The House has introduced a bill that clarifies that a digital currency that is part of an investment contract does not automatically become a security. The Securities Clarity Act, if passed, would settle one of crypto’s most controversial legal questions and make it harder for the U.S. Securities and Exchange Commission to claim that many tokens in circulation are unregistered security.

Bill Hinman’s now-infamous Speech, delivered in 2018, on the application of securities laws to digital assets, was given by Bill Hinman when he was the director of SEC’s Division of Corporation Finance. Bill Hinman suggested that, if a token’s network was “sufficiently” decentralized to the point “purchasers could no longer reasonably expect an individual or group to perform essential managerial or entrepreneurial activities,” the digital asset transaction “may no longer be a security offering.”

Tuongvy le is a partner at Bain Capital Crypto and the head of regulatory. Khurram Dara, a principal in Bain Capital Crypto’s regulatory and policy division, is responsible for the firm’s regulatory and policy activities.

Since then, there has been much discussion about whether digital assets could “transform” into non-security. SEC Chair Gary Gensler repeatedly expressed his skepticism about projects’ claims of decentralization, and refused confirm that the reason why he believes bitcoin to be a non-security is because it is “sufficiently” decentralized.

In its ongoing litigation with Ripple Labs, and two of its executives, over the XRP Token, the SEC is trying to distance itself from Hinman’s 2018 remarks by claiming they are not official agency guidelines.

The SEC has taken enforcement action in recent years to determine whether the claims of decentralization of a token project would cause it to fall outside of the definition of “investment contracts” – which are defined by the Howey Test. The SEC is saying that a token project’s claims of decentralization could make it outside its scope, depending on “facts and circumstance” for each crypto project.

Gensler has stated in the past that the federal securities laws do not allow for this concept.

The answer to this question could change if the Securities Clarity Act, recently introduced, becomes law.

What would Securities Clarity Act Change?

The bipartisan bill announced by Representatives Tom Emmer, R-MN, and Darren Soto, D-FL, in May clarifies and codifies that an asset that was sold or transfered pursuant to a fundraiser transaction deemed as an “investment contracts” – but that is otherwise not a security – does not become a financial security simply because it was transferred or sold as part of a Securities Offering. first introduced a version of the bill in 2021.

The bill distinguishes essentially between an investment contract, which is a security offering, and the investment contract asset which is not often a security (like orange groves at Howey). The bill would allow a token to be offered as part an investment contract without having to “transform” it into something else.

This distinction is crucial because unlike initial coin offerings of the past (ICOs), many teams interested in launching tokens in the U.S. today raise funds through Reg D offerings, which are exempt from SEC registration and typically associated with public offerings. Instead of selling to the general public, these private offerings are sold to “accredited” investors who purchase future token interests via purchase agreements. SAFEs or SAFTs are agreements that require tokens to be delivered upon the fulfillment of certain conditions, such as a network launch or protocol launch.

It is not the question of whether a security “transforms” into a non security, but rather whether a token is packaged as part of a multi-stage deal involving an offering that involves securities, without becoming a financial instrument.

The bill states that the difference between an investment contract and the underlying asset is “well-established” but “unnecessarily conflated” in the context digital assets. Lewis Cohen, of DLx Law , argued this distinction is consistent with the way federal courts have traditionally viewed “investment agreements.”

This bill is good for policy. Gensler has said that existing token projects “should come in and register” with the SEC their assets. To better protect investors, it would be a mistake to confuse an investment contract with the token underlying the transaction. It could even have the opposite impact.

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Our friends at Paradigm have detailed in detail why the current SEC Disclosure Framework is not suitable for crypto assets. It “fails crypto-asset investors and users with the information that they need while also denying cryptocurrency entrepreneurs a viable pathway to compliance.”

The Securities Clarity Act, which clarifies the difference between an investment transaction (or other financial instrument) and its underlying assets in the United States, provides a way to comply with the law.

The bill also helps trading platforms who are currently struggling to determine whether a token initially offered as part of a securities transaction may be able to later be listed or available for trading.

A world where a digital asset could transform from being a security into a non-security, and possibly back again? This presents real challenges to supervision and enforcement.

Emmer’s bill has an important qualification: the asset that underlies the investment contract must not be a security. Without this qualification the bill creates a loophole for issuers who can evade securities law. This qualification means, however, that the SEC has discretion to determine whether an asset that is part of an investment contract constitutes a security. A more aggressive regulator could abuse this.

Facts and circumstances

The bill will provide clarity that was much needed and couldn’t have come at a more opportune time. Grayscale, for example, revealed in a Press Release a day prior to the bill’s introduction that the SEC informed them that they believed that filecoin was a security. This was in relation to Grayscale submitting a registration statement of a filecoin Trust Product.

Protocol Labs, which developed the Filecoin Protocol, raised funds in an exempt securities offering by accredited investors. Protocol Labs didn’t sell tokens for Filecoin to raise money. The SEC’s argument, that FIL is a securities, is likely based on confusing the difference between the investment contract, and the underlying asset that is used to secure and purchase space on a network of decentralized file storage.

Filecoin was used for everything from collecting evidence of war crimes and important scientific information to important scientific data, representing one the most compelling nonfinancial uses cases in crypto.

The proposed legislation does not prevent the SEC from concluding that investment contracts assets are securities. However, it reduces uncertainty for both investors and issuers. It is only five pages long, but it provides clarity by amending the federal securities laws definition of “security”.

The bill, while it faces a tough battle in the Senate to become law, is a step in the right directions from the House Financial Services Committee. It is rumored that the committee is working on a bill to regulate stablecoins for payment, and also plans to pass legislation on market structure.

Jeanhee Kim & Daniel Kuhn edited the book.