The quantum mechanical properties of Ether
Superposition is a quantum property that effectively refers to the ability to simultaneously be in multiple states.
Ether (“ETH”) appears to be in superposition as commentary suggests it is and isn’t a security at the same time.
In 2018, William Hinman, then Director of the SEC’s Division of Corporation Finance, implied that Ether was initially offered through a securities offering but was no longer a security at the time.
Typically, a product that begins as a security remains a security so I see issues with Hinman’s analysis, which I will refer to as Hinman’s puzzle. Issues with the Hinman puzzle have recently been highlighted by former SEC Commissioner Joseph Grundfest in the context of the SEC’s complaint concerning XRP. Grundfest has stated that the SEC has not adequately delineated the difference between ETH and XRP in coming to the conclusion that XRP is a security and ETH is not. For example, both issuances were centrally issued, included premines and had continuing issuances.
As stated by Michael Novogratz, former partner at Goldman Sachs and founder of Galaxy Digital, “…$BTC and $ETH seem to have an SEC pass.”
I do find it strange that Clayton waited years to do this.
— Mike Novogratz (@novogratz) December 22, 2020
Hinman’s reasoning seemingly hinged on his understanding of there no longer being any central enterprise being invested in, and thus purchasers no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts. In other words, Hinman’s position is that assets can transition out of security state through sufficient decentralization. As stated by Hinman, “…when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.”
…when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise…. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
…And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
Ethereum 2.0: Securities analysis
The last part of Hinman’s statement produced above is powerful: in systems that rely on central actors whose efforts are a key to the success of the enterprise, securities laws apply.
I won’t use this forum to delve into a debate regarding Hinman’s previous conclusion that there are not central parties whose efforts are a key determining factor in the enterprise with respect to BTC and Ethereum, as one need look no further than Blockstream / core developers / “co-owners” responsible for final publication authority in the case of BTC and the Ethereum Foundation / core developers / Vitalik Buterin in the case of ETH. The economic and technical control, power and influence over development, information asymmetries, experimenting, changes to protocols and conflicts of interest issues regarding these central parties should give the SEC and other regulators cause for concern and reasons to revisit the Hinman puzzle.
Notwithstanding the above, for the purposes of this article, with respect to Ethereum 2.0, I want to revisit the securities analysis based on Hinman’s emphasis that the determination of whether something is a security is not static. Therefore, as implied by Hinman, while a token like BTC or ETH could transition away from classification as a security, it can revert back into security status. If we assume ETH transitioned away from classification as a security, which as stated above is debatable, there are compelling reasons to conclude that Ethereum 2.0 brings it back to its state as a security—thus, as the title of this article implies, ETH’s journey from a security to a security.
Issuer Liability: Application of digital asset securities laws to Ethereum 2.0
There are, at present, compelling reasons to conclude that the SEC and federal courts are likely to decide that the launch and buildout of the Ethereum 2.0 network constitutes an investment contract under Howey. At the highest level, the transaction between the Ethereum Foundation and the initial validator investors bears resemblance to Telegram’s and Kik’s initial private sales to investors, which qualified as securities transactions (the SEC v. Kik Interactive, Inc. and SEC v. Telegram Group decisions applied the securities framework to token sales). As in both cases, the Ethereum Foundation promised to develop the Ethereum 2.0 network and deliver the ETH2 tokens earned as interest to the initial validators upon the successful launch of this platform. Likewise, as in both Telegram and Kik, there is no consumptive use for the tokens earned on the Ethereum 2.0 network in its present form. Notably, Telegram conceded that this transaction constituted an investment contract.
Bearing in mind that the Howey test is always highly fact-specific, an independent analysis likewise results in the same conclusion.
As to the first element under Howey, a court would likely find that the validators have made an investment of money in the Ethereum 2.0 network because the validators are staking a valuable currency equivalent in exchange for the pledged interest payments. First, users that want to earn rewards for helping to secure the network and process transactions must deposit 32 ETH tokens into a smart contract on the original Ethereum blockchain. An equal amount of ETH is then created on the Ethereum 2.0 beacon chain, which is represented as a new token on that chain, and which the user can put up as collateral to become a validator. These validators only received their 32 ETH on the Ethereum 2.0 network because the critical mass validator threshold was reached, allowing the Ethereum 2.0 network to launch. Second, the ETH created on Ethereum 2.0 cannot be sent back to the original Ethereum blockchain. Third, validators will immediately begin earning interest—potentially as high as to 20%—on their initial 32 ETH investment.
As to the second element of Howey, a common enterprise, the $325 million of ETH staked to launch Ethereum 2.0 would likely be considered a pooling of funds that would give rise to horizontal commonality. As the court held in Kik Interactive, the “key feature” defining a common enterprise “is not that investors must reap their profits” in a specific form or at the same time, but rather is “that investors’ profits at any given time are tied to the success of the enterprise”. Specifically, “the nature of a common enterprise [is] to pool invested proceeds to increase the range of goods and services from which income and profits could be earned or, . . . to increase the range of goods and services that holders of [the digital asset] would find beneficial to buy and sell with [that digital asset]”.
A court is likely to find that the ETH staked to the Ethereum 2.0 network satisfies this test. First, over 16,000 validators collectively staked $325 million, a threshold that was required for the launch of the Ethereum 2.0 network to occur. Second, the ETH created on the Ethereum 2.0 network cannot be sent back to the original Ethereum blockchain, and it cannot be used for any consumptive purposes on the present version of the new Ethereum 2.0 network. Rather, the future value of the staked ETH, if any, turns entirely on the Ethereum Foundation completing the four promised phases of Serenity leading to the merging of the Ethereum mainnet and the Ethereum 2.0 network. Absent a merger of the two networks, the ETH held on the Ethereum 2.0 network would have no consumptive uses and no real value. Thus, these features lead naturally to the conclusion that the $325 million of staked ETH constitutes the pooling of funds to not just increase, but create, the goods and services that holders of the ETH on the Ethereum 2.0 network can use this asset for. In addition, as the Ethereum Foundation has explained, the launch of Ethereum 2.0 is necessary to allow for the scaling and sustainability of the Ethereum mainnet. Thus, if the four-phase plan succeeds, once Ethereum 2.0 has smart contract capability and is merged with the Ethereum mainnet, this could result in an enormous increase in the range of goods and services for which the ETH token may be used.
As to the third element, a reasonable expectation of profits, there are several factors that would support a finding that the validators have acquired additional ETH tokens on the Ethereum 2.0 network (via interest payments) with investment intent. A court would likely find that the following facts weigh in favor of finding a reasonable expectation of profits. First, the ETH earned on the Ethereum 2.0 network is locked on this network until and unless there is a merger with the Ethereum mainnet, and cannot at any point prior to such merger be sent to the Ethereum mainnet. Second, no consumptive transactions or smart contracts can presently occur on the Ethereum 2.0 network. Third, the Ethereum 2.0 network does not have an existing marketplace where the earned ETH tokens are accepted for consumptive use.
Accordingly, the value of the ETH tokens earned as interest payments at present is entirely speculative, and the future value turns entirely on the Ethereum Foundation successfully executing on its four-phase plan leading to the merging of the Ethereum 2.0 network with the Ethereum mainnet. If the Ethereum Foundation does succeed in its plan, these token stand to have a greater value (potentially significantly greater value) than the current market value of ETH tokens, because the merged Ethereum network will have greater capabilities—most notably vastly increased scalability. That potential value is substantial. If the Ethereum Foundation fails, the tokens could ultimately be worthless. Investors understand this.
Further, the first investors to have staked an interest stood to earn higher interest on their investment at the outset than subsequent investors, because the percentage of interest each validator earns changes over time and decreases inversely in proportion to the total number of validators. Thus, the first investors stand to have captured the most value during the initial period when their stake was relatively greater, and thus their interest payments were relatively higher for the same task. Based on these factors, a court would likely conclude that the interest tokens acquired by validators in exchange for staking 32 ETH were acquired with investment intent.
Finally, in evaluating the fourth element—whether the validators bear a reasonable expectation of profits based upon the entrepreneurial or managerial efforts of others—a court would likely consider the fact that the Ethereum Foundation and its employed developers have taken predominant responsibility for building out the Ethereum 2.0 network. Further, the Ethereum Foundation, in its promotional materials supporting the Ethereum 2.0 network, lays out the four-phase plan ultimately resulting in the promised merging of Ethereum 2.0 and the Ethereum mainnet, and promises that this plan “will make Ethereum more scalable, more secure, and more sustainable.” The Foundation further represents that these upgrades are “necessary to unlock Ethereum’s full potential”. It is well understood that the value of ETH tokens turn heavily on whether the network can in fact scale, because the network’s capabilities are significantly limited by its present scaling limitations—which cause slow transaction times and high transaction fees. Furthermore, both the Ethereum Foundation and Vitalik Buterin have repeatedly publicly promoted the Ethereum Foundation’s investment in building out the Ethereum 2.0 network as solutions to these problems. Thus, the promise of scalability is a promise of significant future value. That value turns predominantly on the work of the Ethereum Foundation itself and whether its developers are able to achieve the four-phase plan promised on the ethereum.org website.
Based on these facts, a court might reasonably find that the token’s market value would depend heavily on the efforts of the Ethereum Foundation. As Ethereum’s developers will presumably continue to build out, improve, and administer updates to the network and distribution of ETH post-launch, a court is likely to find that Ethereum 2.0 validators are heavily reliant on the efforts of the Ethereum Foundation for their ETH token holdings on the Ethereum 2.0 network to have any value, let alone to appreciate in value.
Accordingly, there are, at present, compelling reasons to conclude that the SEC and federal courts are likely to decide that the launch and buildout of the Ethereum 2.0 network constitutes an investment contract under Howey.
Exchange Liability: Offer and sale of unregistered securities
In addition to issuer liability discussed above, the ETH analysis should be of particular relevance to digital asset exchanges. As there are several aspects of the sale and distribution of tokens on the Ethereum 2.0 network that could likely cause the SEC or a court to conclude that the entire process constitutes an investment contract and thus qualifies as a security that must be registered, digital asset exchanges that list ETH, or tokenized versions of ETH held on Ethereum 2.0, may be exposed to claims of offering and selling unregistered securities without registering under applicable federal and state securities laws as exchanges and/or broker-dealers in violation of U.S. securities laws.
Recent lawsuits highlight this risk.
- On April 3, 2020, 11 class action lawsuits were filed in federal court against multiple defendants, including four exchanges (also naming executives), alleging they offered and sold billions of dollars in unregistered securities without registering under applicable federal and state securities laws.
As outlined in the claim against Binance, Changpeng Zhao, Yi He and Roger Wang:
Binance would profit handsomely as well by receiving a percentage of each trade and by receiving substantial payments from Issuers to have their tokens listed.
…exchanges like Binance, preying on the public’s lack of familiarity with the technology underpinning these tokens, characterized these tokens as “utility tokens,” even though they were in effect bets that a particular project would develop into a successful venture. In truth, these tokens were securities under federal and state securities laws.
…Binance made statements that reasonably led Plaintiffs and Class members to conclude that the Tokens were not securities.
Binance routinely touted and continues to tout its offerings of tokens as not requiring registration with the SEC because they did not constitute securities. In promoting the Telegram Open Network ICO, for example, Binance Research stated: “As the fundraising of TON was covered via an SEC exemption and Grams have similar use cases as Ether, Grams are thus likely to be classified as crypto assets.”
And as part of the vetting that Binance claimed to do when soliciting sales of tokens, [Changpeng] Zhao has claimed that Binance requires projects to obtain legal opinions that their tokens do not qualify as securities.
- On December 30, 2020, a class action complaint was filed against Coinbase, alleging that by engaging in the unlicensed sale of securities to the public (XRP), Coinbase engaged in acts of unfair competition and gained an unwarranted competitive advantage over digital asset exchanges that only sold commodities.
With respect to this lawsuit against Coinbase, I am expecting to see additional lawsuits against exchanges stemming from the SEC’s complaint against Ripple Labs, former CEO Christian Larsen, and current CEO Bradley Garlinghouse, for the continuous offering from 2013 through the present of over 14.6 billion units of XRP tokens in exchange for consideration worth over $1.38 billion. The SEC noted that Larsen and Garlinghouse personally profited by approximately $600 million from these sales. In addition, the defendants never contacted the SEC to obtain clarity on their obligations nor did they file a registration statement prior to offering or selling XRP. Importantly, the SEC alleges that Ripple engaged in this illegal securities offering even though Ripple received legal advice as early as 2012 that under certain circumstances XRP could be considered an investment contract and therefore a security under the federal securities laws.
My view is that the April 3rd, 2020 actions against the exchanges, the December 30th, 2020 action against Coinbase and those that will likely ensue following the XRP complaint will put a spotlight on digital asset exchanges and procedures that were undertaken to ensure listed tokens were not securities. By virtue of an asset being listed on an unregistered exchange, it is arguable that investors explicitly or implicitly were led by exchanges to reasonably believe they were not investing in securities despite the fact, as highlighted above, exchanges were potentially aware of legal advice that certain assets could be considered investment contracts and therefore securities under the federal securities laws. As alleged in the Coinbase lawsuit, Coinbase knew that XRP was not a commodity, but rather a security under federal securities laws.
Coming back to ETH, in line with the lawsuits discussed above, as there are several aspects of the sale and distribution of tokens on the Ethereum 2.0 network that could likely cause the SEC or a court to conclude that the entire process constitutes an investment contract and thus qualifies as a security that must be registered, digital asset exchanges that offer / sell ETH, or tokenized versions of ETH held on Ethereum 2.0, may be exposed to claims of offering and selling unregistered securities without registering under applicable securities laws in violation of U.S. securities laws.
Broken Window Theory: Once disorder begins, things get out of control
As stated on the SEC’s website, its mission is to protect investors who rely on financial markets to secure their financial futures, maintain fair, orderly, and efficient markets, and facilitate capital formation.
It is my view that the myth of decentralization and a lack of understanding regarding the state of digital assets and platforms have allowed assets such as BTC and ETH to secure the “SEC pass” referred to by Michael Novogratz above. The SEC has taken a positive step with respect to its XRP complaint and should similarly revisit other assets such as ETH, especially in the context of the Ethereum 2.0 analysis above.
The SEC’s lack of movement risks sending a signal that the digital assets will not be policed—the broken window theory—once disorder begins, things get out of control.
When reviewing the SEC complaint re: Ripple, there are some very concerning allegations with respect to digital asset exchanges, specifically surrounding alleged payments that were made to digital asset trading platforms to support XRP’s trading market. As stated in the SEC’s complaint, “Ripple entered into agreements with at least ten digital asset trading platforms—none of which were registered with the SEC in any capacity…—providing for listing and trading incentives with respect to XRP. Ripple paid these platforms a fee, typically in XRP, to permit the buying and selling of XRP on their systems and sometimes incentives for achieving volume metrics.”
Also, separate from issuer liability and exchange liability for offering and selling unregistered securities in violation of U.S. securities laws, exchanges have initiated the offering of ETH staking services; effectively, the sale of a contract with rights to staking profits, which in my preliminary view could also lead to the conclusion that the process constitutes an investment contract and thus qualifies as a security. I would argue that the ETH staking services can reasonably be construed an investment contract by virtue of being a contract, transaction or scheme whereby a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. Staying with ETH staking services, the deposit taking activities, with a right to returns, may in my view trigger banking laws. Lastly, as mentioned above, it appears that some digital asset exchanges may begin to list tokenized versions of ETH held on Ethereum 2.0 as a separate token, which will presumably have an entirely different market value than ETH tokens held on the mainnet, compounding the securities laws issue.
It’s not a stretch to state that disorder has been tolerated and thus things are out of control.
In a quote I have used before, as stated by Former President Barack Obama, “the arc of the universe may bend towards justice, but it doesn’t bend on its own.” It’s time for the SEC and Regulators to do some bending.
Johnny Jaswal is the Managing Director and General Counsel of the Jaswal Institute, responsible for providing regulatory, legal, government relations, strategic and related investment banking advisory services. He has a wealth of experience advising on regulatory matters, mergers, acquisitions, divestitures and capital raising activities.
Johnny represents global blockchain and digital asset companies and is responsible for leading global advisory services. In addition to advising governments and regulatory authorities on digital asset legislation, Johnny has formed/executed the global M&A, capital raising, regulatory and tax strategies for multiple businesses.
Prior to founding his advisory firm, Johnny was a member of senior management on the corporate development and strategy team of TMX Group, which owns a portfolio of financial and technology assets including the Toronto Stock Exchange, an investment banker at TD Securities, which is among Canada’s top-ranked investment banks, a business lawyer at Blake, Cassels & Graydon LLP and Goodmans LLP, two of Canada’s top law firms, and an engineer in several sectors.
Johnny has a Master of Business Administration from the Schulich School of Business, a Juris Doctor from Osgoode Hall Law School, a Bachelor of Engineering: Electrical Engineering from Ryerson University and has been admitted to the Ontario Bar.
This article is for informational purposes only and does not, and is not intended to, constitute legal advice. No person or entity may rely on this article for legal or other advice from Johnny Jaswal/the Jaswal Institute. The article speaks solely as of the date written. Future factual changes or developments, and future court cases or SEC guidance, could affect the analysis or conclusions presented in the article. Johnny Jaswal/the Jaswal Institute are not under any obligation to update the article to reflect future events or factual changes, or for any other reason.
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