Cryptocurrency investors with stakes in failed exchange FTX are learning a hard lesson in investor protection, as the fate of their money now lies in bankruptcy proceedings that will likely take years to conclude.
Cryptocurrencies like bitcoin, ethereum and others in the realm of digital assets exist in a regulatory gray area, according to legal experts.
That means they largely escape the same oversight as traditional holdings like stocks and bonds. Additionally, federal money is not available to support clients in the same way it would be for those with stakes in a failed brokerage firm or bank.
How orange groves affect cryptographic protections
The reason largely stems from a 1946 Supreme Court case about investors in Florida orange groves.
The judges hearing that case — SEC v. WJ Howey Co. — established the so-called Howey test to determine what constitutes a security, or “investment contract.” (More information on how Howey’s test works can be found below.)
Stocks are considered securities, which are regulated by the US Securities and Exchange Commission.
Courts have used Howey’s test to lasso some nontraditional investments — animal husbandry programs, railroads, cell phones, and Internet-only businesses, for example — under the umbrella of “investment contracts,” thus getting the same equity investor protections and supervision.
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Here’s why this matters for cryptocurrencies: In many cases it’s not clear whether digital assets are an “investment contract” according to the 76-year-old Howey test.
Regulatory oversight is thus somewhat ambiguous, said Richard Painter, a professor of securities law at the University of Minnesota.
Experts have questioned whether it might be more appropriate to consider cryptocurrency a currency or commodity, for example, governed by different federal regulators.
“It doesn’t make any sense to have all this reversal of the Howey test in the 1940s case,” said Painter, a former White House chief ethics attorney under President George W. Bush.
“It’s an invitation to disaster,” he said. “Someone has to cover this up.
“We know what goes on with unregulated markets, dating back to the tulip bulbs of 1637 [mania] in Holland,” Painter added, referring to the 17th-century event widely regarded as the first documented case of a major financial bubble bankrupting many investors.
Why the “safety” distinction matters
The Howey test has four parts for determining whether something like bitcoin is an “investment contract.” A contract exists if each is true:
- There is an investment of money;
- in a joint venture;
- where the investor expects a profit; And
- profit comes solely from the efforts of others.
Think of an investor who holds publicly traded shares, for example. The investor does not do the work to generate the profit of the company rather it is done by the employees and managers of the company. For their part, the investor could profit in the form of dividends and/or a higher share price.
But cryptocurrencies are different. In many cases it is decentralized, which means it may not be considered a “joint venture,” said Daniel Gwen, a corporate restructuring consultant at law firm Ropes & Gray. It’s also unclear whether its intent is always to turn a profit, since some use it to transfer funds across borders or as a “store of value,” for example, Gwen added.
The 1946 Supreme Court case centered on the Howey Company, which grew orange groves and solicited investment from tourists staying in an adjacent hotel. A franchisee managed the grove on behalf of the tourists. After the orange harvest, Howey allocated a share of the net profits to each buyer. The transactions “clearly involve” investment contracts, the court ruled.
Even if cryptocurrencies were a clearly defined security, the SEC would be able to police companies that fail to comply with securities laws, said Micah Hauptman, director of investor protection at the Consumer Federation of America, an advocacy group. Such enforcements can also have a deterrent effect on potential bad actors, he said. There would be additional information required for investors, among other protections.
“It shouldn’t make a difference to investors how these assets are regulated, but it really does,” Hauptman said of cryptocurrencies.
The SEC has tried to enforce its regulatory oversight in some cases. For example, the agency sued Ripple Labs and its officials in 2020 for failing to register the cryptocurrency XRP as a security offering. That case is ongoing.
“I don’t think you can fault the regulators” for what happened to FTX, Sheila Bair, former president of the Federal Deposit Insurance Corporation, told CNBC. “They wanted Congress to take action because there’s not a lot of clarity, complete clarity, on what is a security, what is a commodity, what should be with banking regulators.”
“The Law is Everywhere”
Additionally, clients who hold their crypto assets at FTX do not appear to be getting the financial protection afforded to defunct brokerage firms selling stocks, bonds, and other securities.
The Securities Investor Protection Corporation insures investors up to $500,000 in the event a liquid brokerage firm and their interests are locked up in the insolvent company. Suppose a client of Lehman Brothers owned shares in a publicly traded company when the company went bankrupt. SIPC’s goal would be to get the stock back into the hands of investors as quickly as possible, Gwen said.
A similar mechanism exists for bank customers, who are insured up to $250,000 by the FDIC if a bank fails.
However, FTX customers likely lack SIPC protection, Gwen said.
For one thing, that protection applies to securities, which means the ambiguity of cryptocurrencies as security or non-security can be a stumbling block. FTX itself cannot be classified as a brokerage firm dealing in securities products. Additionally, the company is based outside the United States in the Bahamas, which SIPC doesn’t cover, Painter said.
“It does similar things to a broker-dealer,” FTX’s Gwen said. “But the law is everywhere when it comes to [crypto].”
FTX, once valued at $32 billion, filed for Chapter 11 bankruptcy protection on Nov. 11.
It could be a long and difficult process.
“Chapter 11 isn’t really designed to protect this circumstance, where you have an obscure digital asset administered almost like a security, without the very structure,” Gwen said. “That doesn’t mean investors don’t have protections; they have different protections.”