Patrick J. McCarty is the President of McCarty Financial LLC
For all the talk that identifying virtual currencies as “securities” adds greater comfort and stability to financial rules, there is a very (very!) big problem, and one overlooked by market participants and scholars alike: Security Investor Protection Corporation (SIPC) insurance coverage does not cover virtual currency tokens even if they qualify as “investment contracts” under the Howey Test. This is because most virtually currency tokens don’t qualify as “securities” under the Security Investor Protection Act of 1970, as amended (SIPA).
This article for fintechpolicy.org is intended to let readers know just what the consequences are for this little known state of affairs—and how we got there.
Virtually all SEC registered broker-dealers are required to be members of the SIPC – and a total of 3700 are members of SIPC according to their website. SIPC was created in 1970 to provide “insurance” for a “customer’s cash and securities” which are held in the SEC registered broker/dealer which is a SIPC member when it goes into liquidation. See the Securities Investor Protection Act of 1970, 15 U.S.C. 78aaa et seq. SIPC insurance coverage is up to $500,000 in “securities,” including a maximum of $250,000 for “cash,” subject to some “exceptions” and “clarifications” discussed below.
The SIPC focuses on the “custody” function which SEC registered broker-dealers provide for customers’ “cash and securities.” Most US investors who buy and sell securities become “customers” of an SEC registered broker-dealer. The broker dealer is responsible for opening the securities accounts, receiving and transmitting cash, processing customer buy and sell orders, safekeeping cash, issuing confirmations, etc. consistent with the SEC’s Customer Protection and Net Capital Rules.
Since its creation in 1970, SIPC has returned to investors over $1.37 Billion in “cash and securities” which was held in the 325 SEC registered broker/dealers which have been put into SIPC liquidation. Over the last 10 years SIPC is averaging approximately 1.3 broker/dealer liquidations per year.
SIPC Coverage Limitations
While SIPC has provided significant assistance and protection for securities investors, there have been some recent high profile SIPC liquidation cases – most notably the Stanford Antiguan Bank CD and Madoff Ponzi scheme cases – where investors have been sorely disappointed by lack of SIPC insurance coverage. Policy makers and investors need to understand that SIPC is an insurance company and SIPC insurance is “limited” to the “cash and securities” of investors who qualify as “customers” of a SEC registered broker dealer which is in SIPC liquidation proceedings. You may have heard the old joke that insurance companies exist for 2 reasons: First, to collect insurance premiums and two to deny insurance claims. While that may seem funny, it isn’t funny for the disappointed investors who have securities accounts through SEC registered broker dealers and who thought they had SIPC insurance coverage. The Courts have repeatedly sided with SIPC and it’s narrow reading of the SIPA statute and it’s coverage of “customers cash and securities.”
I would note that SIPC goes to great lengths to explain on it’s website the “limits” on SIPC insurance coverage which only covers “cash and securities.” SIPC states very clearly on its website that it doesn’t cover gold or silver coins, commodities, or futures contracts (unless in an SEC approved portfolio margining account). Foreign currencies held in a securities account may be covered but only if they are proceeds from sale of a security or circumstances show that the foreign currency will be used to purchase securities. Interestingly, certificates of deposit are defined as being “securities” under SIPA, but SIPC provides coverage only if the CD is held by the customer in their securities account (which wasn’t the case in the Stanford scandal). See SIPA “security” definition and Stanford litigation.
As of February 1, 2019 there are just over 2,100 separate cryptocurrencies or tokens in existence with a total market capitalization of just over $114 Billion. See CoinMarketCap.com. The value/market capitalization of cryptocurrencies is very highly concentrated. The top 10 cryptocurrency tokens have a market cap of $97.2 billion which is 85% of the total $114 Billion market capitalization. And it should be noted that Bitcoin and Ether – by themselves – have a market capitalization of $72 billion or 63% of the total market capitalization. Excluding the top 10 coins/tokens by market capitalization leaves the remaining 2,090 coins/tokens having a total value of just $17 billion.
In July 2017 the SEC released the DAO Token Investigative Report which determined that the cryptocurrency/DAO tokens in question were in fact “investment contracts” under the Howey Test and therefore “securities” for purposes of the federal securities laws. The DAO Token Investigative Report determination was with respect to the DAO Tokens being “investment contracts” under the Securities Act of 1933 and possibly the Securities Exchange Act of 1934. There was no discussion of SIPA or SIPC coverage/ applicability in the DAO Token Investigative Report. The SEC entered into several settlements in late 2018 which found that many other cryptocurrency tokens were also “investment contracts/securities” and therefore required compliance with various aspects of the federal securities laws. See In the Matter of Zachary Coburn, Securities Exchange Act of 1934 Release No. 84553 (Nov. 8, 2018) Admin Proceeding File No. 3-18888; In the Matter of CARRIEREQ d/b/a AIRFOX, Securities Act of 1933 Release No. 10575 (Nov. 16, 2018) Admin Proceeding File No. 3-18898 and In the Matter of Paragon Coin, Inc.,Securities Act of 1933 Release No. 10574 (Nov. 16, 2018) Admin Proceeding File No. 3–18897).
The Bad News about SIPC Coverage for Cryptocurrency Tokens
The SEC has made clear that they consider virtually ALL cryptocurrency ICOs to be “investment contracts” which are “securities” under the federal securities laws. This has created the impression that any person/entity that [holds] cryptocurrency tokens/ products deemed to be investment contracts are (or should be) eligible for SIPC insurance. Indeed, it is even implied by a number of recent SEC enforcement actions in the cryptocurrency space and efforts to require crypto exchanges to either register as national securities exchanges or become registered broker dealers and operate under regulation ATS.
However, SIPC insurance is unlikely. Most “cryptocurrency tokens” are either a) not “securities” according to the SEC or b) those cryptocurrency tokens which are “investment contracts” don’t meet the “security” definition under SIPA (which is different and narrower than the definition in the 1933 and 1934 Acts!) and therefore wouldn’t be covered by SIPC insurance.
Most virtual currencies are not securities
As noted above, the SEC – through SEC Chairman Jay Clayton and SEC Director of the Division of Corporate Finance Daniel Hinman – has stated publicly that Bitcoin, Ether and presumably their hard forks, are not securities. Clayton CNBC interview June 6, 2018 and Hinman Speech Digital Asset Transactions, When Howey met Gary (Plastics) June 14, 2018. These major cryptocurrency tokens, even if held in a securities account by an SEC registered broker dealer who is a member of SIPC, would not be entitled to SIPC insurance coverage because they are not securities. So Bitcoin, Ether and their hard forks (approximately 10-15 tokens) representing at least 63% to 70% of the cryptocurrency market capitalization would not be eligible for SIPC insurance. Stated another way, two thirds of the cryptocurrency world – by market capitalization – is not within the SEC’s jurisdiction and not covered by SIPC insurance. It is quite possible, however, that the SEC will assert that many of the remaining 2,090 cryptocurrencies tokens – with $17 billion or 33% of the market capitalization – are “investment contracts/securities” and therefore subject to their jurisdiction. Unfortunately, as discussed in detail below, it appears that even those cryptocurrency tokens which are eventually determined by the SEC to be “investment contracts/securities” under the 1933 and 1934 Acts, will not be eligible for SIPC insurance coverage unless the definition of “security” in SIPA is amended/broadened dramatically.
Almost All Cryptocurrency Tokens ICOs are Unregistered Offerings
SIPA’s coverage is quite clear. Notably, its definition of the term “security” diverges in part from those provided under the other federal securities laws (the 1933, 1934 and the two 1940 Acts) and while the definitions are very “close,” they are different and sometimes in very material ways – as is the case here.
The SIPA definition of “security” and the part related to “investment contracts” is defined as:
“any investment contractor certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or mineral royalty or lease (if such investment contract or interest is the subject of a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933 [15 U.S.C. 77a et seq.])” 15 USC 78lll(14)
Critically, not all “investment contracts” are considered to be “securities” for purposes of insurance coverage under SIPA. Id. Under SIPA only those “investment contracts” which “is (are) the subject of a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933” would be a “security” which receives SIPC insurance coverage. Id. This means only “investment contracts” with SEC “registered” securities (and I’m assuming such registration statements have to be “effective” as well to be covered) are provided SIPC coverage. On it’s face, the SIPA definition would exclude “investment contracts” which are offered/sold as private placements (which is quite common for limited partnerships, real estate investment trusts and hedge funds, among others.)
Obviously the SIPA definition of “investment contracts” which qualify as “securities” eligible for SIPC coverage is narrower than the definition of “security” both the Securities Act of 1933 and the Securities and Exchange Act of 1934. Several US Courts of Appeal and Federal District Courts have considered the SIPC coverage issue and consistently concluded that “investment contracts,” such as limited partnership interests, real estate investment trusts and pooled investment vehicles, which are not “registered” with the SEC do not qualify as “securities” under SIPA and therefore do not receive SIPC insurance. See Brentwood Sec. Investors v. Pepperdine University, 925 F.2d 325 (9thCir. 1991); In re Primeline Securities Corp. v. SIPC, 295 F.3d 1100 (10thCir. 2002), Mitchell v. Chicago Partnership Board, Inc., 246 B.R. 854 (N.D. Ill. 2000), In re Omni Mutual Inc., 193 B.R. 678 (S.D.N.Y. 1996).
The analysis in the 2000 Mitchell case is instructive. The Mitchell case involved a customer of a failed SEC registered broker dealer who had invested in unregistered limited partnership interests and claimed SIPC insurance coverage. The Court examined the SIPA statutory definition of the term “security” and discussed whether limited partnership interests should be classified as “investment contracts” which are “securities” under the SIPA. Id. The Mitchell court, in denying the customers claim under SIPC, discusses the legislative history of SIPA and shows that there was clear Congressional intent to limit SIPC coverage to only those “investment contracts” which had filed registrations statements with the SEC under the 1933 Act. Further, the Mitchell court rejected the argument that unregistered limited partnership interests/investment contracts would nonetheless qualify as “securities” under the phrase “and any other instrument commonly known as a security.” The Court stated that well accepted rules of statutory construction – the specific (“investment contract” limitation) overrules the general (“any other instrument commonly known as a security” language) – dictated this argument didn’t work. See 15 USC Sec. 78lll(14)
These observations are important because SIPA only covers an “investment contract” where there is a registration statement under the Securities Act of 1933 with the Commission that is effective. That is, SIPC insurance arises if, and this is a big “if,” the cryptocurrency tokens are the subject of a registration statement with the Commission under the Securities Act of 1933 – in other words a “public offering.”. But this means that the number of tokens eligible for SIPC insurance would be miniscule!?
In 2018, Chairman Clayton noted that “no” ICOs had filed a registration statement with the SEC. While the cryptocurrency token ICO “industry” apparently started to paper ICOs as “private placements” in mid to late 2017 due the SEC Chairman’s comments, no formal registration statements under the Securities Act of 1933 have been filed and gone effective for a true public offering. The clear language of the “security” definition in SIPA only covers investment contracts which are subject to a registration statement with the Commission under the Securities Act of 1933 so any cryptocurrency ICO private placements under Regulation D, Regulation A+ and Regulation Crowdfunding won’t, or shouldn’t, receive SIPC insurance coverage. See In re Primeline Securities Corp. v. SIPC and related cases cited above. So while the securities lawyers may have cured part of the cryptocurrency ICO securities offering problem, they probably haven’t done enough to bring cryptocurrency ICOs tokens within SIPC insurance coverage. Based on clear statutory language, Congressional intent and consistent Court decisions SIPC could, and probably would, deny insurance coverage for any “unregistered” cryptocurrency ICO token even if it is held in a securities account at an SEC registered broker dealer which is a member of SIPC. Ouch!
Only 3 Cryptocurrency Tokens may Qualify For SIPC Insurance
There are only 3 cryptocurrency tokens/investment contracts in existence today which may meet the test for SIPC insurance. As noted above, SEC Chairman Clayton has stated several times that no cryptocurrency token ICOs have filed or attempted to register their “securities” with the SEC. I have not seen any press releases or public statements announcing that a cryptocurrency token ICO has filed a registration statement with the SEC under the Securities Act of 1933 so I’m assuming that remains the case. Despite this there are 3 cryptocurrency tokens which will have SEC “registrations” in effect soon and would have the strong (but I believe ultimately unsuccessful) arguments to be entitled to SIPC insurance.
In November 2018 the SEC announced settlements with 2 issuers of cryptocurrency tokens – CARRIEREQ, INC d/b/a AIRFOX and Paragon Coin, Inc. In the Matter of CARRIEREQ d/b/a AIRFOX, Securities Act of 1933 Release No. 10575 (Nov. 16, 2018) Admin Proceeding File No. 3-18898 and In the Matter of Paragon Coin, Inc., Securities Act of 1933 Release No. 10574 (Nov. 16, 2018) Admin Proceeding File No. 3 – 18897). The SEC Settlement Orders analyze the Airfox Token and the Paragon Token and conclude that both are “investment contracts” under the Howey Test and therefore “securities” for purposes of the 1933 Act and 1934 Act. As part of the Settlements, AirFox and Paragon agreed to file within 90 days of the Order a Form 10 and register their cryptocurrency tokens as a “class of securities” under Sec. 12(g) of the Securities Exchange Act of 1934.
The Form 10 1934 Act filing – which requires submission to the SEC of periodic reports such as Forms 10Ks and 10Qs with required disclosures as well as compliance with proxy statements rules – is “not” the same thing as filing a Form S-1 registration statement under the Securities Act of 1933 for a public offering of securities/tokens. So, both Airfox Tokens and Paragon Tokens will be, once the Form 10 is filed with the SEC and deemed effective, “investment contracts” which are the subject of a registration statement with the Commission.
Instead, such registration statements will be under the Securities Exchange Act of 1934, and not under the Securities Act of 1933, which is what is necessary for one to meet the statutory SIPA definition of “security.” As noted above, SIPC and the Courts have consistently taken a very limited, as opposed to expansive, view of eligibility for SIPC insurance coverage. This is clearly the case with respect to “unregistered” investment contracts. It is highly likely that SIPC will deny insurance coverage for the Tokens because the Form 10 1934 Act registration does not meet the SIPA statutory “registration statement with the Commission under the Securities Act of 1933” requirement. Based on the consistent case law discussed above, the Courts will most likely uphold SIPC’s technical reading and denial.
A 3rd cryptocurrency security token could find itself in a position similar to AirFox and Paragon soon. tZero, a majority owned subsidiary of Overstocks.com, completed a “unregistered” offering of security tokens in December 2018 – raising $134 million from roughly 1,000 investors. Citation. It is highly likely that tZero will need to register it’s security tokens as a “class of securities,” via Form 10 filing under the 1934 Act, since it has over 500 shareholders. As of February 1, tZero has not filed a Form 10 registration under the 1934 Act. Presumably the tZero security token holders would be in exactly the same SIPC insurance position as the AirFox and Paragon Token holders once the Form 10 is filed and effective.
It appears that only 3 of over 2,100 cryptocurrency tokens today have, or will have, any type of SEC “registration” in effect. It is possible, but not probable, that SIPC will consider a cryptocurrency token Form 10 1934 Act registration to meet the SIPA “investment contract” requirements for purposes of providing SIPC coverage. If SIPC takes this expansive view, it would be a good start – and possibly a road map – in terms of providing cryptocurrency tokens with some level of SIPC protection. On the other hand, if SIPC sticks with the plain statutory language in SIPA requiring investment contracts to have a registration statement under the Securities Act of 1933 it means no tokens are eligible for SIPC insurance today and the only way to change this is through ICOs doing full fledged public offerings – which the cryptocurrency token/ICO world has resisted strongly.
There is a gaping cryptocurrency “hole” in the SIPC Insurance scheme today. The reality is that none of the over 2,100 cryptocurrency tokens with a $114 billion market capitalization today qualify for SIPC coverage regardless of whether they are held in a securities account by an SEC registered broker dealer who is a member of SIPC. This is due to the SEC either saying a) the cryptocurrency tokens are not securities (Bitcoin, Ether and presumably their hardforks) or b) those cryptocurrency tokens which are “investment contracts” don’t have an effective registration statements at the Commissioner under the Securities Act of 1933. To date, virtually all cryptocurrency token ICOs have been done as unregistered private placements – not public offerings with registration statements under the Securities Act of 1933 – and therefore are NOT covered by SIPC. Investors who hold cryptocurrency tokens in their securities accounts with an SEC registered broker dealer who is a member of SIPC will be exceedingly annoyed/disappointed when SIPC denies their insurance claim, as one should expect them to do based on the SIPA and existing case law. There is sure to be a lot of yelling and screaming at SIPC and the SEC (and possibly Congress).
The SEC needs to recognize the cryptocurrency “hole” in SIPA/SIPC and make some quick decisions about how to proceed. Among the questions/approaches possible: Should the SEC take a targeted approach and propose to amend the SIPA so that it expands coverage to cryptocurrency tokens generally – as was done with CDs? What impact would this have on SIPC’s traditional limited coverage for only “cash and securities” approach? Will such an approach require SIPA/SIPC changes with respect to other financial products? For instance, foreign currencies held as investments, commodities, futures contracts? Should the SEC propose to amend the SIPA definition of “security” so that all “investment contracts” – even unregistered ones – are covered by SIPC? This would be narrower fix than covering all cryptocurrencies but could raise significant policy questions. On the plus side, this approach would bring SIPA’s definition in line with the 1933 and 1934 Act definitions on “investment contracts.” On the negative side, such a change would significantly broaden SIPC insurance coverage to other unregistered investment contracts such as hedge funds, limited partnerships, real estate investment trusts, and other private placements. This could lead to much higher SIPC insurance premiums for member broker-dealers. Or is it the case that the SEC is comfortable with the status quo: “unregistered” investment contracts do not get SIPC coverage? Does the SEC believe that SIPC insurance should be reserved solely for those investment contracts which register their securities with the Commission under the Securities Act of 1933? It’s not clear where the SEC stands.
These are important questions which could have a significant (negative) impact on a lot of US investors. The SEC needs to consider these issues and should act quickly before US investors are unpleasantly surprised/harmed. At a minimum, the SEC needs to publicly recognize that the SIPC “issues” exist. Let the debate begin!