By Adam Atlas
Attorney at Law
In early June 2023, the SEC filed claims versus the largest crypto exchange in the United States, Coinbase, and the largest crypto exchange in the world, Binance. In its over-100-page-complaints, the SEC alleges that they both operated as unregistered broker dealers of securities.
In the ever-changing world of crypto, there has always been debate around which of the hundreds of virtual currencies and tokens issued are actually securities that can be sold or custodied only by licensed broker dealers or exchanges. Setting aside ideological arguments that one person's distributed ledger is none of the government’s business, there is room for a rational and important debate around how these would-be securities should be regulated.
Let's say I decide to build the next great ISO for selling payment processing services to a new generation of merchants. If I put up a website to sell shares in my new ISO, that public offering of shares in my company is commonly known as an initial public offering (IPO).
Under federal and state securities laws, it is illegal to carry out an IPO without obtaining necessary registrations or exemptions from registrations under those laws. What is more, buyers of the shares in my ISO may wish to trade those shares—which can only be done through a duly licensed exchange that facilitates the exchange of securities (that is, shares).
There are many publicly traded ISOs or payment processing businesses including Fiserv, Square, WorldPay and Nuvei.
Now, let's say I know how to write smart contracts on the Ethereum blockchain or even how to program my own brand new blockchain from scratch, as a fork (copy) from an existing chain or a new one altogether.
Suppose I decide to launch a token on my new blockchain called "ISO" that represents one dollar of payment processing services. This kind of token offering, of which there have been hundreds, is called an initial coin offering (ICO). Investors might decide to buy ISO tokens and sell them to merchants at a higher price, perhaps convincing the merchants that the tokens will go up in price even further.
The fact that the ISO token is entirely digital and is in some ways very different from a classic "share" in a company does not undo the high probability that that token is actually a security for which securities regulator registrations or exemptions are required.
To help decide which kinds of offerings are securities, the leading guidepost is the 1946 case of SEC v. W.J. Howey Co. That case produced the "Howey test," as it is commonly known. In simple terms, according to the Howey test, an offering is of a security when all of the following are present:
A big part of the SEC cases boils down to applying the Howey test to the many tokens offered for sale and exchange on the Binance and Coinbase exchanges.
Way back in 2013 and 2014 (before all the big law firms got into fintech and crypto), I wrote some of the earliest letters to the New York Department of Financial Services and the Department of the Treasury Financial Crimes Enforcement Network (FinCEN) arguing how Bitcoin should or should not be regulated.
The legal landscape of crypto was simple back then because there hadn't been hundreds of ICOs—many of which were scams. There also hadn't been billions of dollars evaporated or stolen in the ensuing crashes of MtGox, Celsius, Voyager Digital, Terra Luna, FTX and others.
Regulators and courts are now a bit white knuckled when looking at crypto matters. The splashy news stories and even political intrigue around some crypto businesses, such as FTX, only heightens the anxiety around whether action should be taken and how strict the enforcement should be.
On a correct technical reading of the Howey test, many crypto tokens look like securities. In some ways, the burden falls unpleasantly on the issuer of a crypto token to prove that it is not a security.
It is outside the scope of this column to do a deep dive into each token named by the SEC in its cases, but my expectation is that at least some of the named tokens will—at the end of the day—be deemed securities, placing these two large exchanges off-side and liable for fines and possibly banning them from being involved in the securities industry as duly licensed brokers.
Coinbase has money transmitter and virtual currency business licenses throughout the United States, while Binance has only some state money transmitter licenses. Binance is not, for example, licensed in New York. An adverse finding by the SEC could negatively impact Coinbase and Binance in the maintenance of their state licenses.
The legal predicament for both of these exchanges versus the SEC looks grim to me. That said, if they drop the more controversial tokens, pay fines and become registered with the SEC to trade in those tokens that are securities, there is a possibly bright future for both of them.
ISOs are in the business of selling regulated financial services. Payment processing by banks is a regulated activity for which ISOs have carved out a niche that is complementary to the regulated activity but not as regulated itself.
Back in the '00s when ISOs started aggregating transactions, the payment networks, banks and regulators were upset because they were not able to see the true identity of the entities for which they were processing.
Enter the payfac, which essentially legitimized the transaction aggregation. The payfac model is pasting new rules on a practice that was prohibited but quite common. It looks like the SEC and courts will eventually do more or less the same with crypto. 
In publishing The Green Sheet, neither the author nor the publisher are engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought. For further information on this article, please contact Adam Atlas, Attorney at Law email: atlas@adamatlas.com, tel. 514-842-0886.
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