin considering a series of lawsuits from the nation’s top securities regulator against some of the largest cryptocurrency companies. This month, judges held hearings in two of the most high-profile cases that could decide whether the multibillion-dollar cryptocurrency industry can continue to grow in the United States.
The legal battles are “an existential issue for cryptocurrencies,” said Hilary Allen, an American University professor who specializes in financial regulation.
Court battles have intensified over the past 18 months, as has the Securities and Exchange Commission has taken legal action claiming that crypto companies were operating as unregulated securities businesses. In response, the industry argued that laws regulating Wall Street trading should not apply to digital currencies. Both sides achieved initial victories in court that left the issue unresolved.
But this month, federal judges held hearings in two cases that legal experts expect will be more decisive: the SEC’s lawsuits against cryptocurrency exchanges Coinbase and Binance, which explore the central issues in the broader legal battle. Preliminary rulings on those cases are expected in the coming weeks, setting the stage for litigation that could eventually reach the Supreme Court.
“We have built our legal strategy around” a possible Supreme Court showdown, said Paul Grewal, Coinbase’s chief legal officer. “These are issues that have potential implications for large sectors of the economy.”
How the courts rule could determine whether the cryptocurrency industry can dig deeper into the American financial system. If the SEC prevails, cryptocurrency advocates say, it will stifle the growth of a new and dynamic technology, pushing start-ups to move offshore. The government has countered that robust oversight is needed to end rampant fraud that costs investors billions of dollars the cryptocurrency market imploded in 2022.
“The history of cryptocurrency markets demonstrates that investors are being put at risk and harmed by these platforms’ total disregard for regulatory requirements,” said SEC spokesperson Stephanie Allen.
Crypto’s origins date back to 2008, when a developer known by the pseudonym Satoshi Nakamato created the software behind Bitcoin. Early proponents envisioned cryptocurrencies as a decentralized alternative to traditional finance, a communal project run by a large network of people spread across the globe.
But as the industry matured, companies similar to traditional financial firms began developing cryptocurrencies and aggressively marketing them. Enthusiasts purchased the digital coins in the hope that they would increase in value. The government saw the emerging sector as an unregulated version of Wall Street, full of fraud and manipulation. According to Cornerstone Research, a consulting firm, the SEC filed 46 cryptocurrency-related lawsuits last year.
The SEC’s blueprint for cryptocurrencies is driven by a 1946 Supreme Court case involving investments in Florida orange groves. The case led to the creation of the Howey Test, a legal standard for determining what makes something a security if it is not a stock or bond.
In this framework, a financial product becomes a security when it offers the possibility of investing in a “joint enterprise” with the expectation of profiting from the efforts of other people. Examples of securities subjected to the Howey test include some insurance products and even sales contracts chinchilla.
Classification as a security comes with a wide range of legal requirements: companies offering securities must provide detailed information and comply with complex investor protection procedures which can be expensive to carry out.
In public statements, SEC Chairman Gary Gensler has argued that most digital currencies qualify as securities under the Howey test because people invest in cryptocurrencies hoping that the companies issuing the currencies will drive up prices. Only Bitcoin, he said, is beyond the reach of the SEC, as no central group or individual oversees it.
Under the regulatory authority of the SEC, Gensler was given the opportunity to develop new regulations for the cryptocurrency industry. But he instead argued that the industry should be regulated by existing laws and court rulings established to protect investors from fraud.
The cryptocurrency industry has called this approach overly broad, countering that a formal contract between the seller of a digital currency and an investor is required for the agreement to constitute a securities transaction.
“Gensler’s approach was to put a square peg in a round hole,” said Teresa Goody Guillén, a partner at BakerHostetler and former SEC counsel. “There needs to be a regulatory regime in place for these new assets beyond just saying they are all securities.”
Gensler’s strategy faced an initial test in the SEC’s lawsuit against digital currency issuer Ripple. In July, a New York federal judge, Analisa Torres, governed that Ripple’s cryptocurrency did not qualify as a security, at least when it was bought and sold on public exchanges by amateur investors. Judge Torres found that these investors did not expect to profit from Ripple’s stock as a company.
The ruling was celebrated in the crypto world. But the enthusiasm was tempered a few weeks later, when a judge in another case endorsed the SEC’s view that a different set of cryptocurrencies qualified as securities and rejected much of Judge Torres’ reasoning.
This split has raised the stakes for judges overseeing SEC lawsuits against Coinbase and Binance, which serve as marketplaces for dozens of digital currencies. In these cases, the SEC argued that at least 20 cryptocurrencies qualified as securities, giving judges the ability to issue wide-ranging rulings that could apply across the digital asset universe.
A hearing on the Coinbase case in Manhattan federal court last week lasted five hours, with more than 500 people tuning in via phone; About 250 people tuned in to Binance’s hearing in Washington on Monday. Both hearings revolved around the applicability of the Howey Test to digital currencies.
Lawyers for Coinbase argued that the SEC is seeking to extend the intent of the Howey Test to cover cryptocurrency investments. Without a clear contractual agreement between the buyer of a digital coin and its issuer, lawyers said, a cryptocurrency is no different from any other “collectible” that could increase in value over time, such as baseball cards or Beanie Babies dolls.
During the hearing, Judge Katherine Polk Failla appeared to support some of Coinbase’s concerns about overruling the SEC, saying the commission may “be too broad in scope.”
“We’re all afraid that you have so little limit on your standards” that some lawyers will argue that Beanie Babies are unregistered securities, he told a lawyer on the commission.
In the Binance case, Judge Amy Berman Jackson in Washington seemed more skeptical about comparing digital coins to collectible toys. But she expressed concern about the SEC’s strategy and urged government lawyers to explain the limitations of their argument.
Those hearings came just days after a major victory for the cryptocurrency industry the SEC has approved a new Bitcoin investment product for trading on Wall Street. Gensler fought to block its introduction until a court ruled against the SEC in August, effectively forcing the agency’s hand.
“It was an amazing thing that gave people reason for hope,” said Coinbase’s Grewal. “There is real optimism in the industry now.”