Jake Chervinsky on Why Ethereum’s Move to PoS Doesn’t Trigger U.S. Securities Laws

Earlier this week, Jake Chervinsky, Executive Vice President and Head of Policy at Blockchain Association, Advisor at Variant Fund, and Board Member at DeFi Education Fund — along with Rodrigo Seira and Amy Aixi Zhang, who are Crypto Counsel and Policy Counsel at Paradigm, dismissed the notion that “staking somehow makes ETH a security.”

On 15 September 2022, the day that Ethereum completed its Merge upgrade, i.e. its transition from proof-of-work (PoW) to proof-of-stake (PoS), Michael Saylor, Co-Founder and Executive Chairman of business intelligence software company MicroStrategy Inc. (NASDAQ: MSTR), implied that $ETH could get classified as a security (rather than a commodity) by the U.S. Securities and Exchange Commission (SEC).

After Ethereum’s Merge upgrade was completed in the early hours of September 15, several influential Bitcoin maxis expressed their reaction to this event.

Saylor, who is a Bitcoin maxi (i.e. believes that — with the exception of fiat-backed stablecoins such as Tether ($USDT) — Bitcoin is the only legitimate cryptocurrency), sent out a tweet in response to comments by SEC Chair Gary Gensler’s most recent comment on PoS cryptocurrencies that suggested he expects the SEC to eventually declare that $ETH is a security (unlike $BTC which they have publicly called a commodity and therefore not subject to U.S. securities laws).

The Wall Street Journal (WSJ) report that Saylor was referring to in his tweet says that “Ethereum’s big software update on Thursday may have turned the second-largest cryptocurrency into a security” in the eyes of the SEC. According to the WSJ report, although Gensler did not specifically mention Ethereum, he said yesterday that the native assets of PoS blockchains could pass the Howey Test since it was possible to view staking as an “investment contract” because “the investing public is anticipating profits based on the efforts of others.”

Here is how Investopedia explains the Howey Test:

The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an ‘investment contract,’ and therefore would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. Under the Howey Test, an investment contract exists if there is an ‘investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.’

The following day, Chervinsky, who was General Council at Compound Labs before joining the Washington, D.C. based Blockchain Association, which represents “the reputable leaders of the US blockchain and cryptocurrency industry”, took to Twitter to defend Ethereum’s move to PoS consensus by explaining why despite what some people may think why the Merge has not turned $ETH from a commodity to a security.

Chervinsky went on to say:

The general idea seems to be ‘if you squint hard enough, staking sort of looks like a dividend or interest, & some actual securities have those, so maybe staked assets are securities too.’ That’s not how the law works. That just means holders of staked assets expect profit…

which alone doesn’t make the assets into securities. Expectation of profit is only one of four Howey test prongs & likely the least important for volatile assets (i.e., non-stablecoins). People hold all kinds of assets with an expectation of profit. Gold, cars, watches, etc.

In other words, expectation of profit is a feature of all investable commodities, not just securities. Whether that profit comes in the form of an increase in market price, a staking reward, or any other mechanism should make no difference to the securities analysis.

A short time later, he went even further, and suggested that rather than the Merge being a mistake, it is win for Ethereum since it reduces the chance that the SEC will classify $ETH as a security:

Well, on October 5, Rodrigo Seira, Amy Aixi Zhang, and Jake Chervinsky published a blog post (titled “Ethereum’s New ‘Staking’ Model Does Not Make ETH A Security”) that explained why “Ethereum’s adoption of a proof-of-stake consensus mechanism does not make ETH (or even staked ETH) an investment contract, and such a finding would result in a nonsensical application of securities laws.

They first talked about the Howey Test:

The Securities Act of 1933 enumerates the types of instruments that constitute a “security,” which include an ‘investment contract.’ As defined by the Supreme Court’s seminal opinion in Howey, an ‘investment contract’ entails (1) an investment of money; (2) in a common enterprise; (3) with the reasonable expectation of profits; (4) derived solely from the efforts of others. In order to meet this definition, a contract, scheme, or transaction must satisfy each of the four prongs.

They then went on to talk about the application of the Howey Test to staking in Ethereum:

Ethereum’s adoption of a proof-of-stake consensus mechanism has led various commentators to suggest that ETH, or more specifically the act of staking ETH, could meet the definition of an investment contract under Howey. The argument takes the following structure: staking ETH as a validator meets the Howey test because a validator is (1) ‘investing money’ by locking up 32 ETH to stake, (2) in a ‘common enterprise’ comprised of the various parties participating in the validation process, (3) with the expectation of receiving profits in the form of staking rewards, (4) that are derived from the efforts of other validators or other parties participating in the validation process.

Putting aside whether a validator depositing ETH into a smart contract would qualify as an ‘investment of money,’ the argument that Ethereum’s adoption of proof-of-stake results in ETH being deemed an investment contract fundamentally misinterprets the second and fourth prongs of Howey, and the failure of either prong is fatal. The conclusion would also result in an absurd and unnecessary application of securities laws because there is no issuer or promoter with privileged access to information who could or should be forced to make disclosures.

They concluded their paper by saying that “analyzing the economic realities of staking ETH on Ethereum’s proof-of-stake network, a court should find that staking fail to satisfy the Howey test because there is no ‘common enterprise’ and validators are never relying on the ‘efforts of others’.” Furthermore, they mentioned that “there are also questions about whether depositing ETH to stake would qualify as an ‘investment of money.’ They also pointed out that “failure to meet any of the four Howey prongs would entail that the transaction is not an investment contract and therefore not a securities transaction.”

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