Classifying Crypto-Currency

Is a Bitcoin a currency or a security?

This is a question that may interest only a small number of geeks and lawyers, but there is a lot of money already in the crypto-currency market and a lot more on the sidelines waiting to jump in if this question is answered satisfactorily.

The key concern is regulation especially if crypto-currencies are ruled to be securities. The securities markets are regulated in virtually every country and the penalties for issuing securities without following those regulations can be severe.

The history of crypto-currencies traces back to Bitcoins which were introduced in Japan in 2009. The coder who introduced them wanted Bitcoins to be considered to be a currency and used as such, hence the name “coins”.  Had he called them “Bitcode” many of the questions about what they are might never have been asked. At the same time much the market for Bitcoins might not have developed.

Part of the allure of crypto-currencies is the fact that some people see them as part of an alternative financial universe. These people seem to believe that crypto-currencies are part of a trend to replace traditional banks and banking.

Bitcoins store value and are a medium to exchange value,which are two prime attributes of currencies.  But having attributes of currencies does not make them currencies.  That point seems lost on many of the people who are insistent that Bitcoins and similar crypto-currencies are currencies. They are not.

Historically, most people who hated fiat currency preferred to use precious metals such as gold or silver for trade, although other commodities, most notably salt have been used over the centuries. But the simple fact is that fiat currencies work because they are almost universally accepted.

Proponents of crypto-currencies argue that they are becoming more and more accepted and that acceptance will increase.  But accepting crypto-currencies as an exchange of value will not make them currencies in the strictest sense. Salt, after all is just salt, no matter how it is used.

If we accept the fact that Bitcoins were mislabeled to give them the appearance that they were currency that is “mined” and kept in electronic “wallets” strictly is a marketing ploy we can free our thoughts for the real issue; are crypto-currencies a security?

The US Securities and Exchange Commission (SEC) has issued several Investor Alerts warning people to avoid investments and especially Ponzi Schemes that are funded by or which purchase Bitcoins and other crypto-currencies.  But the SEC has not come out and said the coins themselves are securities and that is significant.

The SEC has statutory jurisdiction over securities and the securities markets but not all investments are securities. Your home, for example, or other real estate can be a good investment, but is not a security. The same is true of gold bars or bullion; works of art or collectables and all commodities that trade on commodity exchanges.  All are investments, just not securities or the SEC’s problem.

I wrote a blog article about Bitcoins a few weeks back that got a lot more views than most of my articles because crypto-currency is a very hot topic. Several people forwarded legal opinions to me that specifically addressed the issue of whether or not crypto-currencies were a security.  Several of those legal opinions were written by excellent lawyers at excellent law firms. I was not really surprised to see that they reached opposite conclusions; some thought the coins were securities; some thought they were not.

Each of the opinions was interpreting one US Supreme Court case, SEC v. Howey, which basically defines a security as the “investment of money in a common enterprise with an expectation of profits predominantly from the efforts of others.” Law school students studying securities law spend a considerable amount of time with this case and later cases that applied it.  Any legal opinion asking the question “is this a security” will certainly review Howey and apply its reasoning to the facts at hand.

Personally, I do not think that the Howey test applies to crypto-currencies at all.

Let me take a step back and re-frame the question. If a crypto-currency is not a security, what is it?  I think that if a crypto-currency is clearly something other than a security, especially if it is something already regulated under different statutes, it should go a long way to settling the question. So what, exactly, are we dealing with?

Any crypto-currency is nothing more or less than multiple lines of computer code; a long string of ones and zeros.  Computer code is recognized by law as intellectual property which can be copyrighted and is covered by a substantial body of law both in the US and internationally. No one classifies computer code as a security.

The shares of Microsoft Corp. are a security, not the operating system that it sells. That distinction is why I believe that the coins themselves are not a security.

The last time that I heard so many securities lawyers asking the question “is this investment a security” was in the late 1970s.   At that time the marginal tax rate on the highest earners in the US was 50%-70%. If you earned over a certain amount you would pay one-half of the overage to the IRS.  Perhaps not surprisingly, there seemed to be a lot of doctors, business owners and entertainers with this problem.

An industry grew up to provide this group with a series of “tax sheltered” investments.  These transactions were intended to take advantage of IRS rules that provided tax credits and accelerated depreciation when certain physical items were purchased in a business context.  To qualify for the favorable tax treatment, the item purchased had to have a business purpose, be placed in service during the calendar year and not be a security.

In many cases leverage was employed. A doctor would put down $20,000 and sign an $80,000 non-recourse note for the item.  If the tax credit was 50% of the purchase price, then the doctor would save $50,000 from his tax bill for his $20,000 investment; more in subsequent years when he depreciated the value of his $100,000 item over time.

One of the more famous of these tax shelters was a company that sold lithographic masters of artwork from famous artists.  If you bought the master that had been created by an artist such as Andy Warhol, you might make 500 prints from the master before it wore out. If you could sell the lithographs for $200 a piece you could pay back your note, recoup your $20,000 down payment and still save $50,000 on your taxes.

If you sold those lithographs over a period of years, the price might fluctuate. A Warhol lithograph would likely at least retain its value and it could be exchanged for other works of art if you dealt with the right gallery or broker. That did not make the lithographs into a currency even though they had these key attributes of a currency.

Most of these investment programs came with an opinion letter written by a securities attorney that attested to the fact that selling a physical “item” did not involve the sale of securities because the sale did not satisfy the Howey test.  I wrote a few of those opinion letters back in the day because the law was pretty clear that a “thing” was not a security. As far as I can remember the SEC never brought a regulatory action against one of these investment programs taking the position that the items were securities.

The IRS did, however, take issue with a number of these tax sheltered investment programs. They disallowed the credits and deductions that the programs offered and ultimately changed its rules to close the loopholes.  The IRS is not bound to legal opinions and frequently judges the tax treatment of any investment long after the investment is made.

A key issue was whether you were buying a thing or a business. The same is true today. A coin offering might be a security if the coin owner receives a portion of the profits of that company when they purchase the coin.

The SEC is not bound by a legal opinion on the question “is this a security “.  As I said I read several opinions regarding crypto-currencies that went both ways, albeit on slightly different facts. What I did find surprising is that none of the opinion letters that I read, mentioned the fact that the IRS categorized crypto-currency tokens as “property”, not a “security” back in 2014.

The IRS’s classification is also not binding on the SEC.  But given the fact that the IRS had made this determination that the sale of a crypto-currency would be treated as property for tax purposes and the US Copyright Office will issue a copyright on computer code (but not on a stock certificate) I think any legal opinion regarding the classification of a crypto-currency under securities law should mention both.

Several of these opinions were rendered in connection with specific Initial Coin Offerings (ICO). Again this term is intended to create the look and feel of an initial public stock offering (IPO).  This is marketing and it is intended to create the impression (falsely) that an ICO is just like the offering of a security. Of course, if the SEC should assert that these ICOs were actually selling securities because they had the look and feel of securities and attempt to sanction the people behind them, these same people would be screaming that they did no such thing.

In most of the offerings that I reviewed, buying a coin in the ICO neither conferred ownership of the project nor did it promise any payments, so it would not be difficult to opine that all you were getting was a digital coin, not a security. If coin purchasers receive anything other than just the digital coin, then the issue gets murky.  Given that there have already been close to 1000 coin offerings, some very different from others, it can get very murky.

Just to be clear, this article is my opinion of a fairly new legal issue. It is not intended to be specific legal advice as regards one coin offering or another.

If someone came to me with a proposed ICO and sought my opinion I would probably counsel them as follows, just to keep them out of potential legal difficulty.

1) If you intend to use the proceeds of your coin offering to fund your new business then call the coins what they are: “Great New Tech Company Start-up Commemorative Digital Medallions”. This is just truth in packaging. Why call them coins or currency when they are not?

2) Account for the sale proceeds on your books as if you were selling any intellectual property.  If you wrote and sold a book about writing computer code and used the proceeds to fund your code writing business, you would not enter the sale proceeds on your books as an investment.

3) Go about your business and stay under the radar. There are certainly regulators who believe that the whole idea of crypto-currency is a scam.  At the same time, it does not seem to be difficult to raise money using these digital coins. There are multiple reports of multi-million dollar raises being accomplished within hours.  I can see no reason why anyone trying to raise money in this market would write numerous articles or give interviews bashing banks or Wall Street firms or proclaiming crypto-currencies as the new form of unregulated capitalism.  The best way to attract regulators is often to publicize how much money you are making in an “unregulated” business.

If you do want a formal legal opinion letter that your ICO is not the offering of securities, I would be happy to review the facts and prepare one for you. I probably charge a little less than the big Wall Street law firms.  I know that you will understand that I will need to be paid in US dollars not whatever coin you are issuing.  I cannot use your coins at the market, gas station or movies and it is probably going to be a long, long time before I can.



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