A new bill introduced in the House would clarify that a digital asset that is sold as part of an "investment contract" does not necessarily become a security. If passed, the Securities Clarity Act would help settle one of the most debated legal questions in the crypto space and make it more difficult for the U.S. Securities and Exchange Commission (SEC) to argue that many existing tokens are unregistered securities.
In 2018, Bill Hinman, then director of the SEC's Division of Corporation Finance, the agency’s unit that handles securities registration and disclosure, gave his now-infamous speech on how the securities laws apply to digital assets. He suggested that if the network on which a particular token functions was “sufficiently decentralized” to the point where “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,” then the “digital asset transaction may no longer represent a security offering.”
Tuongvy Le is a partner and head of regulatory at Bain Capital Crypto. Khurram Dara is a regulatory and policy principal at Bain Capital Crypto.
Since then, the question of “sufficient decentralization” and whether a digital asset could “transform” from a security to a non-security has been the subject of much debate. SEC Chair Gary Gensler has repeatedly expressed skepticism over projects’ claims about decentralization and has pointedly refused to confirm that the reason he believes bitcoin is not a security is because it is “sufficiently decentralized.”
Meanwhile, in its still-ongoing litigation against Ripple Labs and two of its executives over the XRP token, the SEC has sought to distance itself from Hinman’s 2018 remarks, claiming that they were not official agency guidance.
Even so, a number of the SEC’s recent enforcement actions have considered whether a token project’s claims of decentralization would place it outside the definition of an “investment contract” – a type of security defined by a set of standards known as the Howey Test. In essence, the agency is implying it would be possible for a truly decentralized token to fall outside of its ambit, based on the “facts and circumstances” of each crypto project.
But on the question of whether a security can “transform” into something else, Gensler has previously stated that there is no precedent in the federal securities law for the concept.
If the recently introduced Securities Clarity Act becomes law, however, the answer to that question may no longer matter.
What would the Securities Clarity Act change?
The bipartisan bill, which Representatives Tom Emmer (R-MN) and Darren Soto (D-FL) announced in May, would clarify and codify that an asset sold or transferred pursuant to a fundraising transaction deemed an “investment contract” – and that is not otherwise a security – does not become a security just because it was sold or transferred as part of a securities offering. A version of the bill was first introduced in 2021.
The bill essentially distinguishes between an investment contract transaction, which is a securities offering, and the underlying investment contract asset, which is often not a security (like the orange groves in Howey). This means that a token offered as part of an investment contract would not need to “transform” into a non-security – it would not be a security in the first place.
The distinction is important because today, unlike the initial coin offerings (ICOs) of the past, many development teams that are interested in launching a token in the U.S. raise funds in SEC-compliant securities offerings using Regulation D (Reg D) offerings, an exemption from SEC registration typically associated with a public offering. In these private offerings, rather than sell to the public, issuers sell to “accredited investors” who acquire future token interests through purchase agreements (e.g. SAFEs or SAFTs) that call for token delivery upon certain conditions being met, such as network or protocol launch.
The key question for these projects is not whether a security can “transform” into a non-security, it is whether a token can be packaged in a multi-stage agreement involving a securities offering, without itself becoming a security.
This distinction between an investment contract transaction and an underlying asset had been “well-settled” according to the bill’s text, but has been “unnecessarily conflated in the context of digital assets.” Lewis Cohen of DLx Law argued the distinction is consistent with how federal courts have historically viewed “investment contracts.” In this sense, the bill does not break new ground as much as it provides certainty.
The bill is also good policy. Gensler frequently says existing token projects should “come in and register” their assets with the SEC. But conflating an investment contract transaction with the underlying token in order to shoehorn digital assets into the securities laws would not result in better investor protection. In fact, it might have the opposite effect.
As our friends at Paradigm have thoroughly detailed, the current SEC disclosure framework is unfit for crypto assets, as it “fails to provide crypto-asset users and investors with the information they need, while also denying crypto entrepreneurs a viable path to compliance.”
By providing certainty over the distinction between an investment transaction and the underlying assets, the Securities Clarity Act provides a path to compliance in the U.S.
Moreover, given most crypto purchases take place in secondary market transactions that are independent of the issuer, by separating the investment contract from the underlying asset, the bill helps provide some comfort for trading platforms that currently struggle with evaluating whether a token that may have initially been offered in a securities transaction can subsequently be listed or made available for trading.
Finally, a world in which a digital asset can transform from a security to a non-security (and potentially back again?) presents real practical challenges in terms of supervision and enforcement.
Emmer’s bill does have an important qualification that the asset underlying the investment contract is “not otherwise a security.” Without this qualification, the bill would essentially create a loophole allowing issuers to evade securities laws. Unfortunately, this qualification also means that the SEC can still ultimately determine that an asset underlying an investment contract is a security – discretion that could be abused by a more aggressive regulator.
Facts and circumstances
Still, the bill would provide much-needed clarity and could not have come at a better time. For instance, a day before the bill was introduced, Grayscale revealed in a press release that the SEC had informed the firm of its view that filecoin (FIL) is a security, in connection with Grayscale filing a registration statement for a filecoin trust product.
But Protocol Labs, the team that developed the Filecoin protocol, raised funds from accredited investors in a compliant securities offering that was exempt from registration. Given that Protocol Labs did not sell tokens to the public to raise funds for the development of Filecoin, the SEC's argument that FIL is a security likely hinges on conflating the distinction between the investment contract and the underlying asset, which is used to help secure and purchase storage space on a decentralized file storage network.
Filecoin has been used to collect, verify and preserve everything from evidence of war crimes in Ukraine to important scientific information, representing one of the most compelling non-financial use cases in all of crypto.
Even though the proposed legislation would not preclude the SEC from determining that investment contract assets are otherwise securities, it would significantly reduce uncertainty for investors and issuers alike. At just five pages in length, it is a short but effective bill that would provide clarity with a simple amendment to the definition of a “security” in the federal securities laws.
While any potential legislation faces an uphill battle in the Senate, the bill is another step in the right direction from the House Financial Services Committee, which appears poised to pass a bill on payment stablecoins and is also rumored to be working on a market structure bill.