No, ether is not a security.
Understanding the difference between a token pre-sale and the token itself
As Gary Gensler, former Chairman of the CFTC, said today at the MIT Technology Review Business of Blockchain conference, ether might be classed as a security. His message is important; uncertainty abounds because of the flexible nature of the Howey test, which the SEC would employ to classify a token sale as an investment contract and therefore a security.
We believe, however, that ether, as it exists today, is not a security. Gensler himself suggested why this could be the case when he distinguished between the Ethereum Foundation in 2014 and the Foundation and the Ethereum network, as a whole, today. Reliance on the efforts of a promoter is a key prong of the Howey test. In a token presale there’s reliance on an issuer and maybe the Foundation in 2014 fits that bill. But today, the value of ether and the functionality of the Ethereum network is not reliant on the Foundation, rather it flows from the efforts of thousands of unaffiliated developers, miners, and users. That decentralization is hard to differentiate from Bitcoin’s, a cryptocurrency Gensler suggested is almost certainly not a security for the very reason we’re discussing: no discernable third party (no common enterprise) upon whom we rely for any expectation of profits.
As we’ve said before, it’s possible for a useful decentralized token to not be a security even if it originated in a pre-sale or ICO that qualified as securities issuance. Confusion here is reasonable because the law is complicated and our community keeps adopting less than helpful terminology and using it without precision:
had an ico or is an ico?— Peter Van Valkenburgh (@valkenburgh) March 15, 2018
Securities are legal relationships between issuers and investors. Securities are not the paper on which a contract or other legal relationship is printed; nor are securities the spreadsheet entries that demark fractional ownership of a business; nor are securities any of the ones and zeros the arrangement of which may represent the terms of the deal. Nor are securities the assets that are derived from an investment deal: just because Apple uses invested money to build iPhones doesn’t mean that the iPhones are securities.
And, no, a useful decentralized token itself, like ether, is not a security, regardless of how it was originally sold or how funds were originally raised to build it. Again, a security is the contractual relationship between issuer and investor, nothing more. With that out of the way, what about the contractractual relationships that surrounded ether’s original development and distribution and what about that relationship today?
In 2014, the Ethereum Foundation solicited money and may have (tacitly or otherwise) promised to develop software with that money, which—when run by miners—would award donors with newly invented scarce digital tokens. This relationship: money for software development and token delivery contingent on miners running that software may have been a binding contract and that contract may fit the test for an investment contract under U.S. securities law. So yes the pre-sale agreement may fit the test for securities (though there is a good case to be made that it does not).
However, even if the initial agreement to develop and distribute ether is a security, ether itself, once it was a real token that people could use and hold, was not a security, and ether today is not a security. The token is distinct from the agreement that funded its development, and while the agreement might fit the test for securities, the token does not. Why? Lots of reasons:
- Spreadsheet vs. Blockchain: Presale-rights were evidenced by private records kept by the Ethereum Foundation. Actual token ownership is evidenced by the decentralized Ethereum blockchain.
- Profit vs. use: Presale rights were useful exclusively as a marker of future value owed to the holder. Ether was and is useful for peer-to-peer currency-like transactions, for paying for use of the Ethereum virtual machine, and as a reward for miners who maintain the system.
- Reliant on the few vs. the many: The pre-sale terms, recordkeeping, and promised efforts of the Foundation were dependent on a small number of individuals. The running ethereum network’s continued vitality is dependent on hundreds of independent software developers, thousands of independent nodes, and millions of users.
In short, separate and apart from any investment contract that may or may not have existed at the birth of Ethereum, ether today is too useful and too decentralized for it to fit the relevant test for treatment as a security. Conflating the pre-sale and the running network is confused analysis that could be misunderstanding the tech or the law or both.
To hammer it home: take the facts of the Howey case (from which we get the court-made law upon which this all turns) and make a small change. As before, Mr. Howey convinces people to give him money for land in Florida; he says they own the land and he says he’ll maintain the orange trees that grow on the land. But, instead of promising to pay investors profits from selling the oranges at market, he promises to give them the oranges. This fact does not change the outcome in Howey—the court would still have found that investment contracts for an orange grove in Florida had been sold—but, of course, the oranges themselves would never have been found to be securities. If one of the resultant oranges ends up in a grocery store, you don’t need a broker dealer to buy it for you. People know this intuitively with oranges and other scarce physical things (of course this inert object I hold in my hand isn’t a security—it’s just a thing), but many haven’t yet internalized that scarce digital things now exist and the same reasoning applies.