Today we’re taking a little look at the thorny topic of crypto and securities, after a California resident, Mr. Mark Young, brought litigation that may have far-reaching implications for the space. His suit – which was filed on the first of July in a district court for the Northern District of California targets Solana Labs, the Solana Foundation, its co-founder Anatoly Yakovenko, Multicoin Capital Management, and its co-founder Kyle Samani, plus FalconX.
He’s accusing them of selling and promoting unregistered securities in the form of SOL tokens from March 24, 2020, onwards – the day Mr. Mark started investing. If you don’t know it, Solana is the ninth biggest cryptocurrency by market cap, and is a very popular Defi token with a focus on transaction speed and scalability: it can reportedly handle over 50,000 transactions per second, in contrast to Ethereum’s 3.0, so no crazy gas fees when you want to buy your next PFP NFT. OMG WAGMI.
Here’s an extract from the lawsuit. “[The] defendants made enormous profits through the sale of SOL securities to retail investors in the United States in violation of the registration provisions of federal and state securities laws, and the investors have suffered enormous losses.” Oof, but hang on, let’s start at the beginning and keep going until we get to the end, then we’ll stop –
Howey Company’s igneous plan
What’s security, why the hell do I care if Solana is one or not, and how’s this lawsuit going to affect my portfolio? Well to answer that, we actually have to go back to fair 1940s Florida where we lay our scene. The roaring twenties was by now a distant memory. War was on everyone’s mind. People craved a bit of certainty. So the Howey Company, which was a citrus grower, came up with an ingenious solution:
Why not sell half its groves in real estate contracts to finance its future business developments? Investors would then lease the land back to the company, which would continue all the work as they had done beforehand, tending to trees, pruning leaves, stroking oranges, and whatnot – and they’d then split any profits from that bit of land with the new owners.
The company gets a massive boost of cash from the sale of the land which they can invest back in the business, and they also mitigate the risk of poor futures harvests/turndowns in demand, by taking dollars upfront. Investors meanwhile get a steady income stream for the future. It’s the perfect solution, right?
Well, that’s not how the SEC saw it. Because to the agency, what they were selling seemed an awful lot like securities, which is a basic term to denote fungible financial instruments that hold monetary value, for example, a share in a public company. And that was a big deal. Memories of the Great Depression and all its pain, unemployment, and horrible images of bankers jumping out of buildings were by no means a distant memory at this point in time and the government wanted to ensure it never. Ever. happened. again.
As a result, the Securities Act of 1933 had been enacted, obligating that any issuers selling securities engage in a mandatory registration process, disclosing all the information of material importance related to that security. By requiring registration with a government body – and the public having full access to the necessary information via a prospectus to make an informed decision – the aim was to cut down on grossly inflated financial projections and the possibility of rampant fraud.
Okay well, when it comes to a share in a business or debts in the form of bonds, it’s pretty straightforward what is and what isn’t a security. But does land where oranges are grown, count? Not according to the SEC, and – in 1946 – the Supreme Court, because the Howey Company’s arrangement was basically an “investment contract” – out-of-towners with no experience in agriculture investing just to make bank. And so there lay the real possibility of abuse if no one was watching out for any potential wild promises being made.
What’s the Howey Test?
To make all of this a helluva lot clearer for everyone involved, the Supreme Court established four criteria, now collectively known as the Howey Test – to determine whether an investment contract exists, and therefore whether something is security and should be registered.
The four parts are: An investment of money In a common enterprise With the expectation of profit To be derived from the efforts of others Let’s break them down. Money is fairly self-explanatory, though today we’re moving away from “money” specifically, towards wealth or value instead. ‘In a common enterprise’ can be understood in a few ways, either that investors are all putting their money into the same thing, that the success of investors is intrinsically linked to the party being invested in, OR that the investment itself is reliant on the promoter or a third party’s expertise.
‘With the expectation of a profit’ dissects investor intent. Are people looking to make a profit by doing this, or are they simply trying to store wealth like in a stablecoin for example? Finally, ‘To be derived from the efforts of others, in the case of these citrus groves through the agricultural expertise of the Howey Company itself.
Does Solana fail the Howey Test?
Mr. Mark Young’s lawsuit alleges that the cryptocurrency fails to meet the Howey Test because – and this is the thrust of their claim: “Purchasers who bought SOL securities have invested money or given valuable services to a common enterprise, Solana. These purchasers have a reasonable expectation of profit based upon the efforts of the promoters, Solana Labs and the Solana Foundation, to build a blockchain network that will rival Bitcoin and Ethereum and become the accepted framework for transactions on the blockchain.
What about ETH?
You may have read those above lines and said, yeah, I can personally see why it could make sense, I mean the token did go from $2 to $240 dollars in the space of a year, and they had active socials talking about what they were building, and the development team seems to be intimately involved in building a thriving community of Solana enthusiasts. Why wouldn’t it be security? But if you think that, why is Ethereum not also considered security?
It had an Initial Coin Offering in 2014, and raised $18 million over a period of 42 days – where people were buying in together on the collective expectation that the protocol would become a better alternative to Bitcoin and therefore would create a profit as a result of the efforts of Ethereum’s development team?
An XRP re-run
FYI, this is all basically the same fight Ripple Labs has been fighting for nearly two years now, after the SEC sued them claiming that they traded $1.3 billion in their cryptocurrency XRP as security without registering it. Ripple, for its part, still holds the defense that the SEC is making classifications in an arbitrary and biased way rather than on actual merit (or even clear rules).
They say what Ripple does isn’t materially distinct from most other projects in the space, so why are they being singled out? Solana Labs have so far declined to publicly comment on the lawsuit, but one can imagine them making the same defense when it comes to their turn in court.
SOL token allocation
However there’s a big – alleged – but big difference between Solana and Ethereum that can’t be overlooked: who owns the tokens. According to crypto research platform Messari and the lawsuit itself, some 48% of Solana’s token supply was held by Insiders as part of the initial token allocation, In contrast to Ethereum’s 80%.
This includes Multicoin Capital Management and Kyle Samani who according to the filing at least: “relentlessly promoted SOL securities, after purchasing them for $0.40 in 2019.” And that matters because it means point four of the Howey test – To be derived from the efforts of others – is more acute.
Unlike a very decentralized blockchain such as Bitcoin, where no one party can unduly influence the value of the protocol as a whole, having a considerable insider and core development team stake creates a vested interest in promoting the token and an ecosystem where its success is the determined by the hands of a few. And without the SEC involved, who’s going to guard the guards themselves?
Is everything a security?
Now the question I’ll pose at this point is do the minutiae of token distribution ratios and the like actually matter? Is there a spectrum of security-ess one can slide around like those tricky corners of Rainbow road? Shouldn’t it be a binary choice instead? If public investors give you money to buy your token via ICO or otherwise, the expectation that the project will be a success, and they’re relying on your expertise to make it so, that’s a security.
Ethereum did this, so ETH should be one too, no? The rub here, I fear, lies in the difference between what is being regulated and what should be regulated. As the SEC chair himself, Gary Gensler affirms, they believe their agency has “jurisdiction over probably a vast number” of cryptocurrencies currently in circulation, but “maybe” not bitcoin, which as a “commodity token” would be better overseen by the CFTC. But everything else, even Ethereum, is fair game.
Responsible Financial Innovation Act
However, the long-awaited Responsible Financial Innovation Act sends a slightly different message. The Bipartisan bill – introduced in the United States Senate on June 7 with the aim of creating a regulatory framework for digital assets – talks a lot about working with the CFTC and the SEC to find the right mix of using the Howey test, to figure out which of those agencies best can regulate.
It also has the quote: “Understanding that most digital assets are much more similar to commodities than securities, the bill gives the CFTC clear authority over applicable digital asset spot markets.”
What happens now?
So perhaps the repercussions of the lawsuit will stay pretty much with Solana after all. If the filing does go against the cryptocurrency then we can expect a similar playbook to what happened with Ripple, where all Centralized Exchanges in America – CoinBase, Kraken, and the like – will delist the token and you won’t be able to buy, sell or convert them.
For me though, I find it hard to believe that the other crypto projects won’t now be starting to think long and hard about how they launch and market their protocols in the future – at least until such a time as a meaningful framework makes its way through the legislative process. But until it does and until this court verdict rolls in – which could be a long time– we’re just going to have to go to Winchester, have a nice cold pint of SEC-registered orange juice, and wait for this all to blow over. What do you think? Let us know in the comments below.