No Basis for Trust 2

The author is not an attorney and this post should not be construed as legal advice. 

The grand dream of printing money from thin air remains alive and well in crypto.

As it gradually dawns on promoters that selling unregistered securities to retail investors is against the law, attention has pivoted to maintaining access to trading venues. Secondary market trading is essential because it provides the mechanism for coin offering participants to have an expectation of profits from greater fools. The market seems to have wised up to the fact that most coin offerings were just fundraising schemes for issuers without the quaint norm of “repayment,” but between “initial exchange offerings” and “stablecoins” the idea of the moment is to raise money for an exchange or for a refundable token to be used on one. (This is darkly efficient, as it provides hard currency for the venue’s immediate use rather than requiring it to wait for the speculator first to lose the deposit gambling).

Cryptocurrency exchanges have developed a nasty habit of losing their private keys, customer funds, and access to the banking system. In the US, there may come a day when operating an unregistered broker-dealer stops passing muster with a reckless minority of the securities bar or authorities act to enforce laws against selling securities without registration. In the meantime, stablecoins have gained momentum as a solution to these potential access barriers, creating a transferable on- and off-ramp to even the most untrustworthy cryptocurrency exchange without the unwanted regulatory limitations of handling fiat currency. From the standpoint of the promoter, if redemption of a purportedly redeemable stablecoin can be discouraged or prevented altogether, so much the better: The hapless user has no choice but to buy other digital assets, driving up their price. (A good explanation of how this might work is posited in a Twitter thread here).

Stablecoins look like securities to me.

With stablecoins popping up right and left, some of the more prominent projects have begun to attract scrutiny. Observers including members of the defense bar and Valerie Szczepanik of the SEC have recently observed that stablecoins can resemble investment contracts. A coin that promises redemption, especially when sold at a discount, looks awfully similar to a zero-coupon bond to me. It is a contractual obligation of the issuer to repay a fixed amount of principal on demand. How is that not a security? In my view, the Howey prongs are satisfied because there is clearly an 1) investment of money in a 2) common enterprise (the issuer, which provides custodial services and a peg algorithm) with 3) an expectation of profits (whether from the reversion of the discount or the facilitation of trade in other securities or commodities, especially those provided by an affiliate of the coin issuer) which 4) come from the efforts of others (the coin issuer’s redemption activities or its affiliate’s operation of an exchange or brokerage business).

Some well-known stablecoins that appear to fit this model include:

Tether  — the Bitfinex affiliate, which restricts redemptions and faces credible fraud allegations, recently admitted publicly for the first time that its purported backing is not based on fiat currency. Tether is widely believed to be a transmission mechanism for cryptocurrency market manipulation. It can be bought and sold (even borrowed and sold short), just like a fixed income security.

Basis — recognizing that its token would be deemed a security under US law, Basis shut down late last year.

Gemini Dollar — GUSD caused controversy by selling its token at a discount to market makers, only to refuse to honor their entirely predictable redemption requests. Purchasing GUSD at a discount to $1.00 created an immediate expectation of profits, were Gemini to honor a redemption demand at par value.

What about TrueUSD and the TrustToken platform?

Though all stablecoins are worthy of criticism, I want to spend the remainder of this post picking on TrueUSD because they introduce a novel and, in my opinion, entirely incorrect legal analysis into the debate. Like the misguided concept of “utility tokens” that encouraged startups to engage in unregistered securities offerings based on minority legal views, publicizing incorrect legal claims throws sand in the air and can give cover to bad actors looking to take advantage of retail investors. TrueUSD deserves credit for registering as a money services business and attempting to address some of the issues with schemes like Tether. TrueUSD purports to hold audited fiat collateral in escrow and require KYC and AML checks on purchasers of its token. Though commendable, these efforts do not save the token from its potential status as a security. Whether or not coinholder funds are escrowed or held by a regulated trust is a red herring. Stablecoins that promise a right of repayment are ultimately liabilities of the coin’s issuer — if they are not securities, those liabilities at a minimum resemble demand deposits that may require a banking license.

As I was drafting this post, TrueUSD announced an alarming new partnership with Cred, an apparent unregistered finance lender that is “not a bank” but is making or intends to make deposit-funded commercial loans. Cred is itself a token issuer, which claims to have raised $26 million in an unregistered securities offering (more popularly known as an “ICO”) of its LBA token in 2018. The partnership creates an expectation for TrueUSD purchasers that the efforts of Cred will provide TrueUSD holders with the potential to profit from 8% annual interest.

I believe TrueUSD should file a registration statement and offer the token only in compliance with the securities laws, which would, in turn, limit its use to trading venues that also properly registered with the SEC. The current list of exchanges that trade TrueUSD does not include any such venue.

In its published FAQ, TrueUSD states:

“Will TrueUSD tokens be classified as securities?

Our legal counsel has provided a memorandum that TrueUSD tokens are not securities. They are more akin to deposit & safekeeping receipts, which the SEC has previously analyzed and recommended no enforcement actions for their use (see 40 Fed. Reg. 1695 et. seq).”

TrustToken’s legal counsel Michael Bland did not respond to a LinkedIn message requesting a copy of the memo. Let’s look more closely at 40 Fed. Reg. 1695 et. seq..

The citation is to interpretative guidance issued by the SEC in December 1974 along with three no-action letters provided to sponsors of gold-backed investment offerings. When restrictions on private ownership of bullion were lifted, issuers sought to meet demand for gold and address storage constraints by buying bullion and selling deposit receipts to investors. The SEC determined that X, Y, and Z, respectively a bank, commodity dealer, and registered broker-dealer, could sell receipts to investors without registering an offering under the Securities Act of 1933. The analysis concluded with language consistent with recent SEC commentary regarding coin offerings: “The arrangements described in the foregoing no-action letters are only three of a number of proposals for the public offering and sale of gold which have been brought to the attention of the Commission. Some of these appear to involve the offering of a security and others do not. This would depend upon all the facts of a particular case, and variations in the facts of such cases may lead to different results.”

So, is TrueUSD distinguishable from the non-security gold offerings granted no-action relief in the 1970s?

Facially, TrueUSD is the opposite of a deposit receipt created due to demand for underlying gold bullion — demand for a stablecoin is driven not by demand for underlying dollars, but instead by a desire to avoid using dollars on a cryptocurrency exchange that is untethered to the financial system. There are other major differences. In granting no-action relief, the SEC highlighted certain facts that the gold bullion issuers had in common (emphasis added):

(1) It does not appear that, in the gold investment program described in these letters, the economic benefits to the purchaser are to be derived from the managerial efforts of the seller, promoter, or a third party

(2) It does not appear that the services to be offered In connection with these offers to sell gold rise to the level of being those essential managerial efforts upon which the purchaser must rely in order to make a profit from his purchase. In this regard:

a. The purchaser will pay full value in cash for the gold purchased and purchases will not be made on margin.

b. The depository arrangement is limited to the storage of the gold with a reputable storage facility, insurance against loss or theft from the storage facility, and the issuance of a document which would evidence, the right of the purchaser, or his successors and assigns to take possession of the gold; and

c. Neither X, Y, Z, nor anyone acting on their behalf has any obligation to repurchase the gold or ownership documents from the purchaser, nor to sell such gold or ownership documents for the purchaser’s account; but they may repurchase the gold at the then prevailing market price.

TrueUSD, like other stablecoins, is immediately distinguishable from the gold bullion deposit receipts described in 2(c) because of its redemption mechanism. The company variously notes that it has an obligation to repurchase and even notes the possibility of profiting from that service: “Since traders can always trade TrueUSD for the equivalent USD on, there will be an incentive to buy or sell mispriced TrueUSD on exchanges and convert on” (FAQ) and “TrueUSD holders can purchase or redeem TrueUSDs for US Dollars held in escrow accounts managed by our fiduciary network through the Platform. The Platform is intended only to facilitate such purchases and redemptions” (Terms).

Unlike the gold bullion receipts, TrueUSD is intended as a negotiable instrument to be traded on a secondary market, and the economic benefits to the purchaser arise in part from the managerial efforts of the seller, including its efforts to list the coin on various exchanges. The efforts by the exchanges to list and promote the token further distinguish TrueUSD from the receipts described in (1) above. Furthermore, Letter 2 even goes so far as to state, “Receipts would be in non-negotiable form for the protection of purchasers.” Receipts could only be transferred or assigned through Y with a signature guarantee. Plainly, the SEC was already alive in 1974 to the possibility that a freely tradable instrument would raise investor protection concerns contemplated by the securities laws.

Legal inaction

The TrueUSD website currently states, “The TrueUSD team has developed a legal framework for collateralized cryptocurrencies in collaboration with WilmerHale and White & Case.” An earlier version of the site referenced elsewhere stated, “TrueCoin has developed a legal framework for collateralized cryptocurrencies in collaboration with Cooley and Arnold & Porter.” I’m not sure which of these firms actually developed the supposed legal opinion that TrueUSD is entitled to rely on the SEC’s 1974 no-action letters concerning gold bullion deposit receipts. Nor is it clear which of them intended to lend their reputations to the project by virtue of providing legal advice in some other context. The attorneys of WilmerHale, White & Case, Cooley, and Arnold & Porter all have significantly more experience and knowledge of the federal securities laws than I do, so perhaps I’m missing something. A plain reading of the no-action letters, however, does not appear to provide the type of relief upon which the company purports to rely.

More importantly, TrueUSD and its legal advisors, like so much of the cryptocurrency industry, evince a level of contempt for regulation that perplexes me. Technological innovation need not require open conflict with existing regulation: The SEC has repeatedly indicated that it wants to hear from companies in the industry. Why hasn’t TrueUSD requested no-action relief of its own?

Attorneys often advise clients to rely upon no-action letters and guidance when there is a clear similarity in the fact pattern. It takes a tortured reading of such authority to see that here. Where there is doubt regarding the application of securities laws to a new business venture, attorneys may make a risk-based assessment of the costs of non-compliance and likelihood of enforcement. The normal course by conservative, risk-averse legal counsel would be to request a no-action letter from the SEC when there’s uncertainty about a proposed business. Announcing to the world you’re relying on inapposite guidance falls on the other extreme of that spectrum.

A note on Cable Car’s Blog

You may be forgiven for wondering why this site has hosted no new blog posts for more than a year, and now all of a sudden it’s a priority to write dry legal analysis of a cryptocurrency scheme that may well disappear on its own. Other than short sales of public companies that claim to be developing blockchain-related projects, Cable Car does not even invest in crypto. My interest in the sector has been motivated by broader concerns regarding investor protection and securities regulation.

With the launch of The Funicular Fund, LP last year and the firm’s transition away from managing separate accounts, I had administrative priorities that took precedence over this soapbox. What thoughts I’ve wanted to share publicly have been diverted to Cable Car’s letters, public comments, and the instant gratification of Twitter’s echo chamber.  However, the purpose of this blog remains to share opinions with the investment community that do not fit neatly into another forum. I’ll continue to do that when I get the chance! Feedback remains very much appreciated. As before, no content on this blog should be considered investment advice or an offer of securities. It is certainly not legal advice, either.

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2 thoughts on “No Basis for Trust

  • Reply
    Jacob Ma-Weaver Post author

    I am grateful to a number of attorneys for an engaging discussion of this post on Twitter (thread). While no one defended the applicability of the gold bullion no-action letters to the analysis of whether TrueUSD is a security, some of the more interesting comments raised the question of whether the Howey test for investment contracts is the most relevant standard for evaluating a stablecoin. Above, I argue that the coordinated efforts of stablecoin issuers and cryptocurrency exchanges, among others, to facilitate investment activity, provide custody services, and maintain a peg constitute an investment contract and a common enterprise.

    However, as commenters noted, a stablecoin might not be considered an investment contract. Instead, it might instead be a “note” which could still be considered a security under the “family resemblance” test developed by the Supreme Court in Reves v. Ernst & Young. A good primer on the test is available here.

    Of the four Reves factors, the plan of distribution factor most clearly favors the interpretation that a stablecoin is a security because it is intended to be exchange traded. On the other hand, the presence of an alternative regulatory regime such as that governing money transmission could potentially obviate the need for the application of securities law. However, I am skeptical that MSB registration of the issuer significantly reduces the risk of investing in stablecoins on unregulated cryptocurrency venues. Considering the expectations of the buyer and seller and the broader investing public, Reves does not give a definitive indication of whether or not a stablecoin is a security. It’s not enough for an issuer to make a conclusory statement that it is not, nor for me to make a conclusory statement that it is. My hope is that regulators and the investing public will give the matter further consideration.