Joseph R. Soraghan
If you invest in crypto-based assets, you may believe there are opportunities for profitable new businesses. But what do these businesses look like under the SEC’s securities laws? That depends on the definition of a “security.” The Supreme Court defines a “security” as any investment in a common enterprise with the expectation that any profits will be derived from the efforts of the seller of the investment or of a third party affiliated with the seller rather than the new owner. That’s the famous SEC v. Howey case.
Some examples might be:
Opportunity #1: Sell some of your crypto-assets and contract to manage them for the new owners.
Your contract to manage the crypto-assets calls for your efforts to generate profits. The U.S. Supreme Court says that contract is a security, like stocks and bonds, regulated with complexity by federal and state securities laws.
Opportunity #2: Buy, sell, and manage a pool of crypto-assets to increase their value and sell passive memberships in your company’s crypto and NFTs.
You are selling the equivalent of shares in your company, which are securities. Your company is now a mutual fund (an “investment company”) requiring registration under the Investment Company Act of 1940. Sales transactions to members requires registration (or an exemption) under the Securities Act of 1933 and most state securities laws. Interests sold in crypto-assets to buyers who will themselves own and manage them are not securities.
Opportunity #3: Have investors lend their crypto-assets to your company/platform in exchange for monthly interest payments generated by your company’s lending and investment activities (called block financing or “blockfi”).
Unfortunately, your agreements with the lenders of the crypto-assets are securities, like most promissory notes.
Opportunity #4: Establish a trading platform for digital asset owners to buy, sell, or trade crypto-assets.
You charge for administration of the trading transactions, not for any management leading to an expectation of generation of profits.
Note: In January 2022, the SEC proposed expanding the definition of “securities exchange” to include “communication protocol systems” that bring together buyers and sellers of securities. SEC chairman Gary Gensler commented that crypto trading and lending platforms are probably trading securities similar to traditional regulated exchanges. According to Gensler, security holders trading crypto-based investments should be protected in the same way as traditional securities, requiring registration and regulation.
If You Still Want a Crypto-Business…
Begin with analysis of whether an objective of any parties to the proposed business is profits. My above conclusions regarding the sale and management of crypto-assets (#1 and #2) are based on some pretty clear pronouncements from the SEC. The others (#3 and #4) are based largely on less clear statements by the SEC and the courts, and on law historically applicable to traditional securities.
Securities law restrictions and prohibitions have exceptions (most relating to the size of the transaction or facts unique to the parties) that are not obvious and are complicated, requiring careful analysis. Consider consulting a securities attorney.
Joseph R. Soraghan, business attorney and mediator with Danna McKitrick, P.C., practices in legal matters pertaining to business operations and growth. He guides businesses in financing, contracts, acquisitions, mergers, and sales. Joe frequently resolves commercial disputes as an arbitrator or mediator or through litigation. Joe can be reached at 314.889.7121 or firstname.lastname@example.org.