A deep analysis of the proposed definition of digital token, which is likely to be far simpler than the Howey Test.
In these hyper-partisan times, any bill that includes sponsors from both sides of the aisle is noteworthy. There is one pending now that is particularly important in the crypto space. On March 8, 2021, H.R. 1628, the Token Taxonomy Act of 2021, was introduced by representative Warren Davidson. It was co-sponsored by representatives Ted Budd, Darren Soto, Scott Perry and Josh Gottheimer.
Terms of the Token Taxonomy Act of 2021
Among other provisions, the bill would exempt “digital tokens” from the definition of security, and it would also preempt inconsistent state regulation. Crypto assets would need to meet certain specified requirements in order to count as “digital tokens” under this act:
- First, the interest must be created either in response to the verification of proposed transactions, or pursuant to rules for creation that cannot be altered by any single person or persons under common control, or “as an initial allocation of digital units that will otherwise be created in accordance” with either of the first two options.
- Second, the assets must have a transaction history recorded in a distributed digital ledger or data structure on which consensus is reached via a mathematically verifiable process.
- Third, after consensus is reached, the transaction record must resist modification by any single person or persons under common control.
- Fourth, the interest must be transferable in peer-to-peer transactions, and fifth, it cannot be a representation of a conventional financial interest in a company or partnership.
Davidson has explained that the purpose of the bill is to improve regulatory clarity. In addition, in an interview, he suggested that if the bill had been passed in prior years, “it could have forestalled enforcement actions such as the Security and Exchange Commission’s (SEC’s) suit against Ripple Labs.” This comment examines in more detail how the bill might actually play out with regard to certain forms of crypto.
How would Bitcoin fare?
As virtually everyone in the crypto space is likely to know, Bitcoin (BTC) is issued exclusively in mining transactions. In other words, it is created “in response to the verification of proposed transactions,” meeting the first of the requirements to be a digital token. In addition, its transaction history is maintained on the blockchain, satisfying the second of the above requirements.
The entire process is set up to resist modification or change absent consensus among a large and decentralized community. The entire Bitcoin network was set up to be peer-to-peer although numerous exchanges now also exist to facilitate transfers. Finally, Bitcoin is not associated with any company or partnership, and it represents neither an ownership interest nor the right to share in revenues.
Given these facts, Bitcoin would clearly be a digital token. As such, under the new definition proposed in the act, Bitcoin would be excluded from the definition of security. Moreover, under section 2(d) of the act, state securities law regulations regarding registration or imposing limitations on the use of the asset would be precluded from applying to Bitcoin, with the sole proviso that states would retain authority to regulate and enforce actions based on fraud or deceit.
Because the United States Securities and Exchange Commission already excludes Bitcoin from the reach of the federal securities laws, this would not be a change in federal requirements. It would, however, create a uniform state system pursuant to which Bitcoin is excluded from regulation as securities except as to fraud claims.
Would Ripple’s XRP be a “digital token?”
It is not, however, accurate to assume that all crypto assets will count as digital tokens under the act. Consider Ripple’s XRP (and the pending action by the SEC against the company and its executive officers). For those not totally familiar with Ripple and XRP, the XRP ledger was completed by Ripple in December 2012, and the computer code set a fixed supply of 100 billion XRP. When launched, 80 billion of those tokens were transferred to Ripple, and the remaining 20 billion XRP went to a group of founders.
According to the SEC’s complaint, from 2013 through 2014, Ripple made efforts to create a market for XRP by having the company distribute approximately 12.5 billion XRP through bounty programs that paid programmers compensation for reporting problems in the XRP ledger’s code. From 2014 through the third quarter of 2020, the company sold around 8.8 billion XRP in the market and through institutional sales, raising approximately $1.38 billion to fund its operations. Resales, including resales from XRP previously distributed to the company’s founders, were also occurring at this time. So, would XRP be a digital token and thus exempt from regulation as a security under the act?
Related: SEC vs. Ripple: A predictable but undesirable development
The first requirement is actually the biggest problem for XRP. The bill contains three options for the first part of the test, but it is unclear that XRP meets any of them. Because all of the tokens were issued at the launch, there is no argument that XRP is created “in response to the verification or collection of proposed transactions.”
In addition, because all of the tokens were issued at launch, it is clear that Ripple or those in control of the company could have altered the terms under which XRP was to be issued. This leaves the argument that there was “an initial allocation of digital units that will otherwise be created in accordance with” one of the first two alternatives, and it is doubtful that this happened. XRP was never set up to be mined, and Ripple certainly had the ability to maintain control over the asset since it owned the vast majority of it. This makes it appear that XRP would not actually be a digital token, although the facts might be arguable.
It should be noted that the act also provides a very limited exemption for any “digital unit,” which is a much broader term that covers any “representation of economic, proprietary, or access rights that is stored in a machine-readable format.” The exemption covers any person who has acted with a reasonable and good faith belief that the digital unit is a digital token, but it only applies if all reasonable efforts are used to stop sales and return any unused proceeds to purchasers within 90 days of notice from the SEC that it has concluded the interest is a security. Ripple has obviously declined to follow this course, as it is fighting the current SEC enforcement action in court.
While this analysis and result may not disappoint everyone in the crypto community since some have long argued that XRP is not a “true” crypto asset anyway, it is a clear indication that the act does not create a free pass for all crypto offerings. It also would not be the end of the road for Ripple, which could still argue that XRP is not an investment contract under the Howey Test.
Would Facebook’s stablecoins have been “digital tokens?”
One more illustrative example might also be important to understand how the act would work if adopted. Consider Facebook’s original proposal for Libra. On June 18, 2019, Facebook announced in a white paper that it was actively planning to launch a cryptocurrency to be called Libra in 2020. The entire proposal has been renamed and updated, but the terms of the original white paper are the ones that are considered here.
Libra was conceived by Facebook and designed to be a “stablecoin,” with its value pegged to a basket of bank deposits and short-term government securities for a group of historically stable fiat currencies. It was to be governed by the Libra Association, a Swiss nonprofit organization.
The Libra Association was conceived as a group of diverse organizations from around the world, including not only Facebook but also major investors such as Mastercard, Visa, eBay and PayPal. The original plan was to have approximately 100 members for the association by the target launch date, each of which was to contribute $10 million. In exchange, the association members would have the right to oversee Libra’s development, its real-world reserves and even the Libra blockchain’s governance rules. The group of 100 members would also be able to act as validator nodes for the asset.
Libra was not set to be mineable, but rather to be issued as and when the Libra Association determined. The white paper also described a system that would have allowed the association to change how the system operated and, in particular, set rules for the issuance of the assets. While the association would have a relatively large number of diverse members with their own objectives and interests, they would be acting through the association, which is itself a single legal entity. This means that the Libra coin (as originally conceived) would not have fit within the definition of a digital token as set out in the act.
Would that mean Libra would have been a security? As was the case for XRP, the answer is “not necessarily.” The next step would be to ask whether it would have qualified as an investment contract. Depending on how the association determined to issue the coin, and whether there was any possibility of appreciation (which seems unlikely, as it was supposed to be pegged to fiat currencies as a “stablecoin”), the Libra coin might or might not have been an investment contract. The determination would have been based on the same Howey Test that the act was reportedly designed to clarify.
Conclusion
Defining security to exclude digital tokens means that the SEC will retain no authority to regulate fraud in connection with transactions involving these interests, leaving the bulk of enforcement to agencies like the Commodity Futures Trading Commission. While the CFTC has sought enforcement against those who engage in fraudulent or deceitful conduct in the crypto spot markets (where transactions in crypto rather than those involving futures or other derivatives are involved), it lacks the resources available to the SEC.
For example, the CFTC just announced its first enforcement action involving a pump-and-dump scheme, while the SEC’s list of prior crypto enforcement actions includes a number of market manipulation claims in addition to claims against John McAfee, the target of the CFTC’s recent action.
This difference is explainable, in part, by the relative size of the two agencies. The SEC’s 2021 budget justification plan called for support in the amount of $1.895 billion. On the other hand, the CFTC’s 2021 budget request was a relatively modest $304 million. Moving fraud enforcement to the CFTC is, therefore, not necessarily prudent or wise.
In addition, while it is quite clear that the proposed definition of digital token is likely to be far simpler than the Howey test, it is not necessarily going to replace that analysis in all cases.
Does the Token Taxonomy Act offer increased clarity? Absolutely. Preemption of inconsistent state laws could be particularly helpful in this regard. Does it provide certainty in all cases? No, but that is not necessarily a bad thing. Is the act a good idea? Sadly, probably not. Providing a ready exemption from registration for digital tokens might be supportable. Removing them from the definition of security in the current climate where fraud continues to be a major concern is probably not.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
The opinions expressed are the author’s alone and do not necessarily reflect the views of the University or its affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
