There are questions as to whether Bitcoin falls under the regulations of federal securities law. Federal securities law is a complex area of law that grants courts and the SEC great leeway in classifying investment products as securities. Nevertheless, a Bitcoin in-and-of-itself is not a security that can be regulated under federal securities la.
NOTE: This is a simplified analysis of complex issues. I welcome any comments or debate. A more detailed analysis of the legalities of Bitcoin is in the works.
Where the term ‘security’ comes from
A security implies an investment method or instrument that is secured against something else. A classic example is a share of stock. Stock is secured against the equity interests of a company. Therefore, by owning a share of stock you own an interest in a company.
Similarly, bonds, notes, and other evidences of indebtedness are securities because the ‘thing’ securing it is the debt instrument itself. This instrument creates an obligation for one entity to pay another entity. For this same reason, currency can be considered a security because a U.S. dollar bill represents a promise of value made by the U.S. government. (It used to be backed by our gold reserves, but this ended during the Nixon administration.)
But if currency can be a security, then Bitcoin is a security because it’s a type of currency, right?
Wrong. Bitcoin is not really a type of currency, at least not of the type recognized as securities. No entity or assets back up Bitcoin value. Bitcoin value is entirely virtual—a Bitcoin is only worth what another person thinks its worth. This is different than currency issued by countries.
A country’s currency is backed by that country’s government. This backing can either be by fiat (government regulation or law) or by commodity (such as the gold standard the U.S. used to use). Some compare Bitcoin’s value to the value of fiat money, because like fiat money it is not backed by a commodity, but this is where the similarities between Bitcoin and fiat money end.
Bitcoin is backed by no entity, no commodity, no organization. Bitcoin value is not based on government regulation or law mandating its use in a country. Similarly, it is not backed by a whole bunch of gold sitting in Fort Knox.
That seems simple, so why is everyone confused?
Because it’s not that simple. I alluded to the complexity of securities law at the beginning of this post. This section will delve into it more in-depth. If you’re not interested in nitty-gritty details, I suggest scrolling down to the conclusions below.
So, what is a security under federal law?
Federal securities law is written to provide the courts and Securities Exchange Commission flexibility to handle a great variety of investment schemes. Think of all the financial alchemy you’ve heard about when it came to the recent housing market crash and the collapse of Lehman Brothers and Bear Stearns. Those collateralized debt obligations, or CDOs, you keep hearing about are securities.
The SEC is concerned with more than financial instruments, however. The SEC seeks to regulate all types of investment schemes. A leading case on one type of security, investment contracts, illustrates federal law’s flexibility.
The SEC v. W.J. Howey Co. involved the sale of units of a Florida citrus grove coupled with a service contract for farming those units. The U.S. Supreme Court ruled that this arrangement amounted to an investment contract. Investment contracts are included in the definition of securities in both the Securities Act of 19331 and the Securities Exchange Act of 19342 and are therefore subject to SEC regulations. The Court defined an investment contract as:
a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.3
Some who argue that Bitcoins might be classified as securities point to the broad definition of investment contracts. But, before we delve into a detailed analysis of investment contracts, there is another broad category of securities listed in the securities laws of 1933 and 1934: “in general, any interest or instrument commonly known as a ‘security’.”4
The U.S. District Court of Oregon concluded that pyramid schemes can fall under this general category in the 1972 case SEC v. Glenn W. Turner Enterprises, Inc.5 The defendants in Glenn Turner were selling tapes and lessons on selling . . . something. These contracts were called “Adventures.” The more you paid the more expensive ‘adventures’ you could in turn sell to others. Yet, like a classic pyramid scheme, latecomers would find the market for selling these ‘adventures’ was saturated.
The court in Glenn Turner borrowed a California test for determining whether something classified as a security—the risk capital test. The test looks at whether the investor subjects his money to the risk of an enterprise over which he exercises no managerial control. The idea behind the test is that investments of this type are the basic economic reality of a security transaction.
The test looks at whether the subjection of the investor’s money to the risk of an enterprise over which he exercises no managerial control is the basic economic reality of a security transaction.
So for those keeping score, a number of things can be classified as securities. There are the specifically enumerated types of securities, such as notes and company shares, listed in the 1933 and 1934 securities laws. Those two laws also contain two general, broad categories of securities:
- Investment Contracts, and
- Anything commonly known as a security.
Both of these general categories share common characteristics:
- Investors investing money;
- An expectation of profits from the investment;
- Substantial third-party control of the enterprise.
An investment scheme possessing some or all of these traits might be deemed a security under U.S. law and, thereby, be subject to federal laws (and state laws) regulating securities.
Bitcoin is not an investment contract
Investment contracts are
contract[s], transaction[s] or scheme[s] whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.6
Bitcoins do not require direct investments of money. It only requires investment of computing power. Further, while it might be said the Bitcoin community is a common enterprise, that enterprise is distributed and not run by a single individual or entity. Profits from Bitcoin cannot be expected from the efforts of a “promoter,” for there is no Bitcoin central entity, nor from third parties.
The Oregon District Court in Glenn Turner makes the point that investment contracts should be flexible in their definition, and the Howey court never intended to create a strict definition for investment contracts. Nevertheless, none of the four characteristics of an investment contract—(1) investment in (2) a common enterprise with (3) the expectation of profits from (4) the efforts of another—really fit Bitcoin’s model. As far as Bitcoins themselves are concerned, they do not meet the definition of investment contracts.
Bitcoin does not possess the general characteristics of a security
A Bitcoin does not exist based off of a monetary investment. It exists based off of a computer processing investment. Further, Bitcoins are not reliant on the managerial control of others. In fact, the Bitcoin network is distributed in a way that prevents one party from exercising managerial control.
Bitcoins fail to meet the basic economic reality of a security transaction under the risk capital test created by California courts and relied on by a number of states and federal courts. A Bitcoin itself should not be considered a security under the general definition of securities in federal security law for this reason.
So Bitcoin isn’t a currency, and it isn’t a security, then what is it?
This is the million-dollar question. Bitcoins are not currency and are not securities. Yet, they have the ability to represent value. In some ways they are pure representations of value—their value is not based on relations to outside elements, such as commodities or government regulations, but their value is rather based on what one person is willing to give another for the Bitcoin transfer.
Bitcoin shares some elements of fiat money in the sense it is not tied to tangible goods, yet it doesn’t share fiat money’s government backing. Bitcoins themselves are simply cryptographic strings that represent transactions; except for the willingness of some people to exchange Bitcoins for real-world money, Bitcoin valuation is incredibly difficult.
So Bitcoin ‘investors’ don’t need to worry about securities regulations or laws?
Bitcoin investors should absolutely worry about securities laws. The securities definitions outlined above might not apply to Bitcoins themselves, but they are flexible enough to apply to Bitcoin exchanges that convert a Bitcoin to real-world currencies. Securities law might even apply to exchanges converting Bitcoin to other virtual currencies such as Lindens.
Is their a common economic scheme where a profit is expected based on the efforts of a third party? Then the transactions occurring on an exchange might constitute an investment contract. Is the Bitcoin investor subjecting his money to an enterprise over which a third party has primary control? Then the Bitcoin transaction itself might be a security under federal security law. Securities law is broad enough to potentially capture any enterprise where investment for profit is involved.
This is why security law is so complex—many types of transactions might fall under securities regulation, even if the objects or subjects of the regulation do not. Therefore, the land purchase and servicing deals in the Howey case, while not securities in their own right, become part of an overall security by being an investment contract. Similarly, the investment rules and requirements of a Bitcoin exchange might convert those Bitcoin transactions into a security, even though Bitcoins themselves are not securities.
- Section 2(a)(1) of the Securities Act of 1933. The entire act is codified at 15 U.S.C. § 77a et seq. [↩]
- Section 3(2)(10) of the Securities Exchange Act of 1934. The entire act is codified at 15 U.S.C. § 78a et seq. [↩]
- SEC v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946). [↩]
- See both § 2(a)(1) of the Securities Act of 1933 and § 3(2)(10) of the Securities Exchange Act of 1934. [↩]
- SEC v. Glenn Turner Ent., Inc., 348 F. Supp. 767 (D. Or. 1972). [↩]
- SEC v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946). [↩]