House Bill Shows Challenge of Regulating Crypto Without Giving Tradfi a Free Pass

A draft bill by House Financial Services Committee Chair Patrick McHenry (R-NC) and Agriculture Committee Chair Glenn “GT” Thompson (R-PA) shows just how impossible it is to write crypto legislation that exempts tokens from securities laws while keeping traditional securities issuers regulated.

Many in the crypto industry cheered this discussion draft, including former Commodities and Futures Trading Commission (CFTC) chair and current crypto adviser Christopher Giancarlo, who called it a “landmark bill,” and Coinbase’s Chief Legal Officer Paul Grewal, who said it was “a strong step forward” to legislating on financial regulators’ jurisdiction over crypto.

However, thanks to an appreciated effort to address potential regulatory arbitrage, the bill only creates new regulatory uncertainty.

Todd Phillips is the principal of Phillips Policy Consulting.

The debate over crypto assets is about whether a given token is an investment contract, and therefore a security, under the securities laws. Indeed, this is the basis for the Securities and Exchange Commission’s (SEC) lawsuits against Coinbase and Binance.

The so-called Howey Test, which became a standard way of determining what assets are securities after the 1946 Supreme Court case SEC v. Howey Co., provides that an investment contract is a security if it is an investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others.

Importantly, because the Howey Test is the way that investment contracts are identified as securities, the SEC effectively cannot issue regulations that dictate whether or not a token is an investment contract. The courts would apply the Howey Test regardless.

McHenry and Thompson attempt to sidestep the Howey Test entirely. Their bill would create a new asset class called “digital assets.” Digital assets can come in many forms, but two particularly important ones are “digital commodities” and “restricted digital assets.” In short, the legislation provides that crypto tokens will either be issued as digital commodities in the first instance, or as restricted digital assets that then “mature” into digital commodities after they become sufficiently decentralized.

Restricted digital assets are still securities under the Howey Test but would be exempted from significant parts of the securities laws. If a token issuance meets six qualifications defined under the bill, a more lenient set of disclosure requirements would apply. Once they mature into digital commodities, they would be exempted from the securities laws entirely.

This is where McHenry and Thompson falter. One of those six qualifications is that the sale of the digital asset cannot “involve the offer or sale of equity securities, debt securities, or debt securities convertible or exchangeable to equity interests.” In other words, cryptocurrencies cannot represent an ownership stake in a venture or be used like bonds to raise capital.

The purpose of this provision appears to be to prevent regulatory arbitrage. It would stop those entities that would normally issue stocks or bonds from avoiding the securities laws’ traditional requirements by offering crypto tokens instead.

But the bill does not define these terms. While equities are generally thought of as simply stock in corporations, the term “equity security” is defined in the Securities Exchange Act of 1934 as “any stock or similar security … or any other security which the Commission shall deem to be of similar nature” (emphasis added).

In attempting to prevent regulatory arbitrage, the McHenry-Thompson bill would not at all solve the problems it attempts to address. Not only would the bill not affect the definition of “investment contract,” but it would have the SEC decide which of those tokens are equity or debt securities.

Given that the code governing many dapps [decentralized apps] and decentralized autonomous organizations (DAOs) give token holders the same kinds of rights as stockholders in corporations, the SEC would deem most if not all crypto tokens that meet the Howey Test to be equities subject to traditional securities law disclosures.

Other options to remove SEC discretion while preventing regulatory arbitrage would similarly fail. A bill that carves crypto out of the Howey Test would turn the securities laws from being technologically neutral to one that benefits blockchains over everything else.

A bill that defines equity securities as just “stocks” leaves it up to the courts to figure out what is a stock, resulting in a new judge-made test that – like the Howey Test – requires litigation before legal certainty. Or if equity securities are defined as being only issued by state-chartered legal entities, every company may decide to convert to a DAO that retains the same governance structure as before.

There are a number of other problems with the bill, not the least of which is that it would grant significant new jurisdiction to the CFTC without also providing it with new funding. The bill also appears to exempt DeFi exchanges from complying with the same investor protection provisions as CeFi exchanges. And the CFTC would also be permitted to retroactively or prospectively exempt large swaths of the digital commodity markets from McHenry and Thompson’s customer protection provisions, making the bill’s regulation of exchanges and brokers optional.

The biggest problem, however, is with regulatory arbitrage. While Chairs McHenry and Thompson have endeavored to craft a bill that gives crypto assets a way out of the securities laws, their legislation – like others before it – shows just how impossible it is to do without giving issues of traditional securities a new way to opt-out of those laws as well.