The Securities and Exchange Commission is investigating whether the Ethereum Foundation’s sale of ETH since the September 2022 “Merge” constitutes an unregistered securities offering in violation of US law, according to Fortune.
If the reports are true, then this investigation — just ahead of the SEC’s May deadline for a decision on an Ethereum spot ETF (more on that later) — raises the question: Did Ethereum’s switch to proof-of-stake transform it into a security?
The short answer is “no.”
The slightly longer answer is “still probably no.”
ETH tokens are not, in and of themselves, “securities” in the way that stocks or bonds are. They do not confer legal ownership of any business entity or contractual rights to any kind of payments — they are just code in a decentralized database.
When we talk about ETH “being a security,” we are instead actually asking whether the offer and sale of ETH tokens (in a particular context, between a particular buyer and seller) constitutes an “investment contract” under the dreaded Howey test. Under the Howey test, the offer and sale of an asset like ETH constitutes an investment contract if (1) someone invested money, (2) in a “common enterprise,” (3) in the expectation of profit and (4) where that expectation is based on the “essential managerial efforts of particular others.”
The four Howey “prongs” have already been discussed and debated to death in the crypto space, so I’ll avoid beating a dead horse here. But if you look closely at the language from Howey, I think two things quickly become apparent about the sale of ETH tokens over time:
First, the sale of pre-mined ETH tokens to investors in Ethereum’s 2014 ICO sure looks a lot like an “investment contract.” ICO participants invested money (BTC) in order to receive their allocation of ETH (Howey prong #1). That BTC was pooled to fund a common effort led by Vitalik and the Ethereum Foundation to develop the Ethereum blockchain and produce the ETH tokens (Howey prong #2). Given that the Ethereum blockchain “pre-launch” at the time of the ICO, the only plausible motivation to take part in the ICO was to make money on the price appreciation of ETH (Howey prong #3). And, at the time of the ICO, if Ethereum was going to succeed as a protocol and ETH was going to succeed as an asset, Vitalik and his developers were going to have to roll up their sleeves and put in some good old “managerial efforts” to make the tokens worth anything (Howey prong #4).
Had the SEC brought suit around the time of the Ethereum ICO, they would have almost certainly won in court, and that may well have been the end of ETH.
However, the SEC didn’t bring suit, and the statute of limitations for such a claim (typically five years) would have run out in 2019. And importantly, the Ethereum ecosystem has evolved in ways since its ICO that make current sales of ETH tokens look less like an investment contract than they once did.
For one thing, the proliferation of applications (think DeFi and NFTs) utilizing ETH for “gas” provides a “consumptive utility” for ETH tokens that challenges the notion that current-day purchases of ETH are solely, or even mainly, based on profit expectation.
Even more important, however, is the so-called “Hinman speech” delivered in 2018 by Bill Hinman, then the director of corporation finance at the SEC, where he proposed that a digital asset’s classification under Howey could evolve over time.
According to Hinman’s logic — to the extent that Ethereum’s success no longer hinges on the efforts of a particular entity, like Vitalik or the Ethereum Foundation — the sale of ETH tokens would no longer fulfill the requirement of the final Howey prong that there be “particular others” upon whose efforts a buyer would rely for their profits.
Read more from our opinion section: Staking or not, ETH is no security
Therefore, regardless of the legally dubious nature of the ICO, the Ethereum network (at least from 2018 onwards) has become “sufficiently decentralized.” This means that its native token constitutes a digital commodity like bitcoin, rather than an investment contract, subject to SEC jurisdiction.
Since the Hinman speech, the securities law status of ETH has been at a bit of a stalemate. The SEC has never explicitly endorsed the notion that ETH (even pre-merge) is a digital commodity — which they readily concede with regard to bitcoin. And Gary Gensler regularly ties himself in knots before Congress trying to evade questions about his view on ETH’s current legal status.
But the fact remains that (at least until now) the SEC has never brought an action specifically alleging that primary or secondary sales of ETH constitute investment contracts under Howey(like they did with over a dozen other tokens in the Coinbase, Binance and Kraken lawsuits). The SEC even went as far as to approve the listing of ETFs based on ETH futures contracts that trade on the CME, which would be hard to understand if the Commission felt that ETH tokens traded as unregistered securities.
But what about Ethereum’s migration to proof-of-stake? Does the fact that ETH tokens can be staked for “yield” change the legal situation and turn either (A) current-day sales of ETH, or (B) the act of staking ETH into securities offerings under Howey?
In my opinion (and I spend an unhealthy amount of time thinking about crypto securities law), no.
With regard to present-day sales of ETH tokens — whether directly from the Ethereum Foundation or on the secondary market — I don’t think ETH’s staking functionality makes much of a difference under Howey. That is, the ability to stake does not make ETH tokens any less useful for individuals who might buy them for their consumptive utility (i.e. gas fees).
And while the Ethereum Foundation does indeed still hold a large supply of ETH tokens, there is no reason to think that the introduction of staking makes the foundation’s “managerial efforts” “essential” to the financial success of ETH in some way that was not the case at the time of the 2018 Hinman speech.
The question of whether the act of staking ETH in order to receive “yield” in the form of staking rewards constitutes an investment contract under Howey is more nuanced — but properly understood, the answer should still be no.
Read more from our opinion section: Ether is the Schrödinger’s cat of crypto
When you run a validator node and stake 32 ETH tokens in exchange for rewards, what you are actually doing is providing a service to the Ethereum network and getting paid for that service. You only get the reward if you honestly validate blocks, and you stand to lose your stake to “slashing” if you attempt to validate dishonestly.
This is very different from the type of passive “yield” you might expect to receive from holding a bond or a dividend-paying stock or real estate asset (which rewards ownership and not activity). Unlike with these traditional financial instruments, you are not relying on “managerial efforts” of other people in order to profit when you stake ETH directly, but rather on your own skill and honestly as a validator.
This question becomes trickier, however, when we move from direct proof-of-stake validation to “staking services” such as those run by exchanges like Coinbase and collaborative staking protocols like Lido and Rocketpool.
At one end of the extreme, you could see an argument for how custodial staking services could look quite security-like under Howey (given how reliant depositors would be on the staking service provider’s efforts in order to earn yield).
At the other end of the spectrum, you could imagine a purely on-chain tool that allowed users to jointly stake their ETH in collective, automated, validator nodes with clearly defined behavior looking much more like direct staking than an investment contract.
Where the specific services by Coinbase, Lido and Rocketpool fall on this continuum is very much an open legal question — and one that in Coinbase’s case is being actively litigated in federal court in the Southern District of New York.
But none of this makes ETH itself, even when being used for staking purposes, an investment contract and therefore none of this seems to justify the SEC’s new investigation.
Why, then, might the SEC be pursuing this type of weak claim about Ethereum?
Observing the success of the Bitcoin ETF — and the SEC’s dissatisfaction with its launch — suggests that the investigation into Ethereum might be a pretext to deny the upcoming spot ETH ETF application.
Moreover, acknowledging Ethereum’s transition to a commodity despite its seemingly illegal ICO genesis could concede a legal strategy meant to apply to other token projects that the SEC believes aiming to circumvent securities classification (in other words, creating a loophole).
The SEC’s actions could be seen as a strategic move to maintain regulatory leverage over the crypto market, rather than a clear-cut determination of Ethereum’s status as a security.
Zack Shapiro is the Managing Partner at Rains and leads the law practice. Previously, he was co-founder and general counsel of BZR, a startup backed by Founders Fund, Greycroft, and Abstract Ventures. Zack is a graduate of Williams College and Yale Law School, and started his legal career clerking in the federal courts for the S.D.N.Y. and the 2nd Circuit, and at Davis Polk & Wardwell. Zack serves in various advisory roles in the crypto industry, including as a member of the Pleb Lab Accelerator advisory board, and as a Legal Fellow at the Bitcoin Policy Institute.
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