Are Secondary Token Transactions On Exchanges Securities?
Sign Up for PublicationsClick here to download the PDF.
In the spring and into the summer of this year, the U.S. SEC brought enforcement actions against three major crypto exchanges: Bittrex, Binance, and Coinbase (the “Exchanges”).[1] In each case, the SEC alleged that the Exchanges have operated as unregistered securities exchanges, brokers, and clearing agencies because various tokens transacted on the exchanges are “securities” subject to SEC regulation.[2] The SEC has alleged that at least the dozens of tokens highlighted in the complaints qualify as “investment contracts” or “investment schemes” and are therefore “securities” under controlling precedent.[3]
The issues raised in these cases have implications for the overall operation of the crypto markets in the U.S. If the SEC were to prevail on any of these cases in full, crypto exchanges offering services in the U.S. could be forced to alter operations dramatically, or perhaps wind down some operations all together. On the other hand, wins by the exchanges could offer the crypto sector substantial protection and far more certainty than has been available to date in an era characterized by regulation through SEC enforcement.
Over the summer and into the fall, the three exchanges sought to dismiss the SEC’s enforcement actions. First, Bittrex moved to dismiss on June 30, 2023. Next, Coinbase moved for judgment on the pleadings on August 4, 2023. Finally, Binance moved to dismiss on September 21, 2023. Bittrex has since settled with the SEC, but Binance and Coinbase have continued to litigate. On October 4, 2023, the SEC first responded to Coinbase’s motion and, on October 24, 2023, Coinbase filed a reply in further support of its motion. This note lays out the arguments each side is offering and explains the underlying caselaw driving their disputed interpretations.
The Exchanges focus primarily on two arguments: (1) the SEC has not plausibly alleged that tokens transactions on the Exchanges—almost all of which are secondary market transactions made absent any type of “contract” with an issuer—are “securities transactions” under any accepted legal definition of the term; and (2) under the “major questions” doctrine, the SEC has no authority to regulate such transactions as securities transactions, as such a consequential regulatory decision is reserved for Congress.[4]
Can a Secondary Market Token Transaction That Does Not Involve a Contract Still Be An “Investment Contract”?
Numerous recent district court decisions regarding the application of the securities laws to token transactions have observed that there is never going to be a one-size-fits-all answer to the question of whether transactions in crypto tokens are securities transactions.[5] How the tokens are purchased, from what party, and the reasonable understanding of the parties at the time of purchase—among other distinct factual issues—are all relevant to whether a particular token sale was a security transaction.
In the past, the SEC has brought numerous enforcement actions alleging that sales by token issuers directly to token purchasers are securities transactions.[6] These cases are different. With respect to the Exchanges, the transactions principally at issue are secondary market customer-to-customer transactions where the Exchanges offer customers the ability to buy and sell tokens anonymously through a bid/ask system similar in structure to familiar financial exchanges. Here, the SEC alleges that essentially all secondary market token transactions on the Exchanges satisfy the legal definition of “investment contracts” and therefore are securities transactions under the Securities Act and the Exchange Act.[7]
The Exchanges deny that such transactions could plausibly be “investment contracts” and therefore securities transactions. While token issuers and institutional sellers can buy and sell on the Exchanges, in most instances counterparties are unaware of each other’s identity. Therefore, it is difficult or impossible to allege that token purchasers involved in such blind transactions know or believe that they are investing money with a party whom the purchasers expect to use that money in an enterprise that will then generate profits for the purchasers. Without such allegations, the Exchanges contend, the SEC fails out of the gate.
a. Investment Contracts Under Howey
S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946) is the seminal case setting forth the standards under which federal courts still consider whether a particular transaction is an “investment contract” subject to the Securities Laws.[8] In Howey, the Defendant offered its hotel guests an investment opportunity to buy small plots in a citrus orchard. The customers who agreed to invest also entered into services contracts under which another of the Defendant’s subsidiaries would maintain the orange trees, sell the oranges, and return profits to the investors. Id. at 328, 295-296. The issue in dispute was whether this contractual arrangement—the sale of land and the services contract—amounted to an “investment contract” under the securities laws. It was undisputed that the sale of land, without more, would not have qualified as an investment contract. Likewise, the services contract alone would not have qualified.
The Supreme Court held, however, that the two contracts should be considered together in order to understand the “economic reality” of the situation. Id. at 298. The Court noted that investment contracts include agreements whereby “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of [a] promoter or a third party.” Id. at 298–99. Considering the sale contract and the services contract together, it was clear that the investors had entered into an “investment contract” relationship with the Howey company under which the investors provided capital for the investment and expected to profit from the efforts of the Howey company.
Thus, under Howey and the many cases that have followed it, an investment contract generally requires an agreement between an investor who will provide the investment capital and an entity who will take that capital and use it to fund efforts expected to create profits for the investor.[9] Many investments are not investment contracts—an ongoing contractual relationship out of which the investor expects to profit due to the efforts of others is necessary. For example, a purchase of a collectible such as a baseball card or a piece of art work which an investor hopes will appreciate in value due to market forces is not an “investment contract” because there is no on-going relationship between the buyer and the seller through which the buyer expects to profit thanks to the seller’s efforts. The same is true for the purchase of any commodity such as gold, oil, or produce without an ongoing services contract that could reasonably result in profits related to the investment.
Likewise, many contracts involving future obligations are not “investment contracts” because no “investment” was made. For example, a contract between a homeowner and a company whereby the company agrees to mow the homeowner’s lawn regularly in order to maintain or increase the home’s value is not an “investment contract” because no “investment” is at issue, even if the homeowner expects to profit off the arrangement by selling the house at a higher price. Seeking to crystallize these understandings, Howey held that an “investment” requires (1) an investment of money; (2) into a common enterprise; (3) with a reasonable expectation of profits; and (4) that those profits derive from the efforts of others. 328 U.S. at 298–99, 301.
It is when these two concepts come together, an “investment” into a common enterprise and a “contract” with the sponsor or promoter of that investment for future services reasonably expected to result in profits for the investor, that an “investment contract” is formed.
Thus, as in Howey, a contract to purchase a parcel of land, without more, is not an “investment contract” because there is no ongoing relationship between the buyer and seller whereby the efforts of the seller would result in additional profits for the buyer. A contract to purchase a parcel of real estate, along with a services contract which states that the seller will also work to maintain the property, run a business on the property, and pay any profits from that business to the buyer would qualify as an “investment contract.”[10]
b. The Exchanges Argue Secondary Market Purchases of Tokens Cannot Be Investment Contracts
The Exchanges argue that purchases of tokens on the secondary market through their platforms do not even resemble an “investment contract,”[11] and that the SEC has failed to plausibly allege that any such transactions qualify as securities transactions. The only “contract” at issue in this circumstance is the agreement between two parties transacting in a blind bid/offer setting for the purchase of the token. This contract for the simple sale of a token includes no ongoing relationship between the buying and selling parties, let alone between the buyer and the issuer or promoter (such as the services contract at issue in Howey), and therefore, they argue, cannot qualify as an “investment contract.”[12]
The Exchanges appear to acknowledge that it would be possible that an agreement between a purchaser and the issuer or promoter of a token could qualify as an “investment contract.”[13] In the context of such a purchase, the purchaser could reasonably expect the token to appreciate in value as a result of the issuer’s efforts to promote the token, provide technical support to the token, and grow the token’s network. When a retail investor purchases a token on the secondary market, however, that investor has not entered into any agreement with the issuer of the token whereby the purchaser expects to extract profit because of the issuer’s efforts related to the token. There simply is no “contract” between the purchaser of the token and the issuer or promoter of the token. The Exchanges argue that this lack of contractual privity is fatal to the SEC’s allegation that these transactions amount to investment contracts.[14]
c. The SEC Argues That Tokens Are “Investment Schemes”
The SEC has indicated that its position is that the sales of tokens constitute “investment schemes” which, under Howey, may qualify as “investment contracts” even in the absence of a formal contract between investor and promoter.[15] In making this argument, the SEC relies heavily on the fact that Howey held that “an investment contract for purposes of the Securities Act means a contract, transaction, or scheme whereby a person invests his money in a common enterprise.” 328 U.S. at 298–99 (emphases added). The Court noted that this broad understanding of “investment contract” is necessary “to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey Co., 328 U.S. at 299. Howey was decided against a backdrop of businesses seeking to creatively structure investments in order to evade the federal securities laws and state Blue Sky laws, and the Howey court emphasized that the federal Securities laws had to be flexible enough to deal with new and unforeseen business schemes.[16]
For example, in one older case, a business offered to sell investors small parcels of land on an installment basis. Once a certain amount of installment payments were made, the company would plant and cultivate fig trees on the parcel. The company agreed to cultivate and maintain the trees on the parcels for five years. Once all installment payments were made, the company would transfer ownership of the land to the investor, with a potential promise to also purchase figs from the investor. State v. Agey, 88 S.E. 726, 729 (N.C. 1916).[17] The Court there held that such a company was an “investment company” subject to registration under South Carolinian securities law, regardless of the obscure way that the investment was marketed and papered.[18]
Generally, the SEC argues, when an asset purchase is a mere proxy for the investment of money in exchange for future cash flows from a business endeavor, that asset purchase may be an “investment scheme.” Likewise an investment scheme may exist where multiple contracts between two parties, if viewed together, show that one party expects to invest capital in order to obtain future business cash flows.[19] In this context courts look to the “economic reality” of the relationship between the parties in order to evaluate whether an investment contract exists. See Howey, 328 U.S. at 298-99.
The Exchanges counter that the SEC’s allegation that the tokens are “investment schemes” does not obviate the requirement that there be a “contract” between investor and promoter.[20] On the contrary, the investment scheme cases generally deal with multiple contracts between the parties which are structed in a way to evade the securities laws, not a lack of any contract at all. Indeed, this was just the case in Howey, where no single contract between the parties was an “investment contract,” but the sale contract considered alongside the services contract made it clear that an investment contractual arrangement had been agreed between the parties.
In the case of secondary market purchases of tokens, there simply is no contract at all between the issuer or promoter of the token and the investor. As discussed above, the only contractual relationship that exists is between the buyer and seller of the token through the anonymous bid/ask system in place on the Exchanges.
d. The SEC Argues Recent Case Law in the Crypto Context Alters Prior Understandings
An alternative argument the SEC offers is that, while it may be true that the “investment contract” case law developed in the middle of the twentieth century requires an ongoing contractual relationship between the investor and the promotor of the investment, recent cases decided in the crypto sector point in a new direction.
The SEC relies particularly upon two recent cases for the proposition that an “investment scheme,” particularly in the case of crypto, might not require an ongoing contractual relationship: SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020), and SEC v. Terraform Labs Pte. Ltd., 2023 WL 4858299 (S.D.N.Y. July 31, 2023). These cases involved actions against token issuers, not secondary market exchanges. In Kik, Judge Hellerstein accepted the SEC’s contention that “an ongoing contractual obligation is not a necessary requirement for a finding of a common enterprise.” 493 F. Supp. 3d at 178. Terraform, for its part, rejected an argument that an “investment contract” requires “a formal common-law contract between transacting parties,” and concluded that no “enforceable written contract” is required to establish the existence of an investment contract. 2023 WL 4858299, at *11.
The Exchanges argue that those district court decisions are contrary to decades of established precedent and should not be followed.[21] Regardless, the Exchanges argue that the SEC has not, and cannot, argue that the secondary market transactions on the Exchanges are investment schemes similar to those the Courts identified in Kik and Terraform. In those cases, at least some investors provided investment capital to the issuers of the tokens themselves when they purchased their tokens, and the court could reasonably conclude that those investors expected their tokens to increase in value as a result of the efforts of the issuer. But transactions on the secondary market—where often retail investors purchase from other retail investors—generally do not result in any investor capital being invested with the issuer or promoter itself.
Thus, the Exchanges argue, there has been no “investment” into a “common enterprise” as needed to qualify as an “investment contract.”[22] The Exchanges argue that this missing element—the involvement of the issuer or promoter in the transaction—is fatal to the SEC’s reliance on Kik and Terraform even if the court agrees that those cases eliminate the requirement that there be a “contract.”
The Exchanges further contend that the Ripple summary judgment decision is in accord with this understanding. See Ripple, 2023 WL 4507900, at *11 (no investment contract where buyers “could not have known if their payments of money went to [an issuer], or any other seller of” the subject token). The Exchanges argue that Ripple stands for the proposition that blind bid-ask transactions on an exchange, without any agreement to any future commitment between buyer and seller, cannot be investment contracts.[23] Id. at *11-12. This lack of post-sale obligations between the buyer and seller on the secondary market, the Exchanges argue, shows that the SEC has not plausibly alleged its claim.[24]
e. The Latest Salvo: Coinbase’s Reply
On October 24, 2023, Coinbase filed a reply in further support of its motion for judgment on the pleadings. This is the first direct response to the SEC’s arguments that any of the exchanges has filed, as Bittrex settled its case prior to filing a reply and Binance’s briefing schedule is behind Coinbase’s.
On reply, Coinbase argues forcefully that the SEC’s position requires the court to take a novel legal position, and depart from precedent that has conclusively established the meaning of “investment contract.” Coinbase contends that the SEC’s arguments that there need not be a “contractual undertaking” or even an “investment” to establish the existence of an “investment contract” is directly contradicted by relevant Supreme Court case law. See SEC v. Edwards, 540 U.S. 389, 397 (2004) (“We are considering investment contracts.”) (emphasis in original).[25]
Coinbase argues that the SEC’s position would render the term “securities” unreasonably broad and grant the SEC the right to regulate virtually any commercial activity whatsoever.[26] Coinbase notes (as discussed further below) that the SEC does not have the authority to redefine the scope of its regulatory authority in this way.
Coinbase also argues that the SEC’s reading of Howey’s use of the phase “investment scheme” is simply incorrect, and that this phrase never eliminated the need for a “contractual undertaking” in order for a given scheme to qualify as a “security.”[27] Given that, in Howey, there were multiple contracts at issue that had to be read together to understand the “investment scheme,” this language from the same case cannot provide a basis to argue that an “investment scheme” might exist in the absence of any contract.
Coinbase also responds to the SEC’s reliance on Terraform and Kik, arguing that, in each of those cases, contractual privity existed between the purchasers and the issuers of the tokens. Coinbase emphasises that there is no reading of these cases which would extend the meaning of “investment contract” to secondary market purchases of tokens in a blind bid/ask setting.[28]
Major Questions Doctrine: Will Federal Courts Require Congress, And Not The SEC, To Regulate The Crypto Market
Each of the Exchanges separately argue that the courts should apply the “Major Questions Doctrine” to disallow the SEC from regulating the crypto market through enforcement action and regulation.[29] Under that doctrine, when an agency’s interpretation of a statute implicates major political and economic issues, the agency must have “clear congressional authorization for the power it claims.” West Virginia v. EPA, 142 S. Ct. 2587, 2609 (2022).
The Supreme Court has previously applied this doctrine to limit administrative action in other instances where large economic impact was at issue. See, e.g., Biden v. Nebraska, 143 S. Ct. 2355, 2372 (2023) (“$430 billion in student loans” at issue); Ala. Ass’n of Realtors v. HHS, 141 S. Ct. 2485, 2489 (2021) (per curiam) ($50 billion at stake). The Supreme Court has also applied this doctrine where a given question is of political significance, and where an agency has previously disclaimed its power to regulate the issue in question. See, e.g., Nebraska, 143 S. Ct. at 2364 (Department of Education had disclaimed “statutory authority to provide blanket or mass cancellation” of student loans).
The Exchanges argue that the Major Questions Doctrine should be applied in this case. First, there is no dispute that the crypto asset trading markets that would be affected by the SEC’s actions involve transactions billions of dollars—likely hundreds of billions or more.[30] Second, the Exchanges argue that the SEC’s lawsuits implicate “vast political significance.”[31] The Exchanges note that Congress is considering at least twenty legislative proposals regarding the regulation of the crypto market. The SEC’s lawsuits would undermine this democratic process by imposing the SEC’s preferred regulatory scheme.
The Exchanges further note that the SEC has previously disclaimed its ability to regulate the crypto transactions at issue here. The SEC’s chairman has stated that the SEC lacks a “regulatory framework” for crypto exchanges,[32] and the SEC took no action against crypto exchanges while they were being built. The Exchanges argue that these actions indicate that even the SEC did not consider the transactions at issue here to be “securities” until recently.
Thus, the Exchanges argue that there has been no “clear congressional authorization” for the SEC’s authority here.[33] The Exchanges argue that the SEC’s adoption of a novel interpretation of “investment contract” to mean a situation lacking both an “investment” and a “contract” as previously understood under the case law is a “paradigmatic major question” requiring Congressional action.[34] One way or the other, it is likely that this question will have to be answered by a federal appeals court, if not the Supreme Court.[35]
Conclusion
The courts will ultimately decide which side has the better arguments on this issue—in all likelihood the appellate courts. Although the Exchanges have strong arguments under Howey and its 20th century progeny, recent decisions in Telegram, LBRY, Kik, Terraform and other cases where the SEC has had some success leave open the possibility that a judge may be willing to stretch the definition of “investment contract” or “scheme” to encompass some or all secondary market transactions on the Exchanges.
***
If you have any questions about the issues addressed in this memorandum, or if you would like a copy of any of the materials mentioned in it, please do not hesitate to reach out to:
Emily Kapur
Email: emilykapur@quinnemanuel.com
Phone: +1 650-801-5122
Michael Liftik
Email: michaelliftik@quinnemanuel.com
Phone: +1 202-538-8141
Chris Michel
Email: chrismichel@quinnemanuel.com
Phone: +1 202-538-8308
Andrew Sutton
Email: andrewsutton@quinnemanuel.com
Phone: +1 212-849-7654
Lynette Lim
Email: lynettelim@quinnemanuel.com
Phone: +1 213-443-3746
To view more memoranda, please visit www.quinnemanuel.com/the-firm/publications/
END NOTES:
[1] SEC v. Bittrex, Inc., et al. No. 23-cv-580 (D. Wash April 17, 2023) (“Bittrex Complaint”); SEC v. Binance Holdings Limited, et al. No. 1:23-cv-01599 (D.D.C. June 5, 2023) (“Binance Complaint”); and SEC v. Coinbase, Inc., et al, No. 23-cv-4738 (S.D.N.Y. June 6, 2023) (“Coinbase Complaint”).
[2] Coinbase Complaint ¶¶ 1-2, 6-7, 74-101; Bittrex Complaint ¶¶ 1-8, 58-62, 110-129; Binance Complaint ¶¶ 1-13, 282-324, 510-513.
[3] Coinbase Complaint ¶ 6-7, 114-126; Bittex Complaint ¶¶ 19-43; Binance Complaint ¶¶ 1-4, 315-317.
[4] Coinbase and Binance also argue users who “stake” their crypto holdings on the exchange for rewards have not entered into an “investment contract” qualifying that staking transaction as a security. And Coinbase further argues that providing a wallet app whereby users can view and access their crypto holdings does not make Coinbase an unregistered securities broker. An analysis of these issues is beyond the scope of this memorandum.
[5] For example, in Ripple, certain token transactions made to institutional investors were ruled to be securities, while others to retail investors were ruled not to be. See Ripple, 2023 WL 4507900 at *11. See also SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020); SEC v. Terraform Labs Pte. Ltd., 2023 WL 4858299 (S.D.N.Y. July 31, 2023); SEC v. Telegram Group Inc., 2020 WL 61528, at *2 (S.D.N.Y. Jan. 3, 2020), discussed infra.
[6] See id.; Crypto Asset and Cyber Enforcement Actions,” U.S. Securities and Exchange Commission (available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions).
[7] Coinbase Complaint ¶ 17; Binance Complaint ¶¶ 3-4;.Bittrex Complaint ¶¶ 50-51, 112-115.
[8] See Bittrex MTD at 8-9.
[9] See Bittrex MTD at 8-11; Coinbase MJP at 6-13; Binance MTD at 14-19.
[10] See Bittrex MTD at 10 (collecting cases).
[11] See Bittrex MTD at 8-11; Coinbase MJP at 6-13; Binance MTD at 14-19.
[12] Binance MTD at 14-15 (collecting cases).
[13] Bittrex MTD at 12-13; Coinbase MJP at 13-17.
[14] Bittrex MTD at 20; Coinbase MJP at 18-19; Binance MTD at 20-24.
[15] Coinbase Complaint ¶ 6-7, 114-126; Bittex Complaint ¶ 19-43; Binance Complaint ¶¶ 1-4, 315-317.
[16] The Exchanges acknowledge this flexibility in the definition. Bittrex MTD at 8-9; Binance MTD at 14-16.
[17] See State v. Robbins, 240 N.W. 456, 456 (Minn. 1932) (contract for sale of breeding muskrats and contract for breeding and management services “together . . . constitute a sale of an interest in a profit-sharing scheme”).
[18] See also Coinbase MTD at 7-8 (collecting cases).
[19] See Coinbase MJP at 11.
[20] See Binance MTD at 17-18.
[21] Coinbase MJP at 13.
[22] Bittrex MTD at 8-9; Binance MTD at 19 (“Whether analyzed under the ‘investment of money’ or ‘common enterprise’ prongs, case law dictates what logic and Howey make clear; there can be no ‘investment contract’ unless the buyer’s ‘investment of money’ flowed into the relevant ‘common enterprise.’”).
[23] Binance MTD at 18.
[24] Binance MTD at 18.
[25] Coinbase Reply at 1-2.
[26] Coinbase Reply at 2-3.
[27] Coinbase Reply at 4-5.
[28] Coinbase Reply at 7-8.
[29] See Bittrex MTD at 15, Binance MTD at 31, Coinbase MTD at 21.
[30] Bittrex MTD at 15; Binance MTD at 31-32.
[31] Bittrex MTD at 15; Binance MTD at 32.
[32] Bittrex MTD at 15; Binance MTD at 33.
[33] Bittrex MTD at 15; Binance MTD at 33.
[34] Binance MTD at 33-34.
[35] On Reply, Coinbase notes that the SEC fails to meaningfully rebut the Exchanges’ arguments with respect to the Major Questions Doctrine. Coinbase argues that the SEC’s reliance on Kik and Terraform for the proposition that the SEC may regulate crypto markets is insufficient.