Navigating the Complex SEC Rules for Investing SEC Registration or Exemption? A Crucial Decision...
Taylor Swift and the FTX Debacle
FTX Trading Ltd. (“FTX”) – the now bankrupt cryptocurrency exchange and crypto hedge fund founded by Sam Bankman-Fried and Gary Wang – jumped into the national spotlight after spending hundreds of millions of dollars on sports marketing deals and celebrity endorsements. Notable deals included those with Tom Brady, Gisele Bündchen, Shaquille O’Neal, Steph Curry, and Larry David, and FTX’s paying $135 million for the naming rights to the Miami Heat’s arena (the FTX Arena).
In 2021, Taylor Swift was approached by FTX about a lucrative sponsorship deal involving ticket sales to her fans in the form of non-fungible tokens (NFTs). Swift was at least initially reluctant. She had one very important question for the FTX brass setting the tone for the negotiation to follow: How could it be that FTX’s cryptocurrency was not an unregistered security? Her question would, of course, prove prescient.
Taylor Swift and the FTX Debacle
Correctly identifying a business-legal issue at the outset of an investment and promotion opportunity, the mega-star set the stage for a higher level of due diligence examination and negotiation. In this case, securities regulatory concerns posed a vital issue to be examined in depth for those considering a direct or indirect investment in a complex cryptocurrency exchange opportunity such as that FTX presented.
Asking critical questions and vetting a given team’s business plans can – at the minimal risk of slowing down a deal that may be moving too fast – save any investor a wealth of embarrassment as well as a pile of money.
While negotiations were confidential, there are conflicting news reports on whether Swift or FTX backed out of the deal. Regardless, Swift is avoiding the legal scrutiny of the other celebrities who endorsed FTX and are now accused of lending credibility to risky crypto products.
When does an investment become a security?
A security is a financial asset that can be sold or traded in a financial market. The term securities refer broadly to investments that can be exchanged and used to raise capital. The most common types of securities are stocks, bonds, ETFs (exchange-traded funds), options, and mutual funds. Beyond the common securities listed above, numerous other types of assets and general categories such as an “investment contract” may fall within the definition of a security.
A key question of whether or not a given asset (including a digital asset such as cryptocurrency) is a security is whether it is offered or sold as an investment contract; if sold as an investment contract, then it is a security.
The Securities and Exchange Commission uses a test (Howey Test) to analyze whether or not an investment contract exists at the time of its offer or sale:
- investment of money or other consideration is made
- in a joint enterprise (i.e., two or more parties contributing skills, knowledge, resources or money in a common purpose)
- with the expectation of a profit (or other financial returns)
- which profit or other return is obtained through the efforts of others (i.e., significant or managerial efforts affecting the enterprise’s potential for success).
While this seems to be a simple test, it is extraordinarily complex and exhaustively detailed in nature, draws from decades of precedents and is highly sensitive to all of the specific facts and circumstances of the potential security (including as to its marketing and timing); the applicability of these precedents are severely tested in the digital assets industry.
Why Does it Matter if a Security is “Unregistered”?
All securities that are offered and sold in the United States must be registered with the SEC. Importantly, registration entails required disclosures to investors to provide investors with the information to make informed investment decisions. There are strict rules about how securities are managed, including how they can be traded and how information relating to securities may be shared. If a product is a security, it must be registered with the SEC (and typically state regulators as well), and it can only be traded by licensed stockbrokers unless limited state and federal exemptions from sale or licensure apply.
Transactions that are considered “investment contracts” (whether in trading traditional stocks or shares in a company – or in newfangled digital assets on a cryptocurrency exchange) must adhere to regulations outlined in the Securities Act of 1933 and the Securities Exchange Act of 1934.
Future of Crypto Regulation
In a complaint against FTX executives, the SEC asserted that FTX’s cryptocurrency, FTT, is classified as a security because it was sold as an investment contract. Further, FTT was identified as an “unregistered security” in that it failed to appropriately register its investment contract as a security with the SEC or identify and rely upon an applicable exemption from registration.
The SEC is clearly and perhaps inexorably moving towards increased and clarified regulation of the digital asset industry, which includes cryptocurrencies and other similar digital assets, intermediaries, and exchanges. For a variety of reasons, this complex and youthful industry has significant barriers to quickly installing a workable regulatory regime; for example, terms such as “coin,” “token,” and “currency” are regularly and interchangeably used to describe a disparate group of digital assets making regulation based on nomenclature alone not an option. Instead, a given digital asset’s function – such as the cryptocurrency FTT’s functioning as an investment contract – must be evaluated. Over the last several years, the SEC has focused on digital and cryptocurrency products and platforms potentially engaging in the sale and offering of securities, determining whether such products qualify as a security.
Until such time as the SEC and other regulators issue comprehensive regulations (or signal areas, assets, and scenarios exempt from applicable regulation), following Ms. Swift’s example and employing heightened caution in the handling of digital and cryptocurrency assets is warranted.
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Photo credit: Chad Davis