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Legal Theories on Crypto: The Asset of Everything?

by | May 16, 2022 | Block Chain and Cryptocurrency, Brendan Cochrane

Cryptocurrency may not be everything, but in the eyes of US legal authorities, it may be getting close. Depending on who you ask, it could be a security, property, a commodity, or even money. Let’s look at this more closely.

Could Cryptocurrency Be a Security?

If we want to know whether cryptocurrency is a security, the first step, naturally, would be to define security. The law provides a cumbersome and comprehensive definition of “security” in The Securities Act of 1933. We won’t bore you with that definition, but you should know that as lawyers, that’s where we’d start. A more workable definition of “security” is provided by the Corporate Finance Institute, which defines a security as “a financial instrument, typically any financial asset that can be traded.”

How does this relate to cryptocurrency?

Again, the law starts with The Securities Act, and the list of potential securities, let alone the list of varieties of cryptocurrency is endless. It would seem like common sense, then, for the courts to step in and add some clarity. And that is exactly what they did in SEC v. Howey.

The Howey Test

Howey, the leading case on the subject of securities and decided in 1946, laid out what has become known as the “Howey Test”. Howey and the Howey Test remain good law today, and the test is the primary way cryptocurrencies and other potential securities are analyzed when one wants to determine whether particular something constitutes a security.

Basically, the case involved the offering of units of farmland with a contract for cultivating, marketing, and remitting the net proceeds to the investor. The SEC considered the nature of this agreement, and decided that it was subject to regulation. The questions as to whether the SEC could do this was such a big question that the case went all the way to the Supreme Court, which ruled on the matter and in the process established the Howey Test.

So if you are wondering whether a particular cryptocurrency would be a security, the analysis begins with Howey. The following are the four prongs of the test laid out in Howey, and if satisfied, the cryptocurrency in question would most likely be a security subject to SEC regulation:

  • It is an investment of money.
  • In a common enterprise.
  • With the expectation of profit.
  • To be derived from the efforts of others.

In Howey, the leasing transactions were considered investments of money with an expectation of profit, so the Supreme Court ruled in favor of the SEC. Maybe some cryptocurrencies you know would satisfy these prongs as well.

What This Means for Cryptocurrency

The economy and law surrounding cryptocurrency is still developing, and the Howey Test remains the baseline criteria upon which current and future cryptocurrencies will likely be measured in order to determine if they are securities. Recent cases such as SEC v. Kik Interactive, Inc. give more clarity on Howey as it relates to cryptocurrency, and ongoing legal battles like those involving the SEC and Ripple’s XRP promise to give more. Both cases were brought under the SEC’s claims that the respective companies did not comply with requirements to register their “securities”.

Basically, if you are considering issuing a new cryptocurrency, it is important to have nuanced and cryptocurrency-savvy legal counsel analyze your proposed cryptocurrency against the Howey Test and subsequent case law. For starters, however, you can have a look at the Framework for “Investment Contract” Analysis of Digital Assets to see the SEC’s latest stance on cryptocurrency.

Doesn’t the IRS Say Crypto is Property?

Yes they do.

Many cryptocurrencies will not be considered securities. What else might the law regard them as? Well, the IRS treats cryptocurrency as property for Federal income tax purposes. Actions such as selling cryptos or paying for goods and services with them, are likely taxable events.

The best thing to do when you are transacting in cryptocurrency would be to discuss your activity with professional tax experts, because running afoul of the IRS is never a good idea. To give you an idea of what such experts might tell you, however, please consider the following three IRS points:

  • Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.
  • Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.
  • Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.

IRS notice of 2014-21 added that most transactions with cryptocurrency, such as payments, rentals, trades and exchanges, are taxable. Your purchases of cryptocurrency with USD are likely not taxable events, however. But the complexities of tax law, especially when it comes to cryptocurrency, are best handled by crypto-savvy professionals who can review your transactions to make sure you are in lockstep with IRS expectations. And you certainly want to let your accountant know if you have made profits from cryptocurrency.

Are Cryptocurrencies Commodities, Too?

The endeavor of regulating virtual currencies is a hard one because of the uniqueness of each cryptocurrency and the sheer number of new cryptocurrencies. We’ve seen the SEC and IRS make their positions on cryptocurrency known, but the Commodities Futures Trading Commission has as well and has said they are commodities – like gold.

Additionally, the CFTC has oversight over futures, options, and derivatives contracts and the CFTC’s jurisdiction is implicated when a virtual currency is used, for example, in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. This was all taken from the CFTC’s digital asset brochures and that is a great starting point for people not knowing how to begin assessing risks of virtual currency markets.

For those of you who are just hoping to take advantage of the new cryptoeconomy for its ease of use and potential for profits, the fact that all of these authorities have stepped in may be a bit depressing. But you should know that the CFTC has a very noble focus on protecting consumers, and according to the CFTC’s Primer on Virtual Currencies, its mission is to foster open, transparent, competitive, and financially sound markets. By working to avoid systemic risk, the Commission aims to protect market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act (CEA). So yes, the CFTC has added additional legal complexity to the cryptoeconomy, but it is for a good purpose. We suggest checking with experts before issuing cryptocurrencies, trading with them, or building financial products around them.

Could Cryptocurrency Actually Be Money?

The term cryptocurrency certainly implies that cryptocurrencies are money, or currency. Some people actually make payments with cryptocurrency, and with respect to stablecoins, that is exactly what they do best. So potentially some cryptocurrencies could be viewed as money or currency.

Though the United States and state and local governments have not declared any cryptocurrencies to be currencies, other jurisdictions have made Bitcoin legal tender (see El Salvador’s Bitcoin law).  And if we utilize our reasoning capabilities, we can see that the El Salvador Bitcoin Law may have an impact on US laws such as Chapter 151 of the Texas Finance Code, which governs the licensing of money exchangers and transmitters and defines currency for purposes of currency exchanges as “the coin and paper money of . . . any country that is designated as legal tender and circulates and is customarily used and accepted as a medium of exchange in the country of issuance” see 151.501(b)(1). The California Financial Code has similar language, defining money for purposes of the act as “a medium of exchange that is authorized or adopted by the United States or a foreign government.” Although it is unlikely that Texas and California would regard a foreign jurisdiction’s decision to make a cryptocurrency legal tender as a controlling authority on the interpretation of their respective statutes, it is certainly useful to consider in the wider scope of the drive to make cryptocurrency a viable “money” in the global economy.

At the End of the Day

As we have seen, there is a lot of confusion around the legal status of cryptocurrency. Whether you are planning on investing in cryptocurrencies, or just looking to back an interesting blockchain project, you should always consider the risks behind it. Not every cryptocurrency is a solid project, many scams and fraud schemes can be encountered navigating through these markets. But others are very well-developed enterprises and are worth the risks. Perhaps in the future some of these assets will become completely mainstream and you’ll be able to use them easily through well established norms and procedures. But we’re not quite there yet. Don’t get yourself in hot water working in any capacity with cryptocurrency without doing thorough research first, or even better, seeking the advice of attorneys who’ve spent the time to understand this financial frontier just like you have.

Disclaimer: The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials provided here are for general informational purposes only. Information on in the article may not constitute the most up-to-date legal or other information. This article contains links to other third-party websites. Such links are only for the convenience of the reader, user or browser. This article should not be taken as financial advice. The volatility of cryptocurrencies can mean a high risk for investors, caution is advised.