In these times of bipartisanship, any bill that includes sponsors from both sides of the aisle is remarkable. There is currently one outstanding that is particularly important in the crypto space. On March 8, 2021, H. R. 1628, the Token Taxonomy Act of 2021, was introduced by Representative Warren Davidson. It was co-sponsored by representatives Ted Budd, Darren Soto, Scott Perry and Josh Gottheimer.
Provisions of the Token Taxonomy Act of 2021
Among other things, the draft law would exclude “digital tokens” from the definition of security and prevent inconsistent government regulations. Crypto assets would have to meet certain requirements in order to qualify as “digital tokens” under this law:
- First, the interest must be created either in response to the review of the proposed transactions or according to the rules of creation, which cannot be changed by any individual or by people under common control, or “as an initial allocation of digital entities that would otherwise be are created in accordance with one of the first two options.
- Second, a transaction history for the assets must be recorded in a distributed digital ledger or data structure on which consensus can be reached through a mathematically verifiable process.
- Third, once consensus has been reached, the transaction log must resist modification by a single person or people under common control.
- Fourth, the interest in peer-to-peer transactions must be transferable, and fifth, it cannot be a representation of a traditional financial interest in a business or partnership.
Davidson has stated that the purpose of the bill is to improve the clarity of the rules. In an interview, he also suggested that if the law had been passed in previous years, “it could have prevented enforcement actions like the Security and Exchange Commission (SEC) lawsuit against Ripple Labs.” This comment takes a closer look at how the bill might actually affect certain forms of crypto.
How would Bitcoin fare?
As practically everyone in the crypto space probably knows, Bitcoin (BTC) is issued solely for mining transactions. In other words, it is created “in response to the review of the proposed transactions” and meets the first of the requirements to be a digital token. In addition, the transaction history is managed on the blockchain, which fulfills the second of the above requirements.
The whole process is designed to withstand change or change without consensus between a large and decentralized community. The entire Bitcoin network was set up as a peer-to-peer network, although numerous exchanges are now also in place to facilitate transfers. After all, Bitcoin is not affiliated with any company or partnership and does not represent ownership interest or the right to participate in the revenues.
Given these facts, Bitcoin would clearly be a digital token. Therefore, under the new definition proposed in the law, Bitcoin would be excluded from the definition of security. Additionally, under Section 2 (d) of the Act, the provisions of the State Securities Act relating to registration or the imposition of restrictions on the use of the asset would be excluded from application to Bitcoin, with the sole proviso that states would retain the authority To regulate and enforce measures based on regulations on fraud or fraud.
Since the U.S. Securities and Exchange Commission is already excluding Bitcoin from the scope of federal securities laws, this would not be a change in federal requirements. However, it would create a unified state system whereby Bitcoin would be excluded from regulation as securities with the exception of cases of fraud.
Would Ripple’s XRP be a “digital token”?
However, it is incorrect to assume that all crypto assets are considered digital tokens under the law. Consider Ripple’s XRP (and pending SEC actions against the company and its officers). For those who are not fully familiar with Ripple and XRP, the XRP ledger was completed by Ripple in December 2012, and the computer code provided for a steady supply of 100 billion XRP. At launch, 80 billion of those tokens were transferred to Ripple, and the remaining 20 billion XRP went to a group of founders.
According to the SEC’s complaint, from 2013 to 2014, Ripple sought to create a market for XRP by distributing around 12.5 billion XRP through bounty programs that paid programmers compensation for reporting problems in the XRP ledger code. From 2014 through the third quarter of 2020, the company sold approximately 8.8 billion XRP in the market and through institutional sales, and raised approximately $ 1.38 billion to fund its operations. Resales were also taking place at this point, including resales of XRP that were previously distributed to the company’s founders. So would XRP be a digital token and therefore exempt from regulation as security within the framework of the law?
Connected: SEC vs. Ripple: A Predictable But Unwanted Development
The first requirement is actually the biggest problem for XRP. The bill includes three options for the first part of the test, but it’s unclear whether XRP meets any of them. Since all tokens were issued at startup, there is no argument that XRP is created “in response to review or collection of proposed transactions”.
Additionally, with all tokens issued at launch, it is clear that Ripple or those who control the company may have changed the terms and conditions for issuing XRP. This leaves open the argument that there was “an initial assignment of digital entities that would otherwise be created according to” either of the first two alternatives, and it is doubtful that this has happened. XRP was never set up to mine, and Ripple no doubt had the option to maintain control of the asset as it owned the vast majority of it. This suggests that XRP would not actually be a digital token, although the facts may be in dispute.
It should be noted that the law also provides a very limited exemption for any “digital entity”. This is a much broader term that includes any “representation of commercial, proprietary, or access rights stored in a machine-readable format”. The exemption applies to all persons who, in good faith, believe that the digital entity is a digital token. However, it will only apply if every reasonable effort is made to halt the sale and return unused proceeds to buyers within 90 days of notifying the SEC that it has completed the interest is a security. Ripple has apparently refused to follow that course as it combats the SEC’s current enforcement action in court.
While this analysis and finding may not disappoint everyone in the crypto community, as some have long argued that XRP is not a “real” crypto asset anyway, it is a clear indication that the law does not apply to all crypto -Offers a free pass is created. Nor would it be the end of the road for Ripple, who could still argue that XRP is not an investment contract under the Howey Test.
Would Facebook’s stablecoins have been “digital tokens”?
Another illustrative example could also be important in understanding how the law would work if passed. Consider Facebook’s original proposal for Libra. On June 18, 2019, Facebook announced in a white paper that it was actively planning to launch a cryptocurrency called Libra in 2020. The entire proposal has been renamed and updated, but the terms of the original White Paper are what are considered here.
The scale was conceived by Facebook and conceived as a “stable coin”, the value of which is tied to a basket of bank deposits and short-term government bonds for a group of historically stable fiat currencies. It should be run by the Libra Association, a Swiss non-profit organization.
The Libra Association was conceived as a group of diverse organizations from around the world, including not only Facebook, but also major investors such as Mastercard, Visa, eBay, and PayPal. The original plan was to have about 100 members for the club by the scheduled launch date, each with a contribution of $ 10 million. In return, the association members would have the right to monitor the development of the Libra, its real reserves and even the governance rules of the Libra blockchain. The group of 100 could also act as a validation node for the asset.
The scale should not be degradable, but should be displayed as specified by the Libra Association. The White Paper also outlined a system that would have allowed the association to change the way the system worked, in particular to lay down rules for the issue of assets. While the association would have a relatively large number of different members with their own goals and interests, they would act through the association, which is itself a single legal entity. This means that the Libra coin (as originally thought) would not have fit into the definition of a digital token laid down in the law.
Would that mean the Libra would have been a security? As with XRP, the answer is “not necessarily”. The next step would be to ask if it would have qualified as an investment contract. Depending on how the association decided to issue the coin and whether there was an upgrade option (which seems unlikely as it should be linked to fiat currencies as a “stable coin”), the Libra coin may or may not have been an investment contract . The finding should have been based on the same Howey test that the law reportedly intended to clarify.
The definition of security to exclude digital tokens means that the SEC retains no power to regulate fraud related to transactions involving those interests, leaving most of the enforcement to agencies like the Commodity Futures Trading Commission. While the CFTC has sought enforcement against those who act fraudulently or fraudulently in the crypto spot markets (when it comes to crypto transactions and not transactions in futures or other derivatives), it lacks the resources available to the SEC .
For example, the CFTC has just announced its first enforcement action, which includes a pump-and-dump system, while the SEC’s list of previous enforcement actions for crypto includes a number of market manipulation claims alongside claims against John McAfee, the target of the recent CFTC action .
This difference can be partly explained by the relative size of the two agencies. The SEC’s 2021 budget justification plan included $ 1.895 billion in support. On the other hand, the CFTC’s budget proposal for 2021 was a relatively modest $ 304 million. Moving fraud prevention to the CFTC is therefore not necessarily prudent or sensible.
While it is clear that the proposed definition of the digital token is likely to be much simpler than the Howey test, it will not necessarily replace this analysis in all cases.
Does the Token Taxonomy Act provide more clarity? Absolutely. Avoiding inconsistent state laws could be particularly helpful in this regard. Is it safe in all cases? No, but that’s not necessarily a bad thing. Is The Deed A Good Idea? Unfortunately, probably not. An immediate exemption from registration for digital tokens can be supported. Removing them from the definition of security in the current climate where fraud remains a major concern is likely not.
The views, thoughts, and opinions expressed here are the sole rights of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Carol Goforth is a full professor and the Clayton N. Little Professor of Law in the School of Law at the University of Arkansas (Fayetteville).
The opinions expressed are those of the author alone and do not necessarily reflect the views of the university or its affiliates. This article is for general informational purposes and is not intended as legal advice and should not be construed as legal advice.