Is Staking a Security? A Primer on Staking and Securities Law

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Jae Lee외 1명
Research Associate/
Xangle
Jun 12, 2023

Translated by Lani Oh (elcreto)

*This article was co-authored by Xangle and DeSpread to promote understanding of the controversy surrounding the security status of staking and related assets.


 

Content

Staking: In the Crosshairs

Gary Gensler’s Snipe at Staking

SEC and Staking: How Far Will They Go? 

Part 1. Determining the Security Status of Staking

Securities Laws, the SEC, and the Howey Test

Why Staking and Staked Assets May Constitute Investment Contracts

Why It May Not Constitute an Investment Contract Nonetheless

Part 2. Security Status of Staking Services

Types of Staking Service & Security Classification

Other Factors: Tokens, Protocols, Decentralization, Transparency, and Non-Custodial Nature

Closing Thoughts: Barrage of Regulations Clouding the Outlook for Crypto

An In-depth Look at the Regulatory Landscape of Staking

Domestic Implications; Uncertainty Nearing Its End

 

 

Staking: In the Crosshairs

 

Gary Gensler’s Snipe at Staking.

"The investing public is investing anticipating a return, anticipating something on these tokens, whether they’re proof-of-stake tokens, where they’re also looking to get returns on those proof-of-stake tokens and getting 2%, 4%, 18% returns.”

- Gary Gensler, speaking to the press on March 15, 2023

On March 15, Gary Gensler, chair of the U.S. Securities and Exchange Commission (SEC), voiced his opinion during a meeting with reporters that all tokens with Proof-of-Stake and staking consensus mechanisms are securities and should therefore be subject to SEC oversight. It is significant that the SEC, which is already in the process of expanding its purview over a number of projects, is now recognizing that security status may apply even to the protocol level of staking.

 출처: Staking-as-a-Service | Office Hours with Gary Gensler | US SEC Youtube Channel

Source: Staking-as-a-Service | Office Hours with Gary Gensler | U.S. SEC Youtube Channel

Especially since the Proof of Stake consensus algorithm is becoming the de facto standard for blockchain consensus algorithms after Ethereum’s Merge, a determination that staking activities are securities will beget various regulatory obligations on many blockchain projects. Once again, after the ICO regulations, regulatory uncertainty has loomed over the cryptocurrency market.

SEC and Staking: How Far Will They Go?

To clear up this uncertainty, Xangle and DeSpread teamed up for this joint research to understand the security status of staking within the validator-network relationship, which forms the essence of the asset's existence, and to speculate on how the SEC's upcoming regulatory actions would proceed. In this report, we'll take a look at 1) securities laws, the SEC, and the Howey Test, 2) pros and cons surrounding security classification of staking, and 3) potential implications of security status on staking-as-a-service, such as liquid staking.

 

 

Part 1. Determining the Security Status of Staking

Before we dive right in, let's briefly go over the background and purposes of securities laws, the SEC, and the Howey Test, which constitute the matrix of the security classification.

Securities Laws, the SEC, and the Howey Test

Background of the SEC

The SEC is a U.S. financial regulatory agency created to protect investors under the Securities Exchange Act. Back in the day, before the SEC came into the picture, investors were left to the mercy of Blue Sky Laws *, leaving them wide open to all sorts of fraudulent and manipulative tactics. In October 1929, a market bubble swollen by rampant leverage and fraud burst on "Black Thursday," wiping out fortunes from investors and plunging the U.S. economy into the depths of the Great Depression.

As part of the New Deal, President Franklin D. Roosevelt created the SEC in 1934 to restore investor confidence. Charged with enforcing federal securities laws and protecting investors from fraud and other forms of financial misconduct, the SEC has become one of the world's most important financial regulators, with broad responsibilities that include overseeing stock exchanges, establishing disclosure standards, regulating broker-dealers and investment advisers, and enforcing corporate accounting standards.

* Blue Sky Laws: Prior to Black Thursday, there were state-level securities regulations, known as Blue Sky Laws (so named because some investment contracts were said to have "no more substance than so many feet of blue sky."). The rules not only varied from state to state but were limited in scope and lacked enforcement authority, rendering them virtually non-existent.

 

The Core Framework to Determine Security Status: The Howey Test

The SEC's ability to bring lawsuits, subpoenas, and enforcement actions against financial misconduct gives it tremendous powers as a financial watchdog and enforcement agency. The agency needed standards specifically to determine the traits that constitute securities in order to define the scope of its enforcement jurisdiction.

The security definition is based on the Securities Act of 1933. Types of securities include stocks, bonds, ETFs, options, and even investment contracts, which is currently one of the hottest topics in the cryptocurrency market. Investment contracts encompass all types of contractual arrangements wherein an investment scheme is involved, and are defined as an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." This definition was later established in Supreme Court precedents along with SEC v. Howey (1946)* and SEC v. W.J. Howey Co. (1948)*, and became the basis for the Howey Test, which remains the overarching standards for determining an investment contract.

The Howey Test is a framework for determining whether an investment contract exists in a particular transaction and consists of four elements, all of which must be satisfied in order to pass the Howey Test and be considered an investment contract.

Here’s the example of an investment contract cited in the SEC v. W. J. Howey Co. (1948) case*, which later established the Howey Test. The coexistence of an investment (the purchase of an orange grove) and a contract (a promise to share the profits from the orange grove) created an investment contract, which served as grounds for the SEC to sue W. J. Howey Co. for the sale of unregistered securities. 

 *SEC v. Howey: "In other words, an investment contract for purposes of the Securities Act means a contract, 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”

 

The Howey Test and Crypto

The Howey Test carries significant implications for the crypto space, where the line between securities and non-securities can be blurred. If a particular asset passes the Howey Test, cryptocurrencies that have similar arrangements may inevitably come under the regulatory purview of the SEC. This is why the SEC has been suing several companies and projects in recent years. The strategy is referred to as Regulation By Enforcement*, whereby the SEC establishes precedent and builds the basis for regulation.

 *"Regulation By Enforcement” typically involves establishment or clarification of rules and standards of conduct in a specific industry or regulated area through enforcement actions. One of the most illustrative recent examples is the SEC’s classification of ICOs as securities, which doused the ICO boom of 2017-2018. During this time, numerous companies raised funds by minting and selling digital tokens, yet almost none registered them as securities or complied with laws, rendering the market prone to financial frauds. The SEC brought enforcement actions against some of these companies and successfully classified tokens issued through ICOs as a form of security.

 

Why Staking and Staked Assets May Constitute Investment Contracts

 

The definition of a security is intentionally broad

Supreme Court Justice Thurgood Marshall once said that the Securities Act of 1933 defines the term security in sufficiently broad and general terms to achieve its goal of protecting investors. This is especially relevant in the crypto market, where the line between securities and non-securities is blurry, especially for the much-debated staking assets. Staking assets do not fit within any of the conventional categories of securities, i.e., stocks, bonds, ETFs, and options, and therefore may be subject to the Howey test to discern if the asset qualifies as an investment contract. In light of the recent investor harm associated with cryptocurrencies, a flexible definition of securities is interpreted as a commitment to bringing problematic crypto assets under the SEC's purview to better protect retail investors*.

 *Retail Investor (Non-sophisticated Investor): U.S. securities laws divide investors into three categories based on their financial capabilities and access to information: Accredited Investors, who are classified as insiders or investors with sufficient assets, Sophisticated Investors, who demonstrate sufficient financial knowledge, and Non-sophisticated Investors, who refer to a broad range of general investors. To prevent fraudulent activities and potential harm, the SEC defines assets or products as securities and seeks to address the concentration of information and protect investors from losses within its regulatory jurisdiction through, for instance, disclosure platforms like EDGAR.

 

Staking: If It Passes the Howey Test

Now let's talk about why a native token on a PoS blockchain network might pass the Howey Test. Here’s how staking can tick off all four prongs of the Howey Test:

Put simply, the idea is that the validator nodes that form a consensus in a PoS network and the foundation that helps build the network's infrastructure are engaged in a common enterprise, and the investment is made with the expectation of profit from this business, which is attributable to the efforts of the foundation and the nodes.

 

Original Sin Theory & Embodiment Theory

Besides the Howey Test, the SEC has recently introduced two additional theories to determine the security status of cryptocurrencies, i.e., Ripple and $LBRY: the Original Sin Theory and the Embodiment Theory. Since staking assets are also defined as crypto assets used in the act of staking, these two theories, warrant a look alongside the aforementioned Howey Test.

The original sin theory in crypto reflects the view that a crypto asset sold through an investment contract will always be deemed a security. This classification extends to all future transactions involving the asset, regardless of any circumstances or future developments. This approach allows the SEC to firmly establish an asset's security status based on how the asset was initially distributed.

The embodiment theory serves as a complement to the original sin theory. According to the embodiment theory, if the circumstances and expectations that led to an asset's classification as a security continue to exist, the asset serves to embody what can be expected from an investment in that security. This takes into account the evolving nature of crypto assets and presumes that an asset is a security if the nature of the investment inherent in the asset—the facts, circumstances, promises, and expectations at the time it was classified as a security—remains unchanged.

The SEC has taken a comprehensive approach using these two theories to effectively address the multifaceted nature of cryptocurrencies and related investment contracts, and they have been instrumental in supporting the SEC's reasoning in the high-profile SEC v. Ripple Labs Inc* court case. Based on these two theories, various factors, such as how a cryptocurrency is initially distributed and how decentralized it is, may become more important than the act of staking in the crypto security debate. (Further exploration of the security aspects associated with various staking methods will be covered in a dedicated section below).

This view puts the SEC's current position that most cryptocurrencies including staking are securities into a better perspective. In a House hearing on April 19, 2023, SEC Chair Gensler appeared to take a broader definition of an investment contract, citing Justice Marshall:

"Congress’s purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”

*Ripple v. SEC: In the long-running legal dispute between the SEC and Ripple Labs, the SEC's claims under each theory were as follows:

  •  Original Sin Theory: The SEC argued that XRP should be considered a security because it was initially sold through an unregistered investment contract, and therefore all subsequent transactions involving XRP should be treated as securities transactions.
  •  Embodiment Theory: The SEC alleged that Ripple Labs promoted XRP as an investment opportunity, creating an expectation of profit. This argument is based on the logic that Ripple Labs' efforts to grow the XRP ecosystem would lead to an increase in the value of the asset. As a result, the asset XRP embodies the promises, expectations, and circumstances associated with the investment contract promoted by Ripple Labs to investors.

 

Why It May Not Constitute an Investment Contract Nonetheless

Of course, there is a counter-argument. At the heart of this argument is the notion of commonality, which is the basis for the formation of a common enterprise of the Howey Test, and the notion of economic reality, which is the focus on the actual economic arrangements rather than legal classifications in determining securities. So first, here’s a brief overview of these two concepts.

 

Horizontal and Vertical Commonality

Commonality is a key determinant of the forming of a group with shared interests in the Howey Test that necessitates identification of the promoter to discern the existence of a common enterprise. Depending on the interests and dependencies between the investor and the promoter, commonality can be divided into horizontal and vertical commonality. Generally, the presence of either of them is deemed to establish commonality*.

Horizontal commonality examines the existence of a common enterprise by assessing "horizontal relationship" between investors. This relationship is characterized by the pooling of assets and the distribution of profits based on the efforts of the promoter, thereby linking the individual investor's wealth to that of others. On the other hand, Vertical commonality emphasizes the "vertical relationship" in which a promoter is involved in a common business, and investors significantly rely on the promoter's efforts to pursue their interests. Essentially, establishing commonality relies on the presence of a structure, whether it be horizontal or vertical, through which investors receive profits driven by promoters.

*The commonality standards may vary among courts, but meeting either of these two commonality notions  can be a prerequisite for passing the Howey Test: While Salcer v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 682 F.2d 459 (3rd Cir. 1982); and Milnarik v. M.S. Commodities, Inc. 457 F.2d 274 (7th Cir. 1972) put more weight on horizontal commonality, Mechigian v. Art Capital Corp, 612 F. Supp. 1421, 1427 (S.D.N.Y. 1985); and Dooner v. NMI Limited, 725 F. Supp. 153, 159 (S.D.N.Y. 1989) placed more emphasis on vertical commonality.

 

Does Staking Establish Commonality?

In a proof-of-stake network, stakers (investors) lock tokens into a staking contract as a means of securing the network and maintaining consensus. But there is no entity that manages the deposited tokens, and the tokens deposited by a staker are not tied to the property of any other staker—hence, no investor-promoter relationship. Each staker is individually responsible for operating their nodes, and cannot expect to receive a profit proportional to the revenue generated by the promoter. They may even lose money if the node is operated inefficiently or exposed to slashing. That is, the absence of a structure where investors share profits with the promoter in staking remains a challenge in establishing commonality.

In this case, each staker earns profit based on their individual efforts, e.g., maintaining uptime and verifying transactions and compete* with others to generate blocks, which is more of a competition than a collaboration. There is no horizontal commonality, as staking basically isn’t a process where stakeholders share profits with each other.

 

Economic Reality

The other notion that warrants attention is the economic reality that underlies the act of staking. The concept of economic reality prioritizes the actual economic relationship involved in the use of a good or asset over its legal classification. According to this concept, a good that resembles a security in terms of its legal classification in the course of its use, operation and distribution is not a security if the purpose of its use is fundamentally different from the relationship between the investor and the promoter. A case in point is United Housing Foundation, Inc. v. Forman (1975). Back then, the Supreme Court held that stocks of Co-op City, a New York City co-operative housing corporation, were not securities due to the primary purpose of purchasing the stock being the right to occupy a home rather than investment in a profit-seeking business.

*United Housing Foundation, Inc. v. Forman (1975): The Co-op City Housing Project was a large-scale development intended to provide affordable housing for middle-class families. The project was organized as a co-operative, and each purchaser was required to purchase shares in the United Housing Foundation, Inc (UHF). The shares were not traded on an exchange and did not increase in value. Instead, the share price was directly tied to the price of the apartment, and owning a share gave the right to occupy a home in the co-operative. As such, some purchasers of shares in the Co-op City project filed suit against UHF, arguing that the shares were securities and therefore entitled to certain legal protections and remedies.

The Supreme Court, however, applied the concept of economic reality and focused on the intrinsic nature of the transaction rather than its form. It ruled that the shares were not securities, noting that they were not an investment in a profit-making business and that the primary purpose of purchasing the shares was to obtain the right to occupy the house. The court emphasized that the shareholders did not expect a profit from their investment and that the economic relationship between the shareholders and the co-operative was fundamentally different from the traditional relationship between investors and promoters. The rationale was that the focus of co-operative shareholders was the ongoing operation and maintenance of the housing project, not the pursuit of profit.

 

Staking in the Context of the Howey Test

Below is an overview that sums up the reasons staking on a PoS network does not constitute an investment contract based on the concepts of horizontal and vertical commonality and economic reality.