Continuing the regulatory clampdown on the cryptocurrency sector, the New York Attorney General has alleged that the Ethereum network token ETH is a security. It made the assertion in a lawsuit filed against crypto exchange KuCoin, alleging that it is operating in New York state without licenses as a commodities broker-dealer and securities broker-dealer.
Joe Lubin, the founder of ConsenSys, was a major backer of Ethereum in the early days and had a big chunk of ETH at the time of its initial coin offering (ICO). ConsenSys is heavily involved in both crypto and enterprise applications of Ethereum including as maintainer of the Quorum enterprise blockchain. Ethereum was the first permissionless blockchain to show potential for various applications beyond payment, including real world solutions.
Background: A security or a commodity?
Bitcoin is generally considered a commodity, in part because it didn’t have an ICO. But we’ll come back to that. ETH is considered a commodity by the CFTC, and a 2018 speech by SEC Director William Henman implied that ETH probably was a commodity as well.
The well known Howey test looks at an investment contract. To determine if it’s a security, it asks whether it involves:
- The investment of money
- in a common enterprise
- with a reasonable expectation of profits derived from the efforts of others.
Hinman (sort of) added a ‘sufficiently decentralized‘ test: “If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”
Hence, it was thought ETH probably was a security at the time of the ICO, but by 2018, perhaps it was not.
Is it about staking or new legal precedents?
The NYAG court filing includes the following text, which interprets ETH as an investment and also references staking activities.
The court case states, “ETH satisfies the Waldstein test. The ICO was used to raise funds to develop the Ethereum network, as set forth in the ICO Documents. And Vitalik Buterin and the Ethereum Foundation retained large positions of ETH that they continue to use to fund ETH’s development. ETH was also designed as an investment. It continues to be referred to as an “investment” on the Ethereum Foundation’s website. And ETH is used to generate staking rewards for investors. Furthermore, ETH was used to promote the Ethereum enterprise because ETH is needed to process any transactions on the Ethereum network.”
There’s a lot more in the document about the ICO and staking.
But the NYAG filing also leans on a recent court case in late 2022 where a summary judgment ruled that the LBRY-issued LBC token was a security based on the Howey test. LBRY did not conduct an ICO, and LBC was designed as a utility token for a video network.
An interpretation of the ruling highlighted that LBRY and insiders retained significant quantities of the token, which reinforces the third prong of the Howey test of an expectation of profit based on the efforts of others. However, the alignment of interests is also evidence of a common enterprise. Ropes & Gray argued the case collapsed Howey prongs two and three into a single argument contrary to court precedent.
The law firm added, “There are numerous reasons for a project to retain portions of its own coin that would not relate to an expectation that the coin will increase in value. For example, a project may retain a portion of its own coins to facilitate validation of transactions on a proof-of-stake network.”
Meanwhile, the trial between the SEC and Ripple over whether or not XRP is a security has yet to conclude after starting under the previous administration.