Cryptocurrency Regulation | By Eric Ybarra
Most at home investors are looking for the next great investment to usher their portfolio to the level of Buffet, Icahn, or Soros. Recently many have flocked to cryptocurrency to do just that. With the onset of the popularity of cryptocurrency, such as Bitcoin, Etherium, and Litecoin, it is important to understand what cryptocurrency is; how it affects our personal finance; and most importantly, what protections we are insured in this unregulated world. Cryptocurrency is a virtual currency that is a digital asset used as a medium of exchange with its popularity rooted in deregulation (Commodity Futures Trading Commission v. McDonnell, 2018). Investors exchange cryptocurrency in two major ways: (1) by using a coin exchange to buy interest in a coin from a like investor (similar to a stock exchange) or, (2) to fund the Initial Coin Offering (ICO) where they receive various interest (coins) in the enterprise in exchange for capital to develop the technology and market the coin. However, even with its increase in popularity, there are still questions regarding cryptocurrency’s regulation, and the assurance that a common person is protected when investing in cryptocurrency. According to the Wall Street Journal, one in five ICOs are fraudulent money grab scams (Neer Varshney, 2018). The only protections guaranteed are from the coin exchange or cryptocurrency’s internal security; but if an ICO is fraudulent, that internal security does not exist. Because of this, it is important to understand whether or not we can regulate, protect against, and prosecute fraudulent ICOs.
Several federal organizations have expressed a position on their classification of an ICO; however, many states including California, have not taken a position on cryptocurrency or ICOs being money or currency, leaving the question of whether a district attorney can prosecute fraudulent ICOs. The Commodity Board has taken a position that ICOs are a commodity; the IRS has decided that ICOs are taxable property; and the SEC has deemed ICOs a security (Internal Revenue Service, 2014); (McDonnell, 2017). But who protects investors who trade on levels that surpass the attention of the SEC or other large federal agencies? If California were to classify ICOs as a security, then district attorneys could charge the people behind fraudulent ICOs under securities fraud charges.
What is a Security?
To first analyze if ICOs are a security, we must first identify what a security is and how to determine if something is a security when not listed in the statute; as well as, what implications surround the process of determining a security. The California definition of a security is modeled after the federal definition of a security, and shows little to no difference (People v. Black, 2017). In California Corporations Code § 25019 a security is defined as:
“Security” means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a security ; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. Security does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section 31100 or 31101. Cal. Corp. Code § 25019 (2001).
The federal language defining a Security is found in 15 U.S.C. § 77b(a)(1), it reads:
The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. § 77b(a)(1) (2012).
Both the Federal and California statutes are riddled with ambiguity, such as the terms “notes,” “certificate of interest,” or even “subscription.” The United States Supreme Court saw the need for a standard test (The Howey Test) to eradicate some of this ambiguity, and upon its implementation, California adopted it along with a second test (The Risk Capital Test), and included them in the state securities statute (see emphasized portion).
The Howey Test
To determine if something concerns a security, the Supreme Court outlined a test now known as the Howey Test (S.E.C. v. W.J. Howey Co., 1946). Under the Howey Test, an investment is a security when an investor trusts a third party with money, as a part of a scheme, with the expectation of profits. In Howey, The Howey Company owned a large portion of orange groves, some of which they kept for themselves and some they offered interest to the public to “help fund additional development.” Each investor who paid in full or for a fraction of the acreage would agree to a contract, which a warranty deed was conveyed as a receipt of interest. The contract made the investor responsible for the cultivation and harvest of the portion of the orange groves. The SEC contended that the contracts relied on the ignorance of this provision to gain money for the Howey Company without having to pay out returns on investment; they further contend that investors were attracted under the belief that their investment would see returns based on the profits made from the groves, not knowing that profit only comes from the self-harvest and cultivation of the groves. Howey responded by questioning if the contract itself was under the jurisdiction of the SEC, and contended that it was not a security.
The court outlined a test to determine what does and does not involve a security under the federal definition. The court asked “whether the scheme involves an investment of money in a common enterprise with profit to come solely from the efforts of others.” The court in S.E.C. v. R.G. Reynolds Enterprises, Inc. elaborated that “a common enterprise may be established by showing ‘that the fortunes of the investors are linked to the efforts of the promoter such as in a profit sharing scheme” (S.E.C. v. R.G. Reynolds Enterprises, Inc., 1991). The court elaborated on the phrase “solely expected from the efforts of others,” which established the importance of what is known as the independence prong, by stating that that the risk in the efforts of others is tied to the skill of the promoter in managing the investor’s money to create a return on investment. Further, the court stipulated that any action in the management or operation by the investor destroys the “at arm’s length” nature of a security; Reynolds, further elaborated that the “efforts of others” requirement is found in the essential managerial efforts (S.E.C. v. R.G. Reynolds Enterprises, Inc., 1991). The court did find that the contract for the investment in an orange grove was a security, and all elements of the Howey Test were met, stating, “such persons have no desire to occupy the land or to develop it, [Investors] are attracted solely by the prospects of a return on investment.”
Under the Howey Test, an investment is a security if (1) it involves the investment of money, (2) there is an expectation of profits, (3) the investment is a common enterprise, and (4) any profit comes from the efforts of a promoter or third party (S.E.C. v. W.J. Howey Co., 1946).
The Risk Capital Test
California courts also accept another test called the Risk Capital Test. Since the California Supreme Court’s decision in Silver Hills Country Club v. Sobieski, California courts have generally accepted and applied the Risk Capital Test. Under the Risk Capital Test an investment is a security when a business or enterprise offers an investment opportunity (to the public) when the investor has no personal interest in the day-to-day operations of the corporation and there is substantial risk of no return on the investment (Silver Hills Country Club v. Sobieski, 1961). In Silver Hills, the Silver Hills Country Club offered to sell memberships for their club and with the membership fees, they would build and improve the amenities at the club. After a Commissioner deemed the sale of membership an unqualified sale, he ordered a “desist and refrain order.”
Upon review, the court looked directly at the definition of a security in California and saw one distinct aspect to all examples—the degree of risk. The court looked at whether the membership fees were a risky investment and ultimately determined they were not. Once a member has paid his or her monthly dues, he or she would gain continued access to the amenities of the club. Furthermore, any new amenity that would be built would also be included in the membership. Although the members’ money was invested and entrusted to another to use appropriately, there was no risk to the investor. Unless the membership fees were not paid, the member would be granted access to the amenities at the club, thus there was no risk of loss to the return. The court held that membership to a country club was not a security within the California definition, and this analysis paved the way for the Risk Capital Test.
A formal application of the Risk Capital Test is seen in Graham. People v. Graham, 1985. In Graham, Graham was partnered with Chapek, who was advertising a machine that harvested gold from the ground and water. They both secured an investment from Mr. Krueger for a mining operation in Arizona and instructed him to recruit other investors in San Diego’s military community. At a later meeting to go over a sales pitch, Graham and Chapek expanded the machines capabilities to now detoxify chemicals. Upon hearing this, Krueger did some research, grew worried based on his findings, and contacted the FBI, who turned the case over to the local District Attorney. Krueger worked with the DA to set up another meeting in which an undercover investigator, posing as a potential investor, arrested the men. Graham contested that the investment opportunity was not a security and argued that this failed the Risk Capital Test because of Krueger’s involvement as a “partner.” The court disagreed.
The court reasoned that a security is involved if the investor has provided capital that is subject to risk for the enterprise and persons other than the investor will be primarily responsible for managing the business. The defendant contended that the test failed on the last part because he was contracted as a “partner” of the enterprise. The court reasoned that the investor must not exercise managerial control in the enterprise, meaning the investor must not be active in “those essential managerial efforts which affect the failure or success of the enterprise.” When a contract for investment gives you a “partner” status with no control in the direction of the enterprise that can affect the success, or lack thereof, and simply seeks recruitment of other investors, you do not have managerial control that affects the failure or success of the enterprise.
The factors for the Risk Capital Test are: (1) the funds are raised for a business or enterprise, (2) the transaction is offered “indiscriminately to the public at large,” (3) the investors are “substantially powerless” to affect the success of the venture, and (4) investor’s money is “substantially at risk” because of the unsecure nature of investment (Moreland v. Department of Corporations,1987).
Does an ICO Qualify as a Security in California? Could an ICO Qualify as a Security in California?
In short, we do not know if an ICO is considered a security because California has not taken a position on what it considers an ICO to be. However, an ICO would be classified as a security if it is a part of a common investment scheme, promoted by a third party as seen in Securities and Exchange Commission v. Shavers, 2013, but when the law is applied to the principles of an ICO, they alone qualify as securities under the Howey and Risk Capital Tests, thus allowing prosecutors to file criminal charges for the promotion and sale of fraudulent ICOs.
ICOs as Securities
Courts outside of California have recognized the need for protections in cryptocurrency investment, and have found that cryptocurrency falls within the width of other financial classifications. The District Court of the Southern District of New York ruled that ICOs and cryptocurrency are considered funds (United States v. Murgio, 2016), while the court in Faiella held that Bitcoin and cryptocurrency is considered money based on the plain language of the statute that defined money (U.S. v. Faiella, 2014). The court simply applied the plain language of the term “money” under 18 U.S.C. § 1960, and determined that the transmitting ability and the nature in which cryptocurrency is used is analogous to money, therefore, deeming cryptocurrency funds. Further, an Eastern District Court in the state of New York found that they had jurisdiction in a lawsuit brought by the Commodity Futures Trading Commission because the Federal Courts considered cryptocurrency a commodity (Commodity Futures Trading Commission v. McDonnell, 2018).
However, most compelling is a case from the Eastern District of Texas, where the court deemed that cryptocurrency and ICOs are a security (Securities and Exchange Commission v. Shavers, 2013). In Shavers, the defendant began a business selling and trading Bitcoin and other cryptocurrency to investors. In 2011, the defendant began to advertise Bitcoin sales with a 1% interest daily deal. Due to this, the defendant acquired 700,467 Bitcoins, amounting to roughly $4,591,806. The SEC claimed that the defendant made several fraudulent statements and assertions to acquire the Bitcoins. The defendant saw the loss of 263,104 Bitcoins, and roughly $23 million in current Bitcoin exchange rates. The Defendant questioned the SEC’s jurisdiction to bring the charges against him by asserting that Bitcoin was not a security. The court determined that Bitcoin was a security and within the jurisdiction of the SEC.
The court applied the Howey Test to determine if Bitcoin is a security. First, the court had to determine that the investment to the defendant was an investment of money. The court determined that because Bitcoin can be spent like money to purchase goods, services, and pay for living expenses, the only limitation was that the seller or provider had to take Bitcoin as a currency; but the court further reasoned that Bitcoin could be exchanged for almost all forms of physical currency and therefore was absolutely money. Second, the court had to establish that the investment into the Bitcoin was a part of a common enterprise. To establish this, the court looked to see if there was interdependence between promoter and investor, meaning that the promoter does not benefit from a share of the profits, the investor relies solely on the expertise of the promoter, or the investor doesn’t have a hand in the decisions that affect the success or failure of the enterprise. The court found this prong was established because the investors were recruited to invest in this ‘new’ currency, but also the courts found that the defendant promised large returns due to his expertise in the Bitcoin markets. Lastly, the court found that the investors relied on the efforts of the promoter to create profits. Because the advertisement was originally 1% interest return and rose to 3.5% at one point, investors were anticipating a profit from the defendant’s efforts.
While Shaver establishes that a cryptocurrency will pass the Howey Test and will be considered a security, the remaining question is whether or not an investment in a fraudulent ICO without a third-party investment manager would pass the Howey Test alone. In Howey, an investment is a security if it (1) involves the investment of money, (2) there is an expectation of profits, (3) the investment is a common enterprise, and (4) any profit comes from the efforts of a promoter or third party (S.E.C. v. W.J. Howey Co., 1946). An ICO will always be an investment of money, as an ICO is a capital campaign to raise funds to further develop the cryptocurrency. There is an expectation of profits because like any other investment there is a hope or expectation it will appreciate in value and be worth more at a later time. An ICO is a common enterprise because it is a system to gain capital to develop the cryptocurrency, which is done by the development team, and usually done by people with no ties to the investor; to fail this prong there would need to be evidence that the person investing in the ICO was a part of the development team or somehow connected to the day to day managerial efforts of the company behind the ICO. Lastly, if there is any chance of profits for the investor it will come from the effort of a promoter. If there is analysis of this prong, it has thus been established that there is investor independence (3rd prong), and that the investor is relying on someone other than himself or herself. Now while in Shaver this prong was established by showing there was a third-party investment manager, however in the definition of a promoter this prong can be established by showing that a person or persons who want to sell or put forth an idea for a project or business plan to another party (Black’s Law Dictionary 9th ed., 2009). The Howey case itself expands the standard to prove the fourth prong of Howey as “the investor has no part in the essential managerial efforts” (S.E.C. v. W.J. Howey Co., 1946). Now in the case of an ICO, the underwriting company (the company creating the cryptocurrency) is promoting the ICO to investors to get them to invest; this promotion is usually done through a website but is completed in detail through a business plan called “the white paper.” The white paper is a detailed outline of the goals, process, and direction of the company for the cryptocurrency, which is used as a means of convincing people to invest in their ICO to achieve the information outlined. This alone is the promotion of the ICO and is enough to establish that a promoter is promoting the ICO and potential profits. In this case the promoter is not a third party, but the cryptocurrency developers themselves. Now unless there is a situation of an investor also working for the underwriting company, or another odd situation of breaking independence, an ICO would pass the Howey Test on its own.
As stated before, California also accepts the Risk Capital Test to prove an investment is a security. While an investment in a cryptocurrency seen in Shaver is likely to also pass the Risk Capital Test, we must show that a fraudulent ICO investment would pass the Risk Capital Test on its own. The factors for the Risk Capital test are: (1) the funds are raised for a business or enterprise, (2) the transaction is offered “indiscriminately to the public at large,” (3) the investors are “substantially powerless” to affect the success of the venture, and (4) investor’s money is “substantially at risk” because of the unsecure nature of investment (Moreland v. Department of Corporations, 1987). An ICO raises money for a business enterprise that is developing the cryptocurrency. ICOs are also indiscriminately offered to the public. Except for in very specific situations, ICOs are posted to websites either for the company or to advertise the ICO. Once this is done, any person can invest in the ICO, and a true ICO will accept an investment from any willing potential investor. Like in Howey, the investor must be substantially powerless in the operation and like in Howey, unless there is some odd circumstance, most of the investors will be independent of position or ties to the enterprise. Lastly, ICOs are unregulated and not backed or guaranteed by any organization or institution. If the cryptocurrency doesn’t get the backing or popularity needed to take off like a Bitcoin or LiteCoin, the currency is at risk of failure and thus a loss of investment by the investor. There is inherent risk in all cryptocurrencies as not every cryptocurrency will take off and join Bitcoin in popularity. Based on this, ICOs pass the Risk Capital Test as well.
Shaver, deemed that an investment into a Bitcoin Investment Scheme, passes the Howey Test and is thus deemed a security under Howey. Furthermore, based on the nature of an ICO, fraudulent ICOs alone would pass both tests accepted by California, and are securities.
California has not deemed cryptocurrency or Initial Coin Offerings to be securities to date. However, with such a large number of ICOs being fraudulent, the need for regulation and criminal prosecution of underwriters grows with every investment. While speaking about the needs of the industry, the SEC Chairman has recently doubled down on the organization’s stance that all ICOs are securities (Securities and Exchange Commission, 2018) But how does that protect all investors? The SEC understands the growth of popularity of cryptocurrency by now stating that popular currencies such as Bitcoin and Ether trade like a commodity, such as gold and oil (Securities and Exchange Commission, 2018). This ever-growing popularity and evolution only makes it more apparent for the need of regulation, and universal protections. The legal analysis is clear; ICOs are securities in California. It is now up to the California Courts and the legislature to protect every investor, and deem ICOs and cryptocurrency a security.
 A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type.
 Property is anything that a person or business has legal title over. Property can be either tangible or intangible, and having legal title to it grants the owner certain enforceable rights.
 Common enterprise is established by: showing ‘that the fortunes of the investors are linked to the efforts of the promotor’ such as in a profit sharing scheme.” S.E.C. v. R.G. Reynolds Enterprises, Inc. 952 F. 2d 1125 (9th Cir. 1991)
 “Efforts of a promotor or third party” is established by showing: the investor has no part in the essential managerial efforts.
 “Substantially powerless” to affect the success of the venture: see court analysis of Graham, 210 Cal. Rptr. 318.
 Common enterprise is established by: showing ‘that the fortunes of the investors are linked to the efforts of the promoter’ such as in a profit sharing scheme.” S.E.C. v. R.G. Reynolds Enterprises, Inc. 952 F. 2d 1125 (9th Cir. 1991)
 “Efforts of a promoter or third party” is established by showing: the investor has no part in the essential managerial efforts.
 “Substantially powerless” to affect the success of the venture: see court analysis of Graham, 210 Cal. Rptr. 318.
- 15 U.S.C. 77b(a)(1) (2012)
- Black’s Law Dictionary (9th ed. 2009)
- Corp. Code § 25019 (2001)
- Commodity Futures Trading Commission v. McDonnell, 287 F. Supp. 3d 213 (D.C. N.Y. 2018)
- DOA/Slock.it, (2017, March 25). Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DOA (Release No. 81207).
- Moreland v. Department of Corporations, 239 Cal Rptr. 558 (Cal. Ct. App.5th) (1987)
- People v. Black, 214 Cal. Rptr. 3d 402 (Cal. Ct. App. 6th 2017)
- People v. Graham, 210 Cal. Rptr. 318 (Cal. Ct. App. 4th 1985).
- Internal Revenue Service, (2014, March 25) IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply [Press Release]
- Securities and Exchange Commission, (June 15, 2018). Ether is not a security [Press Release]
- Securities and Exchange Commission, (2018, June 15). Statement on Initial Coin Offerings [Press Release]
- Wall Street Journal, (2018, May 18) 1 in 5 ICOs is phony, study finds
- E.C. v. R.G. Reynolds Enterprises, Inc. 952 F. 2d 1125 (9th Cir. 1991)
- E.C. v. W.J. Howey Co., 328 U.S. 293 (1946)
- Securities and Exchange Commission v. Shavers, Fed. Sec. L. Rep. P 97,596 (2013)
- Silver Hills Country Club v. Sobieski, 13 Cal. Rptr. 186 (Cal. 1961)
- S. v. Faiella, 39 F. Supp.3d 544 (S.D.N.Y. 2014)
- United States v. Murgio, 209 F.Supp.3d 698 (S.D.N.Y. 2016)
Eric Ybarra is a second-year law student at Chapman University School of Law. When an Orange County District Attorney tasked him with researching how the law would respond to cryptocurrency, his interest was piqued. This is his first publication, but hopes to continue to educate the public on new legal developments.