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Cryptocurrency investors with holdings in failed stock exchange FTX are learning a hard lesson about investor protection, as the fate of their money is now in bankruptcy proceedings, which will likely take years to complete.
According to legal experts, bitcoin, ethereum and other cryptocurrencies in the field of digital assets exist in a regulatory gray area.
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This means they largely avoid the same scrutiny as traditional holdings like stocks and bonds. In addition, federal money is not available to back clients as it is for those with holdings in a failed brokerage firm or bank.
How orange groves affect the protection of cryptocurrencies
The reason for this depends on a 1946 Supreme Court case about investors in Florida orange groves.
The justices who heard the case—SEC v. WJ Howey Co. – established the Howey test to determine what constitutes a security or “investment contract”. (See below for more information on how the Hovey test works.)
The shares are considered securities regulated by the US Securities and Exchange Commission.
Courts have used the Howey test to give some non-traditional investments—breeding programs, railroads, cell phones, and Internet-only businesses, for example—under the umbrella of “investment contracts” the same protection and oversight as stock investors.
Here’s why this is important for cryptocurrency: It’s not clear in many cases whether digital assets are “investment contracts” under the 76-year-old Howey test.
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Regulatory oversight is therefore somewhat uncertain, said Richard Painter, a securities law professor at the University of Minnesota.
Experts have questioned whether it makes more sense to consider cryptocurrency a currency or a commodity, such as a commodity governed by various federal regulators.
“It makes no sense to turn the Howey test into this whole case in a 1940s case,” said Painter, a former White House chief ethics lawyer under President George W. Bush.
“It’s an invitation to disaster,” he said. “Someone has to cover it up.
“We’ve known what happened to unregulated markets since the tulip bulbs of 1637 [mania] In the Netherlands,” Painter added, referring to what is believed to be the first documented case of a major financial bubble in the 17th century that bankrupted many investors.
Why is the ‘security’ distinction important?
The Howey test has four parts to determine whether something like bitcoin is an “investment contract.” If each is true, a contract exists:
- There is a monetary investment;
- in a general enterprise;
- that the investor expects profit; and
- profit comes only from the efforts of others.
For example, consider an investor who owns open stocks. The investor does not do the work to make the company’s profit, rather the company’s employees and managers do. In turn, the investor can reap profits in the form of dividends and/or a higher stock price.
But cryptocurrency is different. Daniel Gwen, a business restructuring consultant at the law firm Ropes & Gray, said that in many cases it is decentralized, meaning it cannot be considered a “general enterprise”. Gwen added that it is also unclear whether its intention is always to make a profit, as some use it to move money across borders or as a “store of value”.
A 1946 Supreme Court case involved the Howey Company, which cultivated orange groves and solicited investments from tourists staying at an adjacent hotel. A branch managed the garden on behalf of the tourists. After the orange harvest, Howey allocated a share of the net profit to each buyer. According to the court’s ruling, the transactions “clearly contain” investment contracts.
Micah Hauptman, director of investor protection at the Consumer Federation of America, an advocacy group, said if cryptocurrency also had a clearly defined security, the SEC could police companies that don’t comply with securities laws. According to him, these applications can also act as a deterrent for bad actors. In addition to other protections, additional disclosures will be required for investors.
“How these assets are regulated shouldn’t make a difference to investors, but in reality it does,” Hauptman said of cryptocurrency.
The SEC has sought to assert regulatory oversight in some cases. For example, the agency sued Ripple Labs and its employees in 2020 for failing to register the cryptocurrency XRP as a security offering. That work is ongoing.
Sheila Bair, former chairman of the Federal Deposit Insurance Corporation, told CNBC that “I don’t think you can blame the regulators” for what happened at FTX. “They want Congress to act because there’s not a lot of clarity, not a lot of clarity, about what’s a security, what’s a commodity, bank regulators.”
“Law is everywhere”
Customers who store their cryptocurrencies on FTX also do not receive the financial protection afforded 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 of liquidation of a brokerage firm and the liquidation of their shares in an insolvent firm. Suppose a client of Lehman Brothers owned shares of a publicly traded corporate stock when the firm went bankrupt. SIPC’s goal will be to get the shares back into the hands of investors as quickly as possible, Gwen said.
A similar mechanism exists for bank customers who are insured by the FDIC for up to $250,000 in the event of a bank failure.
However, FTX customers likely do not have SIPC protection, Gwen said.
First, this protection applies to securities, meaning that the uncertainty of cryptocurrency as a security or non-security can be a barrier. FTX itself cannot be classified as a broker dealing in securities products. In addition, the company is located outside the United States in the Bahamas, which is not covered by SIPC, Painter said.
“He does things like a broker-dealer,” Gwen said of FTX. “But when it comes down to it, the law is everywhere [crypto].”
FTX, once valued at $32 billion, filed for Chapter 11 bankruptcy protection on Nov. 11. Customers who own cryptocurrencies should hope to get some — if any — money back in bankruptcy court.
This can be a difficult and long process.
“Chapter 11 isn’t really designed to protect this situation, where your intangible digital asset is handled almost like a security, without the same framework,” Gwen said. “That doesn’t mean investors don’t have protections; they have different protections.”