On July 25th, the Securities and Exchange Commission (SEC), citing the long established “Howey Test” and other cases, determined that a public offering of digital tokens known as “the DAO” was in fact an offering of securities that was subject to federal law. While this ruling temporarily quelled an otherwise raging initial coin offering (ICO) market, it also provided some certainty to token issuers who were offering “profit-based” coins, or whose offerings shared similar characteristics with the DAO (and would need to comply with securities laws).
The ruling created uncertainty however, in that it didn’t opine on tokens with an “underlying utility” (often called “app” or “utility” based tokens) where the token isn’t a profit-based token, per se, but rather grants the holder some right to a service (like data storage for example), leading some to believe these offerings were unregulated. A recent Commodity Futures Trading Commission (CFTC) “Primer on Virtual Currencies” (the first of its kind by the CFTC), as well as statements by Commissioner Brian Quintenz has cast further uncertainty on the ability of issuers to offer unregulated “utility tokens”, even if those tokens are not “securities”, as they may still fall within the regulatory ambit of the CFTC. Further muddying the waters was SEC Chairman Jay Clayton’s remark last week that he has “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” All of this begs the question – is the regulatory uncertainty in the virtual currency space an intentional tactic?
The LabCFTC Primer on Virtual Currencies And Regulatory Uncertainty
The Primer on Virtual Currencies was issued by “LabCFTC”, an initiative launched by the CFTC this past May to facilitate “market-enhancing financial technology (FinTech) innovation, fair market competition, and proactive regulatory excellence and understanding of emerging technologies.” The primer discussed various “use cases” for virtual currency as well as an interpretation of the CFTC’s role in oversight and jurisdiction. A close review of the primer reveals several implications for ICO tokens that aren’t otherwise considered securities.
First, a virtual currency can fall under many descriptions including medium of exchange, unit of account, store of value, and convertible currency. Next, the definition of “commodity” in the Commodity Exchange Act (CEA) is broad enough to include both “currency” and “all services, rights and interests…in which contacts for future delivery are presently or in the future dealt in.” Finally the CFTC has jurisdiction over a wide range of commodity matters including “fostering open, transparent, competitive and financially sound markets” protecting the public from “fraud, manipulation and abusive practices” ensuring “financial integrity” ensuring “fair competition” and mitigating against operational, cyber-security and speculative risk.
While the SEC’s DAO determination makes clear that the facts and circumstances of that specific token offering qualify it as a security, it provides no such certainty for the class of ICOs known as utility tokens. Even if a token offering were to avoid ‘security’ status under the Howey Test, the CFTC’s primer indicates the token could still be subject to CFTC jurisdiction. This could occur if the CFTC classifies the token as a currency or deems the token to be a contract for the future exchange of services, rights or interests, and thereby subject to the jurisdiction of the CEA. The latter determination is subject to wide interpretive discretion, as no doubt utility token issuers would argue their token functions more like a prepaid expense and less like a contract for future delivery. Regardless, there are no bright lines in the primer, only general guidance that the CFTC considers virtual currencies to be commodities and they will be actively monitoring this segment of the market.
Several legal experts have opined on the effect of the primer on the “non-securities” ICO market. Dan Berkovitz, co-head of the Derivatives and Futures Group at Wilmer Cutler Pickering Hale & Dorr recently told Bloomberg Law that “[p]eople might not have realized that they were getting into a commodity business” and Allison Baker Shealy, former CFTC lawyer now with Shulman Rogers Gandal noted, “[f]or people trying to do it right, the CFTC should be on their radar now too.” Further, recent comments by CFTC Commissioner Brian Quintenz add to the confusion. On October 19th, 2017, while speaking at the first annual “Fintech Week” at Georgetown Law Center, Commissioner Quintenz suggested that virtual currencies could potentially “transform” into commodities over time.
CFTC Backdoor Rulemaking and Policy Through Enforcement
Prior to the primer, the CFTC’s foray into the virtual currency market had been by way of orders granting registration as a derivatives clearing organization and swap execution facility to LedgerX, as well as enforcement actions against BFXNA Inc. (a Hong Kong based Bitcoin exchange that was not registered as a Futures Commission Merchant) and Coinflip, Inc. (Derivabit) and Francisco Riordan (for operating an online facility connecting Bitcoin options counterparties). However, up until the primer (which serves more as a guideline rather than a bright line test) there have not been any direct rules published on policies and enforcement criteria. The CFTC considers its primer to be consistent with the SEC’s directive on the DAO and that “depending on the facts and circumstances” a token could be a security or commodity as the CFTC will “look beyond form and considers the actual substance and purpose of an activity.”
As a result, the CFTC’s approach to the virtual currency market has been described by Richard Hill at Bloomberg as “making policy about financial technology through enforcement actions rather than traditional rulemaking” and that this form of regulation denies “the opportunity to weigh in on new policies through administrative notice and comment procedures.” This is not the first instance where the CFTC has been accused of regulating through the “backdoor.” Hester Pierce, in a working paper published through the Mercatus Center at George Mason University, argues that the CFTC has engaged in extensive backdoor policy making measures (like staff letters, long policy statements, guidance and enforcement actions) in relation to implementing its mandate under the Dodd-Frank Act, making it difficult for the public to opine on such measures and (arguably) violating the Administrative Procedure Act.
Conclusion: Is This Goodhart’s Law Applied To Virtual Currencies?
When considering the “regulation via enforcement rather than policy” accusation and the resultant uncertainty in the virtual currency market for utility tokens, one is reminded of the famous “Goodhart’s Law” (named after economist Charles Goodhart). Duke Professor Lawrence Baxter, co-director of the Global Financial Markets Center, has summarized this phenomenon, as “target regulation is inherently self-defeating because strategic action will be taken to work around the target.”
Goodhart’s law is often cited in relation to financial regulations that “miss the mark” since market participants will “game the system” and act strategically around the regulations. Perhaps the regulatory approach currently identifiable in the cryptocurrency market – overlapping jurisdiction, rule making through enforcement, application uncertainty – is intentional, as it keeps ICO issuers on their feet (and continually consulting with their lawyers) as they are otherwise unable to “game” the system.
Even if the current regulatory approach is unintentional, it is arguably the most reasonable path to take given the nascency of the cryptocurrency market. However, ‘keep them guessing’ is not a tenable long-term strategy. Assuming present growth in the cryptocurrency market continues, a time will come when regulatory agencies will have sufficient information to establish clear-cut guidelines. Exactly when that times comes, is anyone’s guess.
 See SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
 See SEC v. Edwards, 540 U.S. 389, 393 (2004); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975); Tcherepnin v. Knight, 389 U.S. 332, 336 (1967).
 Allen Scott, Legal Experts: Inverstors May View SEC’s Statement as Validating ICO’s, Bitcoinist News (August 2, 2017), http://bitcoinist.com/legal-investor-sec-statement-ico/.
 See Jeff John Roberts, The SEC’s Big Digital Ruling: What It Means, Fortune (July 26, 2017), http://fortune.com/2017/07/26/sec-icos/; See also, Josh Garcia and Marco Santori, SEC Publishes Landmark Guidance on Blockchain Tokens, Lexology (August 9, 2017), https://www.lexology.com/library/detail.aspx?g=0db16fb4-5e48-43a0-b08d-5c8a0f7b0455.
 See Kari S. Laren & Michael Selig, CFTC Releases Primer on Virtual Currencies, Lexology (October 19, 2017), https://www.lexology.com/library/detail.aspx?g=e12b3475-c3ab-43f8-88cb-4e705edf4e1a; See also Stan Higgins, CFTC Aligns With SEC: ICO Tokens Can Be Commodities, Coindesk (October 17, 2018), https://www.coindesk.com/cftc-no-inconsistency-sec-cryptocurrency-regulation/.
 See U.S. Commodity Futures Trading Commission, Order of Registration In The Matter of The Application of LedgerX, LLC For Registration As A Derivatives Clearing Organization, available at http://www.cftc.gov/idc/groups/public/@otherif/documents/ifdocs/ledgerxdcoregorder72417.pdf.
 See U.S. Commodity Futures Trading Commission, Order of Registration In The Matter Of The Application Of LedgerX LLC For Registration As A Swap Execution Facility, available at http://www.cftc.gov/idc/groups/public/@otherif/documents/ifdocs/orgledgerxord170706.pdf.
 See U.S. Commodity Futures Trading Commission Order Instituting Proceedings Pursuant To Sections 6(c) and 6(d) of the Commodity Exchange Act, As Amended, Making Findings and Imposing Remedial Sanctions, CFTC Docket No.16-19 (June 2, 2016) available at http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfbfxnaorder060216.pdf.
 See U.S. Commodity Futures Trading Commission Order Instituting Proceedings Pursuant To Sections 6(c) and 6(d) Of The Commodity Exchange Act, Making Findings and Imposing Sanction, CFTC Docket No. 15-29 (September 17, 2019) available at http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.
 See Lawrence G. Baxter, Adaptive Financial Regulation and Regtech: A Concept Article On Realistic Protection For Victims of Bank Failures, 66 Duke L. J. 567, 575 (2017).
 See John Kay, Law That Explains Bank Regulation Folly, Financial Times (September 11, 2012), https://www.ft.com/content/e5436a62-fb49-11e1-87ae-00144feabdc0?mhq5j=e7.