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Cryptocurrency investors owning the failed FTX exchange are learning a hard lesson about investor protection as the fate of their money now hangs in the balance is in bankruptcy proceedings it will likely take years.
Cryptocurrencies such as Bitcoin, Ethereum and others in the digital asset space are in a regulatory gray area, according to legal experts.
This means they largely avoid the same scrutiny as traditional holdings like stocks and bonds. Also, federal money is not available to support clients in the same way it would be to those with holdings in a failed brokerage firm or bank.
The reason for this largely depends on a 1946 Supreme Court case involving investors in Florida orange groves.
The judges who heard the case – SEC v. WJ Howey Co. – established the so-called Howey test to determine what constitutes a security or “investment contract”. (See below for more on how the Howie test works.)
The shares are considered securities regulated by the United States Securities and Exchange Commission.
Courts have used the Howie test to bring certain non-traditional investments — such as livestock programs, railroads, cell phones, and Internet-only businesses — under the umbrella of “investment contracts,” thereby providing the same protection and oversight as investors. in action.
Here’s why it’s important to crypto: In many cases, it’s unclear whether a digital asset is an “investment contract” under the 76-year-old Howie test.
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As such, regulatory oversight is somewhat ambiguous, said Richard Painter, a securities law professor at the University of Minnesota.
Experts question whether it might be more appropriate to consider crypto a currency or a commodity, for example, governed by various federal regulators.
“It doesn’t make sense to put all of this under the Howey test of a 1940s case,” said Painter, the former chief White House ethics lawyer under President George W. Bush.
“This is an invitation to disaster,” he said. “Somebody has to cover it up.
“We know what happens to unregulated markets – ever since 1637 tulip bulbs [mania] in HollandPainter added, referring to the 17th-century event widely regarded as the first documented case of a major financial bubble that bankrupted many investors.
Howie’s test has four parts to determine whether something like Bitcoin is an “investment contract”. A contract exists if each of the following is true:
- There is an investment of money;
- in a joint venture;
- in which the investor expects to make a profit; and
- profits are derived solely from the efforts of others.
Consider, for example, an investor holding a publicly traded stock. The investor does not do the work to make the company profit, but the company’s employees and managers do it. For its part, the investor can profit in the form of dividends and/or a higher share price.
But crypto is different. In many cases, it is decentralized, meaning it cannot be considered a “joint venture,” said Daniel Gwen, a business restructuring consultant at law firm Ropes & Gray. It’s also unclear whether its purpose is always to make a profit, as some use it to transfer funds across borders or as a “store of value,” Gwen added.
A 1946 Supreme Court case focused on the Howey Company, which is cultivated orange groves and solicited investment from tourists staying at a nearby hotel. The branch managed the grove on behalf of the tourists. After the oranges were harvested, Howie distributed a share of the net profit to each buyer. The deals “clearly involve” investment contracts, the court said managed.
If crypto were also a clearly defined security, the SEC would be able to monitor companies that do not comply with securities laws, said Micah Hauptman, director of investor protection for the Consumer Federation of America, an advocacy group. These measures could also have a deterrent effect on potential bad actors, he said. Additional disclosures will be required for investors, among other protections.
“It shouldn’t matter to investors how these assets are regulated, but it really does,” Hauptmann said of crypto.
The SEC has tried to assert its regulatory oversight in some cases. For example, an agency sued Ripple Labs and its employees in 2020 for not registering the cryptocurrency XRP as a security offering. This case is ongoing.
“I don’t think you can blame the regulators” for what happened at FTX, Sheila Bair, former chairman of the Federal Deposit Insurance Corp. told CNBC. “They wanted Congress to act because there’s not a lot of clarity, total clarity, about what is a security, what is a commodity, what should happen with bank regulators.”
Customers who hold their crypto assets in FTX, too do not seem to receive financial protection provided to defunct brokerage firms that sell stocks, bonds, and other securities.
The Securities Investor Protection Corporation insures investors for up to $500,000 in the event the brokerage firm is liquidated and their holdings tied to the insolvent firm. Suppose a client of Lehman Brothers owned shares of a publicly traded company when the firm went bankrupt. SIPC’s goal would be to get the stock back into the hands of investors as quickly as possible, Gwen said.
There is a similar mechanism for existing bank customers insured up to $250,000 FDIC in case of bank failure.
However, FTX customers probably don’t have SIPC protection, Gwen said.
First, this protection extends to securities, which means that the ambiguity of crypto as a security or not as a security can be a hindrance. FTX itself cannot be classified as a securities brokerage firm. What’s more, the company is located outside the U.S. in the Bahamas, which SIPC does not cover, Painter said.
“It does broker-dealer-like things,” Gwen said of FTX. “But the law is everywhere when it comes to this [crypto].”
FTX, once valued at $32 billion, filed for Chapter 11 bankruptcy protection November 11. Customers with crypto holdings should hope that they can recover some – if any – of their money in bankruptcy court.
This can be a complex and lengthy process.
“Chapter 11 is not really designed to protect that circumstance where you have an obscure digital asset that’s managed almost like a security without the same structure,” Gwen said. “That doesn’t mean investors don’t have protections; they have different protections.”