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Top Five Cryptos Analyzed: Security or Not Security?

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TRANSCRIPTION OF VIDEO

Hello this is attorney Jeremy Hogan and welcome to Legal Briefs – it’s the weekend and there’s nothing I like to do more on the weekend than get a little wild and crazy, cut loose a bit, go a  little crazy, and so I am  going to analyze the top five crypto currencies out there and apply the law found in the Howey test to each of the five  top crypto projects out there by value and give each a danger rating as far as securities violations. Wild and crazy. Weekend. Ok, the truth is that I’ll probably spend the weekend watching cartoons with my kids and laughing at the inappropriate jokes they hopefully don’t get.

So, I have done my research and today we are going to make it thru the top five crypto coins by value and give them a Legal Briefs “Danger Rating” as far as SEC enforcement. Let’s find out exactly how safe your holdings are and we’ll call this Part I – depending on how this goes.

First, my “this is not legal advice” disclaimer.  This is not legal advice.  But I would strongly suggest if you need a lawyer to contact this lady

Bonus points if you know in what state she passed the bar.

Anyways, We are beginning with Bitcoin which is the top dog crypto currency and which as we know was created by  a mysterious and unknown individual or perhaps group of individuals who go by the name “Satoshi.”  If you are really interested in Bitcoin I stumbled across the creepiest cartoon ever made and it happens to be about Bitcoin.  Here’s Bitcoin’s origin story from the Bitcoin and Friends channel – check it out on Youtube.

And that was the creation of the first block of Bitcoin. And believe it or not, the cartoon  gets stranger from there…

In any case, Bitcoin is about as decentralized a ledger as it gets. The ledger was created in 2009 and then the first coins were mined by some guys with Blackberries running through Imacs. And now here we are 12 yrs. Later with small countries dedicated to mining it.

But Bitcoin is completely decentralized so the SEC could never regulate it as a security, right?  Well, that’s not how an SEC lawyer might see it. Under U.S. law something is a security when a person invests money in a common enterprise and led to expect profits from the efforts of a third party.

So, applying the facts to the law, we might think right away that Bitcoin cannot be a security because there IS no third party and since Bitcoin is mined, there was never an investment of money. Case closed. Not quite. The problem is that Bitcoin is not as decentralized as we are led to believe. Here in this story you can see that:

“1,000 entities own approximately 40% of all circulating bitcoin and 2% of account holders now control 95% of bitcoin.”

 You also have more big players in the Bitcoin game like Grayscale’s Bitcoin Trust which controls $23 billion in Bitcoin.

So, it could be argued, if the SEC had some inkling that the price of Bitcoin was being manipulated or pumped up by a large holder or group of holders, that it could argue that there was a common enterprise there and sales by the group was in effect an investment contract – a sale of a security.  It’d be a stretch but that would be the argument.

Yes, let’s cut to the chase, with Chinese organizations controlling so much Bitcoin, I am envisioning a lawsuit by the SEC against China. And that would be the most interesting legal thing ever. Sign me up.

With that being said, I give Bitcoin a Legal Briefs danger rating = 2 out of 10!  Here’s a graphic:

There’s an argument to be made about Bitcoin but it’s very weak.  I wouldn’t lose sleep over it.

Ok, moving on from Bitcoin we hit the big one.

 That’s Ethereum.

So, Etherium is a blockchain network which allows you to use applications on the platform and you pay to play so to speak by using the Etherium Token. The big difference between Bitcoin and Etherium is that there IS a centralized organization who not only oversees the Etherium network but it is very involved and ALSO HAS raised money to fund the project.

The Etherium Foundation is headed up by a guy named Vitalik Buterin who is a great personality but more importantly, can dance and rap:

God I love Youtube.

The big problem Etherium has from a legal perspective is that it has raised money to develop the ledger AND more importantly, the funding was called a “Pre-sale” meaning coins were being sold BEFORE being in existence. This took place in the summer of 2014 and raised $18million. That tends to suggest that the common enterprise prong of the test is met because pre-sale purchasers were relying on the developers for the value of the coins they bought.

And we have further evidence of the centralized management structure of Ethereum and how it can Affect price when we look at the DAO hack.  Back in 2016 a group was able to exploit some issues in the network and steal money.  In response, two important things happened – First, the Ethereum Foundation decided to do hard Fork of the ledger. 

A hard fork (hold fork) of the ledger.  So apparently the ledger was not as decentralized as people thought.  And perhaps more importantly, look at what happened to the price of the Etherium token after the Hack and Fork:

That’s right, the price dropped after the hack and corrected somewhat after the fork.  That is consistent with an investment contract – a common enterprise for profit. That’s problematic.

But wait, you might be thinking, didn’t former SEC director Hinman state publicly that Ethereum is not a security:

“ … based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

Yes, he did say that, but as we now know from the Ripple litigation, NOTHING anyone at the SEC ever says matters. Completely doesn’t matter so, no, that doesn’t legally matter as to whether the SEC will go after Ethereum but it does make it a little harder so I will give a point for that.

So, Ethereum has some serious problems with its initial fundraising which, although not called an Initial Coin Offering, sure does look like one.  Also, there is a centralized management group – although loosely formed.  But, there are at least entities for the SEC to sue. That’s not good for Ethereum.  We’ve also seen how the price of Ethereum correlates with things that the Foundation does or leads.  BUT the Foundation is a non-profit corporation and not a distinct entity like the SEC likes to pursue – not a company trying to use Ether to make money.  SO, that’s good for it.

Overall, there is danger here but not “run from the house screaming” danger. Ethereum gets a 4 out of 10 Legal Briefs danger rating. 

You will probably be happy.

But, I’d probably be more concerned if I was an individual back in the early days and I’m now rich.  Vitalik  – call me if you get in any trouble and I will add dance lessons for free.

BUT, as you probably know, Ethereum 2.0 is coming out next month I think and it changes Ethereum’s model to a proof-of-stake system and this also changes the securities analysis.  AND Ethereum 2.0 is technically our 3rd coin to analyze. 

Be careful.

Remember, we are looking for an investment of money into a common enterprise with an expectation of profit from the work of others.

The change to staking creates a problem first because the validators who stake their Ethereum do so with an expectation that their stake will earn them a return – that’s the whole point. So that goes to the “Expectation of profit” prong.

And in its latest guidance release back in 2019 for digital assets, the SEC stated when talking about whether there is reliance on others to make profit, that:

“An Active Participant”  is responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an AP to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality.

Well, isn’t the upgrade to Ethereum 2.0 exactly the type of thing that would raise the SEC’s alarm system – get the old death star fully functional and ready to destroy? Definitely seems like the SEC might see a “promotion” and “improvement” of the network by a semi-centralized entity with the rollout of 2.0. And now you have the profit to stakers added to the equation.

With that being said, Ethereum 2.0 injects a lot of attention and  danger and gets it a Legal Briefs danger rating of 6 out of 10!

Just ignore that TV stuff – our production level is basically Google Images Search level.

Ok, next on our list is the stable coin Tether.

The Tether coin is backed by exactly one U.S. Dollar just how our dollar is backed by Gold of course – leading to sound monetary policy.

What? We went off the gold standard back before even my Dad was born?  That’s insane – that would lead to all sorts of crazy monetary policy and institutionalized inflation and devaluing of the Dollar… Why wasn’t I taught this in school?

Well, at least with Tether it’s all on the up and up and Tether is backed by …

Oh. “In 2017, Bitfinex and Tether misled the market about Tether’s U.S. Dollar backing.”

And that Settlement Agreement is from the New York Attorney General’s office and I would say that gives Tether a 9 out of 10 on the Danger rating.  But you don’t own it and never will so I’m guessing you don’t care too much. I just wish the New York AG would go after Congress with the same gusto.  That would be something to witness.

WHICH takes us to Number five and that is the Binance Coin.

Binance is the second largest crypto exchange and can match 1.4 million trades per second. It’s fast and it’s also expensive.

You can pay Binance for trades the old fashioned way OR you can buy Binance Coins and use those coins to receive rebates on Binance.  For example, your first year you will save 50% on your trading fees IF you use the Binance token.

Now, is the SEC likely to go after the Binance Coin as a security? Well, Binance already has a history with U.S. regulators and the issue was that Binance was never designed to even operate in the U.S. but U.S. consumers, being very savvy and smart, found a way around that and were trading on Binance by making friends with a person in China who would make the trades for them.  Just kidding – we were using VPN routers to mask our location.

Imagine that, US Citizens having to act like we are in China, in order to do engage in capitalism.  Hmm..

In any case, Binance recently launched Binance US and submitted itself to our government regulation. As of 2 hours ago you can buy/sell Binance Coin on the U.S. site so we can analyze it under the Howey test.

First, is there an investment of money?  Yes, you buy the coins. And where did the coins come from?

Well, Binance had a genuine Initial Coin Offering – an ICO in 2017.  This is exact thing that Chairman Clayton and new SEC chairman Gensler have basically said is an investment contract.  And here’s how that looked:

There you can see that the Founders of Binance received 40% of the tokens and are now Billionaires, 50% was sold to the Public – ostensibly some of that was sold to American investors, and 10% went to Angels.

I think “Angels” might be code for “bribe money” in China.

In any case, this is not looking good and to make matters worse the control of the Binance Coin is very centralized. In fact, in order to maintain the value of the coin, Binance buys back and burns the coins every quarter and even said in its White Paper that the purpose was to keep the coins scarce and valuable.

So, there was an investment of money, made to build and upgrade the platform and exchange, there is a common enterprise in which Binance is actively involved in promoting the coin and increasing it’s value. The ONLY thing that Binance has going for it is that it’s a utility token and will gain value from its utility – but even THAT is tied to the centralized Binance platform and that meets the third prong of the Howey test.

For those reasons we have lots of strong arguments that the Binance Coin is a security and it gets an 8.5 Legal Briefs Danger rating.

Funny, I used to have a 1986 Honda 4 cylinder and that’s exactly how the speedometer looked.

 The SEC can’t sue every coin out there but this one would seem to be an easy target. Be careful.

In Summary, we have danger ratings of 2 for Bitcoin, 4 for Ethereum, 6 for Etherum 2.0, a 10 million for Tether and an 8.5 for Binance Coin.

But you my friend get a “100” for watching to the end and let me know in the comments if you agree, disagree or if you even want me to do a part II.

 Investing is all about risk containment and, unfortunately, SEC regulation and litigation has become part of that analysis.  Live within the framework you find yourself but never give up to it.  Make the change you want in the world.  Have a great weekend.

Jeremy Hogan
Jeremy Hogan
Attorney Jeremy Hogan is a partner at Hogan & Hogan.