Credit: Marco Verch | CCNull
Following the volatile growth and subsequent implosion of the FTX cryptocurrency exchange, the SEC is gearing up to tackle one of the largest players in the crypto market. In a press release last month, the Paxos Trust Company announced that it received a Wells notice from the SEC regarding one of Paxos’ supported cryptocurrencies, Binance USD (BUSD). Since 2019, Paxos has been partnered with Binance, and through this partnership, Paxos “serves as the USD custodian and issuer of [the Binance USD]” Cryptocurrency. Binance is the world’s largest cryptocurrency exchange with over $65 Billion in assets. At its peak in November 2022, BUSD had a total market capitalization of over $23 billion U.S. dollars; however, as of March 9, the total BUSD in circulation has halved. A Wells notice is a letter sent by the SEC to companies warning them of impending action by the SEC. The Wells notice sent by the SEC notified Paxos that the SEC staff recommends that an action be filed against Paxos. In its notice, the SEC alleges that BUSD is a security and Paxos failed to register the offering of BUSD under the federal securities laws. In Paxos’ issues statement, Paxos comments:
“Paxos categorically disagrees with the SEC staff because BUSD is not a security under the federal securities laws. This SEC Wells notice pertains only to BUSD. … [Paxos] will engage with the SEC staff on this issue and are prepared to vigorously litigate if necessary.”
What Are Stablecoins?
BUSD belongs to a peculiar subset of cryptocurrencies called stable value coins or stablecoins. Unlike other cryptocurrencies, stablecoins have a fixed value, one typically set to that of a fiat currency, such as the U.S. dollar. The value of a stablecoin is set, monitored, and often backed by the issuing company. In most instances, the issuers of stablecoins will support the value of the stablecoin with a sizable collateral reserve, to prevent price fluctuation. Collateral reserves are not all created equal – some companies collateralize their stablecoin with a reserve of “real” fiat currency, while other companies opt to collateralize their stablecoin with a reserve of cryptocurrencies. A third subset of companies create uncollateralized “algorithmic” stablecoins, where the value is stabilized by algorithm, independent of assets held in reserve. According to a 2021 statement from the SEC, stablecoins only make up 5% of all crypto assets; however, more than 75% of all crypto trading is done between stablecoins and some other token.
However stable they might seem, stablecoins are not necessarily a safe investment compared to the fiat currencies they mirror. For example, in May 2022, TerraUSD (UST) lost 75% of its value seemingly overnight. Rather than holding a reserve of fiat currency, UST relied on an algorithm and its sister currency, Luna, to stabilize its price. When the value of UST faltered due to the unstaking of $2 billion worth of UST, UST ‘unpegged’ from the U.S. dollar, falling to about thirty cents.
Unlike UST, BUSD and most prominent stablecoins are supported by fiat collateral and are pegged to the U.S. dollar. According to Paxos and Binance, BUSD is backed “1:1 with US dollar-denominated reserves,” allowing holders of the BUSD cryptocurrency to exchange it for $1 per unit. In contrast to UST, BUSD has maintained a stable price despite the ever-declining health of the cryptocurrency market. A month after Paxos’ receipt of the SEC’s Wells notice,
BUSD remained steady, fixed at $1.00 USD. BUSD is the third largest stablecoin behind Tether (USDT) and USD Coin (USDC). Today’s total market capitalization of all stablecoins is approximately $140 billion U.S. dollars.
The SEC and Securities Regulation
The Securities Exchange Commission was created by the United States Congress with the primary purpose of protecting securities investors from misinformation and market manipulation. Under the Securities Act of 1933’s 15 U.S.C. § 77(c), a security is defined as
“any note, stock, … bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, … [or] investment contract.”
In providing such a broad definition, Congress sought to protect investors, when investing in instruments that behaved like a security, regardless of their nomenclature. Securities regulations require companies selling securities to the public to register their offering with the SEC. Companies must make public disclosures regarding the initial sale, contained in a registration statement. Once the company has issued securities to the public, securities regulations also require the company to make additional disclosures by filing quarterly (Form 10-Q) and annual (Form 10-K) reports. Failure to meet the mandatory disclosure requirements may result in action by the SEC. In the case of Paxos and BUSD, the SEC considers the BUSD stablecoin to be a security, subject to the requirements of federal securities regulations. In determining whether an asset falls within the definition of a security, courts rely on Supreme Court precedent.
Investment Contracts and Howey Applied to BUSD
When evaluating whether an asset or scheme falls within the definition of a security, courts rely on the definition of ‘investment contract’ from the Supreme Court case SEC v. W.J. Howey Co, 328 U.S. 293 (1946). Back in the 1940’s, the Howey company sold orange-laden orchards in Florida to buyers across the United States. In tandem with the purchase agreement for the orchards, the Howey Co. offered purchasers a separate service contract, under which the Howey company would harvest the oranges from the land and the neighboring land plots. Under the second contract, Howey Co. paid the landowner for the oranges harvested from their land. Most, but not all, purchasers of land also agreed to the long-term service agreement with the Howey Company. In Justice Murphy’s majority opinion, the Supreme Court defined an ‘investment contract’ as any “transaction or scheme whereby
a person invests his money
in a common enterprise and
is led to expect profits
solely from the efforts of the promoter or a third party.
In Howey, the Supreme Court opted for a broad definition of investment contract, turning on the ‘economic reality’ of the entire scheme. In the context of Howey, the Supreme Court evaluated both the land purchase and the service contract together, determining that Howey Co. had sold securities to the public. The Howey test is the primary method of determining whether an investment by contract becomes a security.
Howey Test: Investment
The first element of the Howey test is a low bar to meet. Simply put, an investor must invest money in the transaction or scheme. The Supreme Court has held in subsequent case law, in Int’l Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 569 (1979), that “the securities act ... does not purport to set substantive terms of financial transactions.” The Supreme Court in Daniel requires that an investor must choose to give up a tangible, financial
“consideration in return for a separate financial interest with the characteristics of a security.”
The exact investment mechanism need not be evaluated, so long as the investor has placed value in the enterprise.
With regards to purchasing BUSD, the initial sale of the stablecoin requires the exchange of an instrument of value, such as a fiat currency, for the BUSD stablecoin. The sale of BUSD satisfies the investment element of the Howey test.
Howey Test: Common Enterprise
The second element of the Howey test requires the investment of money be made in “a common enterprise.” The First Circuit Court of Appeals provides further guidance in SEC v. SG Ltd., 265 F.3d 42, 50 (1st Cir. 2001). The court focuses on the concept of horizontal commonality – “the pooling of assets from multiple investors in such a manner that all share in profits and risks of the enterprise.” SEC v. SG Ltd. provides that the assets of investors must be pooled (typically through the initial sale to the public). Secondly, the investors must share in both the profit and risks of the enterprise.
The initial investors in BUSD, who directly purchased BUSD from Paxos, paid into the same pool of money held by Paxos. Additionally, the investors share the same risks and rewards of the enterprise, should the value of BUSD fluctuate. The SEC can readily show that investors in BUSD share horizontal commonality, satisfying the second element of the Howey test.
Howey Test: Reasonable Expectation of Profits
The third element of the Howey test requires that the investor is “led to expect profits” from the investment. In United Housing Foundation Inc. v. Forman, 421 U.S. 837 (1975), the Supreme Court required the investment in a venture be “premised on a reasonable expectation of profits.” The cornerstone of the third element of the Howey test is the reasonable expectation of the investing individuals to whom the instrument was offered. As noted in Howey, investors will be “attracted solely by the prospects of a return.”
Unlike the value of other cryptocurrencies, the value of stablecoins is designed to be fixed. Stablecoins, like BUSD, do not significantly exceed the value of the fiat currency to which they are pegged, nor do stablecoins experience growth, payment of dividends, or interest. A reasonable investor would therefore not expect to gain profits from an investment in a stablecoin alone. To put it another way, it may be unreasonable to expect profits from an asset whose value is fixed and does not increase. Paxos has a strong argument that BUSD is not a security because investors would not have a reasonable expectation of gaining profit.
However, the SEC has a strong counterargument. Binance notes on their website that if crypto-investors want to purchase other cryptocurrencies (such as Bitcoin) on the Binance exchange:
“For better coin compatibility, you consider buying a stablecoin like USDT or BUSD first, and then use that coin to buy Bitcoin (BTC).”
As noted previously, 75% of all cryptocurrency purchases involve trading a stablecoin for another cryptocurrency. The Howey test considers the “economic reality” of the purchases. Binance, in its partnership with Paxos, encourages investors in crypto to first purchase BUSD, before exchanging it for their desired cryptocurrency. Considering the multiple transactions, the SEC has a strong argument that investors are purchasing BUSD from Paxos to subsequently purchase another cryptocurrency. Based on the “better coin compatibility” offered to holders of BUSD, a reasonable investor in BUSD can expect to realize a benefit or profit from the subsequent transaction. These transactions become related through the partnership between Paxos and Binance. The SEC will likely succeed in establishing that investors had a reasonable expectation of profit.
Howey Test: Efforts of the Promoter
The fourth and final element of the Howey test requires that the reasonable expectation of a return is derived “solely from the efforts of the promoter or a third party.” A fact-driven inquiry is required when applying this element to cryptocurrencies. As before, courts consider the “economic reality” of the situation, where “no single fact will likely be dispositive.” A sufficient amount of control, direction, or effort needs to be established. However, as the SEC noted in the matter of the DAO, even in decentralized exchanges, the promoter of the coin has sufficient control such that investors can rely on those efforts in making their investment. In another example, SEC v. LBRY, Inc, a case resolved in November 2022, the federal court found that LBRY, the issuers of a cryptocurrency on a decentralized blockchain, exercised sufficient effort and control upon which reasonable investors could rely, because LBRY Inc held 10% of LBRY to fund continued development. The court found that “by intertwining LBRY’s financial fate with the commercial success [of the coin], LBRY made it obvious to investors that it would work diligently to develop the network so that [the coin] would increase in value.”
In the context of BUSD, Paxos makes significant efforts to maintain the value of BUSD. Notably, control over the BUSD reserve is entirely within Paxos’ control. By maintaining its 1:1 collateral reserve, Paxos makes substantial efforts to provide their stablecoin with value. Absent these efforts of the promoter to maintain a collateral U.S. dollar reserve, BUSD could foreseeably lose value (a similar result as UST.) The SEC may note that Paxos has also tied its “financial fate” to the commercial success of the coin. Provided the SEC files suit against Paxos, the court will have to deliberate on whether keeping collateral to support a stablecoin is sufficient effort of the promoter.
Reves Test:
Even if an asset fails to satisfy the Howey test, it is not per se a non-security. An asset may fail the Howey test and nevertheless be a security under the “family resemblance” test of Reves v Ernst & Young, 494 U.S. 56 (1990). Under the family resemblance approach, a court
will examine whether the instrument “resembles any of the enumerated categories of non[-]securities,” such as gold, rare coins, and other such “real” assets of value. Where the note is dissimilar from these non-securities, the court may find the instrument is a security. The Reves approach evaluates:
the motivations of the buyer and seller,
the plan of distribution,
the reasonable expectations of the investing public, and
other risk-mitigating factors.
In the context of Paxos, BUSD allows investors to exchange the coin for U.S. dollars. Rather than being used to solve cash flow problems, the BUSD note is being used primarily for the profit of Paxos, through its partnership with Binance. Paxos’ motivations in offering the BUSD stablecoin do not resemble any non-security. In that sense, BUSD is similar to a promissory note. Additionally, the distribution plan indicates that BUSD is designed to be used in speculative trading in the cryptocurrency market, which does not resemble a non-security. Considering the expectations of the investing public, per Binance’s website, the public may purchase BUSD to make more cost effective transactions on Binance’s exchange. The public expectation of BUSD is dissimilar from any enumerated non-security. Lastly, as noted by the President’s Working Group on Financial Markets, there are few risk-mitigating factors present from other regulatory agencies. Paxos’ BUSD does not resemble a non-security; under the Reves Test, the SEC will likely succeed in establishing BUSD is a security.
Conclusion:
Stablecoins make up an integral part of the cryptocurrency market and the majority of transactions. Regardless of who prevails in the inevitable lawsuit, the determination will have monumental effects on Binance, Paxos, and the broader cryptocurrency market. Under the Howey and Reves tests, the SEC will likely establish that Paxos’ BUSD stablecoin is a security. Under Howey, the initial sale of BUSD pools assets from investors in a collateral reserve, allowing investors to share in the risks and benefits of the coin. Furthermore,Paxos leads investors to a reasonable expectation of profit by offering “better coin compatibility.”
Lastly, Paxos exercises sufficient control over the cryptocurrency, thereby satisfying all elements of the Howey test. Under Reves, Paxos’ motivations and plan of distribution of BUSD does not bear a resemblance to those of any enumerated non-security. When considered with the reasonable expectations of the investing public, BUSD does not share a family resemblance with any non-security. When the SEC inevitably files an action against Paxos, the SEC will likely prevail. For better or for worse, the cryptocurrency market will face drastic changes.
*The views expressed in this article do not represent the views of Santa Clara University.