For more than a decade, crypto industry leaders have envisioned digital currencies as an alternative branch of finance, an insurgent sector that would operate beyond the reach of major banks and government regulators.
But as digital currencies like bitcoin and ether spread, the cryptocurrency industry ran afoul of a 1946 Supreme Court decision that established what is known as the Howey test, a legal analysis that determines when a financial product becomes subject to the same strict rules as stocks. And bonds.
In recent years, regulators have exploited this legal precedent to argue that cryptocurrencies are just another security, like Apple or General Motors stock. The cryptocurrency industry has resisted, leaving it in a legal gray area with an uncertain future in the United States.
Now the long-running dispute is moving closer to resolution, as federal judges begin considering a series of lawsuits filed by the nation's largest securities regulator against some of the largest cryptocurrency companies. This month, the justices held hearings on two of the most important cases, which could determine whether the multi-trillion-dollar cryptocurrency industry can continue to grow in the United States.
Hillary Allen, a professor at American University who specializes in financial regulation, said the legal battles are “an existential issue for cryptocurrencies.”
Court battles have intensified over the past 18 months, with the Securities and Exchange Commission filing lawsuits claiming that cryptocurrency companies were operating as unregulated securities firms. In response, the industry argued that the laws governing Wall Street trading should not apply to cryptocurrencies. Both sides won early court victories that left the matter unsettled.
But this month, federal judges held hearings in two cases that legal experts expect to be more decisive: lawsuits filed by the Securities and Exchange Commission against cryptocurrency exchanges Coinbase and Binance, which explore key issues in the broader legal battle. Initial rulings in these lawsuits are expected in the coming weeks, paving the way for litigation that could eventually reach the Supreme Court.
“We've built our legal strategy around” a potential showdown in the Supreme Court, said Paul Grewal, chief legal officer at Coinbase. “These are issues that have potential implications for huge sectors of the economy.”
How the courts' ruling could determine whether the cryptocurrency industry can delve deeper into the US financial system. Cryptocurrency proponents say that if the SEC prevails, it will stifle the growth of new and dynamic technology, prompting startups to move offshore. The government responded that strong oversight is necessary to end rampant fraud that cost investors billions of dollars when the cryptocurrency market collapsed in 2022.
“The history of cryptocurrency markets shows that investors are vulnerable and harmed by these platforms’ complete disregard for regulatory requirements,” SEC spokeswoman Stephanie Allen said.
The origins of cryptocurrencies go back to 2008, when a developer known by the pseudonym Satoshi Nakamato created the software behind Bitcoin. Early proponents of cryptocurrencies envisioned it as a decentralized alternative to traditional finance, a community project run by a vast network of people spread across the globe.
But as the industry has matured, companies that resemble traditional finance companies have begun to develop and market cryptocurrencies aggressively. Enthusiasts bought cryptocurrencies in the hope that their value would rise. The government viewed the emerging sector as an unregulated version of Wall Street, rife with fraud and manipulation. Last year, the SEC filed 46 enforcement actions related to cryptocurrencies, according to Cornerstone Research, a consulting firm.
The SEC's blueprint for cryptocurrencies is guided by a 1946 Supreme Court case regarding investments in orange groves in Florida. This case led to the creation of the Howey Test, a legal standard for determining what makes something a security if it is not a stock or bond.
Under this framework, a financial product becomes a security when it offers the opportunity to invest in a “joint venture” with the expectation of benefiting from the efforts of others. Examples of securities under the Howey test include certain insurance products and even chinchilla contracts.
Classification as securities comes with a wide range of legal requirements: companies offering securities must provide detailed disclosures and comply with complex investor protection measures that can be expensive to implement.
In public statements, SEC Chairman Gary Gensler has argued that most cryptocurrencies qualify as securities under the Howey Test because people invest in cryptocurrencies with the hope that companies issuing the currencies will drive up prices. Only Bitcoin is outside the SEC's control, he said, as there is no central group or individual overseeing it.
Under the SEC's rule-making authority, Mr. Gensler had the option of developing new regulations for the cryptocurrency industry. But instead, he said the industry should be subject to existing laws and applicable court rulings to protect investors from fraud.
The cryptocurrency industry has described this approach as too broad, objecting to the need for a formal contract between a cryptocurrency seller and an investor in order to arrange to constitute a securities transaction.
“Gensler’s approach was to put a square peg in a round hole,” said Theresa Judy Guillen, a partner at Baker Hostetler and former SEC litigation counsel. “There needs to be a regulatory system in place for these new assets that goes beyond just saying they are all securities.
Mr. Gensler's strategy faced an early test in the Securities and Exchange Commission's lawsuit against cryptocurrency issuer Ripple. In July, New York federal judge Analisa Torres ruled that the Ripple cryptocurrency did not qualify as a security — at least when it was bought and sold on public exchanges by amateur investors. Judge Torres found that these investors did not expect to benefit from Ripple's actions as a business.
The ruling was celebrated in the cryptocurrency world. But the enthusiasm cooled a few weeks later when a judge in another case upheld the SEC's view that a different group of cryptocurrencies qualified as securities and rejected much of Judge Torres' reasoning.
The split has raised the stakes for judges overseeing the SEC's lawsuits against Coinbase and Binance, which serve as marketplaces for dozens of cryptocurrencies. In those cases, the SEC argued that at least 20 cryptocurrencies qualified as securities, providing an opportunity for judges to issue broad rulings that could be applied across the world of digital assets.
Last week's hearing in the Coinbase case in federal court in Manhattan lasted five hours, with more than 500 people listening by phone; About 250 people attended Binance's hearing on Monday in Washington. Both sessions revolved around the applicability of the Howey test to cryptocurrencies.
Coinbase's lawyers argued that the SEC is trying to expand the scope of the Howey test to include cryptocurrency investments. Without a clear contractual agreement between a digital currency's buyer and its issuer, cryptocurrency is no different from any other “collectible currency” that may rise in value over time, such as baseball cards or Beanie Babies dolls, the lawyers said.
At the hearing, Judge Katherine Polk Failla appeared to endorse some of Coinbase's concerns about SEC overreach, saying the commission may be “sweeping too broadly.”
“We're all afraid that you will have so few restrictions on your standards,” she told the committee's lawyers, that some lawyers will argue that Beanie Babies are unregistered securities.
In the Binance case, Judge Amy Berman Jackson in Washington seemed more skeptical of the comparison between digital currencies and collectible toys. But she expressed concern about the SEC's strategy, and pressed government lawyers to explain the limits of their argument.
These hearings came just days after a major victory for the cryptocurrency industry, when the Securities and Exchange Commission (SEC) approved a new bitcoin investment product for trading on Wall Street. Mr. Gensler had fought to block its filing until the court ruled against the SEC in August, effectively forcing the agency to do so.
“This was an extraordinary thing that gave people reason for hope,” said Mr. Grewal of Coinbase. “There is real optimism in the industry now.”
