[Harsh N Dudhe and Pranay Bhardwaj are Year IV Students at NALSAR, Hyderabad]
On June 1, 2022, the US Attorney’s Office in the Southern District of New York had alleged charges of wire fraud and money laundering in connection with a scheme to commit insider trading in non-fungible tokens (NFTs). In this indictment in United States of America v. Nathaniel Chastain, it was stated that Nathaniel Chastain was an employee of the platform OpenSea and was responsible for selecting NFTs to be featured on the OpenSea’s webpage. OpenSea kept the information regarding the featuring of the NFTs confidential. It is alleged that the former employee of OpenSea used the confidential business information about what NFTs would be featured to buy dozens of NFTs shortly before those NFTs, or NFTs by the same NFT creator, were featured on the OpenSea’s homepage. This is the first time such charges of insider trading are being formally discussed in relation to a digital asset. Cryptocurrency, which is also a digital asset, has been facing similar issues (here and here). All this has led to the Securities and Exchange Commission of the United States of America (SEC) to lead an inquiry on crypto-exchanges in relation to insider trading.
However, the one issue which the market regulators in India, as well as in the United States of America would have to ponder upon is whether these digital assets would be “securities” in order to exercise their jurisdiction over them. According to the SEC Chair Gary Gensler, these digital assets would fall within the ambit of “investment contracts”, and are therefore “securities” by the virtue of the “Howey Test” under the securities laws of the United States of America.
In this post, the authors put the definition of “securities” as is used in the United States of America to the test vis-a-vis digital assets. The authors argue for a transplant of such a provision in India, albeit as a temporary measure given the various limitations of the same. In conclusion, the authors argue that the market regulators of India, in the long run, would have no option but to redefine “securities” to include digital assets. This is necessary to fulfill the objectives of protecting interests of the investors, to promote the development of the market and to regulate the same.
Understanding Digital Assets
Before moving on to our analysis, it would be imperative to lay the ground as to what digital assets are. Cryptocurrency is a digital form of currency that is not regulated or issued by a central authority. It employs a decentralized system of “blockchain technology” to record transactions and manage the creation of new units of the currency. It also relies on “cryptography” to prevent unethical practices like counterfeiting and fraud.
NFTs and cryptocurrencies are both developed using blockchain technology, but they are different in every other aspect. Cryptocurrency is fungible in nature. This means it is interchangeable. The value of one bitcoin, for instance, is the same as the value of another bitcoin. NFTs, on the other hand, are non-fungible. This implies that the value of an NFT is not the same as that of another, as it is essentially digital art, each with its own unique composition and valuation.
A crypto exchange is a platform for the trading of cryptocurrencies. The possible trades include the exchange of one cryptocurrency for another, like converting Ethereum for Bitcoin, or the exchange of cryptocurrency for regular government issued currency like the exchange of Bitcoin for Rupee. These exchanges indicate the market price of cryptocurrencies at any given moment.
The Definition of “Securities” in the United States of America
According to section 2(a)(1) of the Securities Act, 1933, the term “security” means the following:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The definition of “security” is not limited to the statute book and has been given an expansion under Securities and Exchange Commission v. W.J. Howey. According to this case, if: (a) there is investment of money (b) in a common enterprise (c) where the purchaser expects to receive profits and (d) there is expectation of profits and such profits are from the entrepreneurial efforts of others, then it would qualify to be an “investment contract” (therefore a security).
The first condition of the Howey Test (investment of money) would easily be satisfied when there is a sale of digital assets in a general transaction on a crypto-exchange, since there is exchange of the digital asset and either fiat currency or another digital asset. This is because cash is not the only form of investment that would lead to the creation of an investment contract. Moreover, in SEC v. Shavers, Bitcoin was held to be an investment contract. This was because the respondents therein were operating a “Bitcoin Savings and Trust” as an online investment scheme wherein all the transactions were in Bitcoin. It was held that since Bitcoin was used to purchase “goods and services”, it would be considered as “money” to satisfy the first condition of the Howey Test.
The criterion of “common enterprise” is tested through the concepts of vertical or horizontal commonality. The former defines “common enterprise” as something where the profits of the investor are totally dependent on the person who either is seeking the investment, or of a third party. The latter defines common enterprise as the pooling of a common interest which is commonly coupled with the pro-rata sharing of profits. Therefore, digital assets will fulfill this condition of the test as long as there is an investor-investee relationship, or if a group of persons have a pooling of a common interest, as observed in SEC v. Shavers.
The third and fourth conditions of the Howey Test would be questions of fact that would have to be determined on a case-by-case basis.
A Case to Re-define “Securities” under Indian Securities Laws
According to section 2 (h) of the Securities Contract Regulation Act, 1956, the term “securities” refers to units or any other instrument issued by any collective investment scheme as well as shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or “of any incorporated company or other body corporates”; any derivatives; any government securities, instruments declared by Central Government to be securities, or any rights or interests in securities.
This provision restricts its application to incorporated companies or bodies corporate. Digital assets would not fall within either criteria given the definition. On the other hand, in the United States of America, there is no such restriction and, by virtue of the Howey Test, “common enterprises” are given emphasis over mere body corporates. Moreover, the biggest merit of the Howey Test is that it is flexible in its approach, and gives more importance to the substance rather than the form of the transaction. By the very nature of the test, courts have been able to take into account various schemes and exercise jurisdiction in that regard. Such an approach has the potential to include digital assets, based on the facts at hand.
This would be a major hurdle for Securities and Exchange Board of India (SEBI) to exercise its jurisdiction to regulate digital assets. Given that frauds and insider trading cases are reported to be prevalent in crypto-exchanges, the lack of action from SEBI would result in the opposite effect of why the regulator was created in the first place. Though the nature of crypto-exchanges and the classic stock exchanges may differ, it does not take away from the fact that persons are investing in digital assets in the present day, and would need protection from such instances. Therefore, we argue that SEBI would need to reflect on the definition under the SCRA, and come up with a framework to include digital assets within that definition. Since this would take a lot of deliberations from the market regulator, we argue that at least as a temporary measure, SEBI could consider adopting the already available definitions and, to the extent necessary and relevant, consider the tests used in the United States of America.
We argue that this should be a temporary measure because the American Law and the Howey Test have their limitations with regards to its ambit to regulate digital assets. One of the major contentions is the inconsistent application of the principle (see here and here). Secondly, the definition of “common enterprise” would not include transactions on the crypto-exchanges. Following up from the second contention, the third contention is that under the said law, digital assets themselves are not considered to be securities. The case of SEC v. Shavers considered Bitcoin to fulfill the Howey Test due to the facts at hand, and not because there is a positive law or precedent holding Bitcoins as security.
In contrast, most of the Initial Coin Offerings are considered to be securities, whereas Bitcoin is not, which is due to lack of a central third-party common enterprise. The point is that the case from which this test emerges was decided a time when digital assets were not in existence. Therefore, it would not be able to capture the nuances of the nature of digital assets being traded today. Yet, at the same time, “common enterprise” in light of the other conditions has the scope to take into account digital assets on a case-by-case basis. Given these limitations, the transplant should only be a temporary measure, and India should develop its own framework to redefine securities taking into account the reality of digital assets in the present day.
The authors believe that since investments are being made in digital assets, investor protection becomes imperative. This would be possible when the market regulators are able to exercise their jurisdiction over such digital assets. This is especially because the issue is bound to get even more precarious with time. Currently, NFTs and cryptocurrencies are not included in the definition of “securities” in Indian law, and thus the market regulators would not be able to take any action if the situation so arises. It is clear that, despite its limitations, reference can be made the Howey Test under US jurisprudence as a temporary measure in considering transactions in digital assets in India. However, in the long term, the more sustainable solution to the issue is for SEBI to develop a completely new, more inclusive and substance-based definition of “securities” which can include NFTs and cryptocurrencies and other relevant digital assets within its ambit.
– Harsh N Dudhe & Pranay Bhardwaj