For more than a decade, cryptocurrency industry pioneers envisioned digital currencies as an alternative branch of finance, a renegade branch that would operate outside the reach of big banks and government regulators.
But as digital currencies like Bitcoin and Ether became more mainstream, the crypto industry ran afoul of a 1946 Supreme Court decision that created what’s known as the Howey Test, a legal analysis that determines when a financial product is subject to the same strict rules with shares. and bonds.
In recent years, regulators have taken advantage of this legal precedent to argue that cryptocurrencies are just another security, like shares of Apple or General Motors. The crypto 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 resolution as federal judges begin to consider a series of lawsuits from the nation’s top securities regulator against some of the biggest crypto companies. This month, judges held hearings in two of the most important cases, which could dictate whether the multi-trillion dollar crypto industry can continue to grow in the United States.
The legal battles are “an existential issue for crypto,” said Hilary Allen, a professor at American University who specializes in financial regulation.
Litigation has intensified over the past 18 months as the Securities and Exchange Commission has brought enforcement actions alleging that crypto firms were operating as unregulated securities firms. In response, the industry argued that the laws governing Wall Street trading should not apply to digital currencies. Both sides scored early victories on the pitch that left the issue unsettled.
But this month, federal judges held hearings in two cases that legal experts expect to be the most decisive: the SEC’s lawsuits against crypto exchanges Coinbase and Binance, which explore key issues in the broader legal fight. Preliminary rulings in those lawsuits are expected in the coming weeks, setting the stage for appeals that could eventually reach the Supreme Court.
“We’ve built our legal strategy around” a potential Supreme Court showdown, said Paul Grewal, Coinbase’s chief legal officer. “These are issues that have potential implications for huge parts of the economy.”
How the courts’ decision could determine whether the crypto industry can penetrate deeper into the US financial system. If the SEC prevails, cryptocurrency advocates say, it will stifle the development of a new and dynamic technology, prompting startups to move overseas. The government responded that strong oversight is necessary to end the rampant fraud that cost investors billions of dollars when the crypto market crashed in 2022.
“The history of crypto markets shows that investors are at risk and being harmed by these platforms’ complete disregard for regulatory requirements,” said SEC spokeswoman Stephanie Allen.
Crypto’s origins date back to 2008, when a programmer known by the pseudonym Satoshi Nakamato created the software behind Bitcoin. Early proponents envisioned crypto as a decentralized alternative to traditional finance, a community project run by a broad network of people scattered around the world.
But as the industry matured, companies that looked like traditional financial firms began to develop cryptocurrencies and market them aggressively. Enthusiasts bought the digital coins in the hope that their value would increase. The government viewed the emerging sector as an unregulated version of Wall Street, full of fraud and manipulation. Last year, the SEC filed 46 crypto-related enforcement actions, according to Cornerstone Research, a consulting firm.
The SEC’s plan for crypto is guided 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.
Under the framework, a financial product becomes a security when it offers the opportunity to invest in a “joint venture” with the expectation of benefiting from other people’s efforts. Examples of securities under the Howey test include certain insurance products and even contracts for the sale of chinchillas.
Classification as a security comes with a wide range of legal requirements: Companies offering securities must provide detailed disclosures and comply with complex investor protection procedures that can be costly.
In public remarks, Gary Gensler, the chairman of the SEC, argued that most cryptocurrencies qualify as securities under the Howey Test because people invest in crypto hoping that the companies issuing the coins will drive up prices. Only Bitcoin, he said, is outside the SEC’s purview since no central group or individual oversees it.
Under the SEC’s rulemaking authority, Mr. Gensler had the option to develop new regulations for the crypto industry. However, he instead argued that the industry should be governed by existing laws and established court decisions to protect investors from fraud.
The crypto industry has called this approach too broad, countering that there must be a formal contract between the seller of a digital currency and an investor for the deal to constitute a securities transaction.
“Gensler’s approach was to put a square peg in a round hole,” said Teresa Goody Guillén, a BakerHostetler partner and former litigator with the SEC. they are all titles”.
Mr. Gensler’s strategy faced an early test in the SEC’s lawsuit against cryptocurrency issuer Ripple. In July, a federal judge in New York, Analisa Torres, ruled 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 benefit from Ripple’s actions as a business.
The decision was celebrated in the cryptocurrency world. But the excitement was tempered a few weeks later when a judge in another case upheld the SEC’s view that a different set of cryptocurrencies qualified as securities and rejected much of Judge Torres’ reasoning.
That split has raised the stakes for judges overseeing the SEC’s lawsuits against Coinbase and Binance, which serve as marketplaces for dozens of digital currencies. In those cases, the SEC argued that at least 20 cryptocurrencies qualified as securities, offering an opening for judges to issue broad rulings that could apply to the entire world of digital assets.
A hearing last week in the Coinbase case in Manhattan federal court lasted five hours, with more than 500 people tuning in by phone. about 250 people tuned into Binance’s Monday hearing in Washington. Both hearings revolved around the application of the Howey Test to digital currencies.
Coinbase’s lawyers argued that the SEC is trying to expand the intent of the Howey Test to cover crypto investments. Without a clear contractual agreement between the buyer of a digital currency and its issuer, lawyers said, a cryptocurrency is no different than any other “collectible” that can increase in value over time, such as baseball cards or Beanie Babies.
At the hearing, Judge Katherine Polk Failla appeared to condone some of Coinbase’s concerns about SEC overreach, saying the panel may be “sweeping too broadly.”
“We all fear that you have such a small limitation on your standard” that some lawyers will argue that Beanie Babies are unregistered titles, he told a committee lawyer.
In the Binance case, Judge Amy Berman Jackson in Washington seemed more skeptical of the comparison between digital currencies and collectible toys. But he expressed concern about the SEC’s strategy and pressed government lawyers to explain the limits of their argument.
These hearings came just days after a major victory for the crypto industry when the SEC approved a new Bitcoin investment product for trading on Wall Street. Mr. Gensler had fought to block its listing until a court ruled against the SEC in August, effectively forcing the agency’s hand.
“This was an extraordinary thing that gave people reason for hope,” Coinbase’s Mr. Grewal said. “There’s real optimism in the industry now.”
