In a letter dated February 18, 2020, the CFTC recently made a very interesting statement with respect to digital assets. In an unusual invitation by SDNY Dist Ct Judge Kevin Castel for the CFTC to submit a letter regarding issues raised in the SEC v. Telegram case, in which the defendant, Telegram, argued that its planned issuance of a digital currency, the “Gram” is a commodity and not a security and not subject to registration under the Securities Act of 1933 (’33 Act).
In the letter, the CFTC makes two points: 1) Digital currency is a commodity; and 2) many commodities are securities. Thus, a digital currency, while a commodity, may also be subject to the securities laws, if it is a security within the meaning of the ’33 Act. To be more specific, the CFTC points out that many securities fall within what it terms the “Catchall for Services, Rights and Interests” within the statutory definition of the term “commodity (“all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery [i.e., futures contracts] are presently or in the future dealt in,”) Section 1a(9) of the CEA. (CFTC LETTER (Rob Schwartz, Deputy General Counsel, Div of Enforcement) – HON. P. KEVIN CASTEL (SEC V. TELEGRAM GROUP, INC.)
The United States is the only country that has separate agencies to regulate securities and futures. The advantages and disadvantages of this anomaly have been and will continue to be the subject of heated debate. But one of the ancillary effects of the bifurcation of regulation is the increased importance it places on delineating jurisdictional boundaries and the importance of the definition of a future regulated by the CFTC as opposed to a security regulated by the SEC. Most of the time, it is not an issue. It becomes important, though, when dealing with a stock index contract (security) versus a futures contract on a stock index and how and who can trade those products. These are extremely similar products yet one is traded on securities exchanges and the other is traded on futures exchanges. And the trading, clearing, and brokering of these products are done under separate rule regimes.
Typically, futures have a commodity as an underlying asset. Traditionally, we think of corn, oil, or gold futures. Product innovations over the years have pushed the envelope of what a future can be. Contracts like Eurodollar or Treasury futures are based on interest rates. And of course the S&P500 future is based on a securities index. So when the CFTC stated that a digital asset, which is definitely a commodity, can also be a security, this throws us off a bit. Are you saying corn, oil or gold can be a security? That seems incongruous.
But if you think about what makes a security a security, then it makes more sense. Most of us have heard of the Howey case, which is the US Supreme Court decision that defined the elements of a security. Those four elements are:
- It is an investment of money.
- There is an expectation of profits from the investment.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a promoter or third party.
The comments of William Hinman, Director, SEC Division of Corporate Finance speech are instructive. Mr. Hinman boils the analysis down to focusing on how the product is being promoted. If the thing being sold is marketed as something with a chance at profiting from the efforts of others, then it becomes a security. At issue, really, is a potential “information asymmetry” between issuer/promoter and a passive investor. If that potential exists, where the success depends on third party efforts, there is probably a requirement that an investor is entitled to understand the fundamental details of the transaction and its potential risks. There are also suitability requirements and all of the attendant bells and whistles required for promoting and selling securities.
A digital currency or asset is a commodity, of course as software code it is far from our traditional understanding of a commodity. As the CFTC made clear, however, digital currency can still be a security, depending on how it is promoted, marketed or sold.
That is clear. But can somebody explain how software code can be a commodity but onions and box office receipts, which are specifically excluded from the statutory definition of the term “commodity,” are not?
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