Investment Laws, Commodities, and Unregistered Exchanges

Securities, Commodities, Accreditation Laws, and the Risk of Unregistered Exchanges  

More and more “assets” in the digital space continue to face scrutiny as to what they are registered as and therefore what operating guidelines they must abide by. Needless to say, an overwhelming majority of the ecosystem is not operating under the proper guidelines, and this is starting to become more and more apparent across the space. Unfortunately, this phenomenon is only likey to increase, and we are going to explain why we think that throughout this article citing some current events as evidence. To be clear, this isn’t and should never be considered financial advice, it is purely educational and to help you become a better critical thinker when it comes to analyzing potential investment opportunities.   

What is a security?  

Believe it or not, the outcome of a Supreme Court case that happened over eight decades ago determined what the definition of a security is to this day. 

The story behind the case is that in 1940, the Securities Exchange Commission (SEC) sued an orange farmer in Florida over not registering his business in which he would sell plots of land, lease them back form the landowner(s), sell fruit, and then share profits with the landowners. The Supreme Court sided with the SEC, creating the four prongs of the “Howey Test” that determine what assets are considered securities in the eyes of the law or not.  

These four prongs are: 

1. An investment of money
2. in a common enterprise 
3. with the expectations of a profit
4. to be derived from the effort of others. 

As you can see, the orange farmer’s business should certainly be considered a security and therefore registered with and disclosing certain information to the SEC.  

It is important to note here that this test can (and will) be applied all assets… NFTs, DAOs, stocks, gold, $BTC, beach houses in Miami, baseball cards, whatever tangible thing it might be that is under scrutiny from the SEC… However, just because something is getting “howey-tested,” does not mean that it is a security. For example, most single family homes, $BTC, and $ETH (as we will talk more about in this article), are not securities.

Another example of a security is our uniquely structured hedge fund, the Jupiter Fund, which is considered a security because we are bringing together investor’s money to invest in specific assets that they hope to derive profits from, therefore, we meet all of those prongs. The reason we don’t have to disclose all of our info with the SEC yet (although we are still “registered” with them through something called a Form D*), is because we are under a certain size ($100M in AUM) and only offering our fund to a select group of individuals according to the accreditation laws which were established before the Howey Test- we talk about these more below. 

*Form D allows us to be exempt from registering and disclosing certain information to the SEC until we break out of one or all of the exemptions.     

Seven years before the Howey Test was created, it became US law that businesses selling securities must be registered. This Securities Act also determined an “Accredited Investor” to be somebody who has made at least $200K per year for the last two years or has a net worth of over $1M. A “Qualified Purchaser,” was determined to have at least $5M in investments (beyond house, car, etc.).

Being an accredited investor and of course a qualified purchaser opens you up to the most exceptional investment opportunities… At least as compared to “retail investors,” or everyday people that aren’t very wealthy or in financial services- otherwise deemed to be not sophisticated enough to invest in unregistered securities by the SEC.

Note that the above definitions were from Regulation D of the Securities Act of 1933. 

Finally, in 2020, the SEC expanded the definition of an accredited investor to include those that hold specific certifications or qualifications such as a Series 7, 65, or 82 license. While nothing too crazy, in our opinion this was a step in the right direction to qualify more people as “educated” or qualified enough to invest in risky, early stage, unregistered securities- it’s almost as risky as purchasing cigarettes and alcohol, or how about some lottery tickets!  

Quickly following the Securities Act of 1933 was the Securities Exchange Act of 1934 which created the SEC and empowered them to regulate exchanges, brokers, clearing agencies, and all self-regulatory organizations (SROs), like the Financial Industry Regulatory Authority, (FINRA). Registering with the SEC does not require a lot of disclosure and they make it especially easy when first starting out. This law also defines prohibited behavior when acting in markets and puts the SEC in charge of defining the rules for the space, along with the ability to come after any potential bad actors, even SROs. The SEC and SROs are supposed to work together to protect the integrity of the markets.   

These laws that were created decades ago are being referenced more and more today as projects are being exposed as having been operating outside of US Legislation (wonder who saw that coming). A recent example is the SEC charging three Coinbase managers with insider trading. The SEC stated that at least nine of the sixteen assets under investigation “were securities,” however, Coinbase’s Chief Legal Officer said that “Coinbase doesn’t list securities. Period.” Clearly, there are some serious misconceptions of not only what a security is but also what legal and regulatory implications come with that determination.

Some people argue that coins used for “utility” shouldn’t be considered securities, but Commodity Futures Trading Commission (CFTC) Commissioner, Caroline Pham, when speaking on the SEC v Wahi (Coinbase case), said that that “the SEC complaint alleges that dozens of digital assets, including those that could be described as utility tokens and/or certain tokens relating to decentralized autonomous organizations (DAOs), are securities.” 

Prior to this action, in early August 2022, the Digital Commodities Consumer Protection Act was introduced and clarifies (or claims) that Bitcoin and Ethereum are commodities, as opposed to securities which are under purview of the SEC. 

We believe these assets got determined to be commodities, rather than securities, because they meet the first two prongs of the Howey Test but not the second two. When people put money into $BTC looking at it as a “store of value,” they aren’t necessarily expecting a profit from it, but perhaps for it to hold its value relative to other assets over the test of time. Additionally, there isn’t one group of people who’s job it is to make $BTC profitable; instead, there are computers executing immutable code (unfortunately currently at a momentous clip of energy).   

Michigan Senator Stabenow said in a statement that “one in five Americans have used or traded digital assets, yet these markets lack the transparency and accountability that people expect from our financial system… that’s why we are closing regulatory gaps and requiring that these markets operate under straightforward rules that protect customers and keep our financial system safe.” Both the House and Senate Agriculture Committees have signaled interest in subsuming more digital assets to the authority of the CFTC.  

NFTs and DAOs are also areas with a lot of confusion right now, as most NFTs involve a lot of speculation and a lot of DAOs involve governance and/or utility as part of their value proposition. Both of these assets are starting to be ubiquitously looked at (but not yet regulated as) securities. In our next article we will be diving in much deeper on this, but technically, most of them are currently and have been raising money completely illegally as they should in almost all cases probably be considered securities.

Some states, like Wyoming and Vermont, have made it easy for people to create and operate DAOs legally, assuming you follow the prevailing securities laws. Some projects, like Orange DAO, are doing this legally by setting up a traditional domestic fund alongside an offshore to DAO to help fill the fund with additional investors as only one slot in the fund. 

KKR, one of the largest asset managers on the planet, recently enlisted Securitize Capital to tokenize an interest in their $4B Health Care Strategic Growth Fund II (HCSG II) on the Avalanche blockchain.

Investing in funds like these are usually reserved for large institutions and ultra-high-net-worth individuals. However, a creative approach to structuring, infrastructure to support public reporting requirements, and the continued development of new technologies have enabled large asset managers like KKR to accept smaller checks, improve digital onboarding and compliance protocols, and increase liquidity for a large number of investors that previously haven’t had access to these limited access and usually more illiquid vehicles.

While this isn’t the first time KKR has revolutionized the fund space, it certainly is the first time an institution of this scale has tokenization an interest in one of their large funds. We are very excited about this maneuver and see it as a massive bullish indicator for the entire space 1. because it happened with these very reputable groups and 2. because it showcases blockchain’s ubiquitous room for adding value across industries.