SEC Says Much of Crypto Mining Not Subject to Securities Laws
Commentary by Gage Raju-Salicki and Steven Lofchie
The SEC Division of Corporation Finance ("Division") stated that it would not regard "Protocol Mining" as involving "the offer and sale of securities."
In a public statement, the Division said it analyzed the "economic realities" of Protocol Mining under the "'investment contract' test set forth in SEC v. W.J. Howey Co." to determine whether money was invested with "a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others."
The Division asserted that both "Self (or Solo) Mining" and participation in a "Mining Pool" involve individuals using their "own computational resources" to secure the network, validate transactions and earn rewards, with profits derived from their own efforts rather than the entrepreneurial or managerial efforts of others. The Division highlighted that in solo mining, miners operate independently, while in mining pools, they combine resources to increase their chances of mining new blocks, but still earn rewards based on their own contributions. The Division concluded that whether mining solo or in a pool, miners are not relying on the "entrepreneurial or managerial efforts of others" to earn rewards.
SEC Commissioner Caroline A. Crenshaw criticized the statement saying it provided "neither progress nor clarity." Ms. Crenshaw said the statement relied on flawed logic by assuming that miners mine solely to "receive rewards," not profits from others' efforts. She emphasized that the statement limits itself by addressing only general Proof of Work mining, not its variations or specific protocols. She also noted that by issuing the statement, the Division acknowledged that a Howey analysis is needed to determine if a "specific mining arrangement" qualifies as an investment contract.
Commentary
The Division's statement clarifies something many have long believed: proof-of-work crypto mining is not a form of investment contract under the Securities Act. The statement covers both solo and pooled mining—the latter being of more interest. The Division's Howey analysis of pooled mining "efforts" indicated that pooling computational resources is merely an administrative or ministerial activity. To that end, the Division also noted that "a pool operator's activities in operating the mining pool using the combined computational resources of participating miners primarily are administrative or ministerial in nature." Moreover, the Division stated that "whether a miner self (or solo) mines or mines as a member of a mining pool does not alter the nature of Protocol Mining for purposes of the Howey analysis." Accordingly, the crux of this analysis appears to be providing/relying on computational resources and the nature of immutable proof-of-work protocols (like Bitcoin).
What the Division relies on, then, is aligned to a growing movement in "crypto law": the notions of decentralization and immutability. The Fifth Circuit relied heavily on the concept of immutability in Van Loon, while the Second Circuit in Risley relied on decentralization. To that end, if you operate a mining pool, this statement provides strong support for arguing that the activity does not implicate securities laws.
More interesting, however, is the omission of and potential implications for proof-of-stake consensus mechanisms endemic to this statement. If a proof-of-stake mechanism (such as Ethereum) functions kind of like a giant mining pool—in the most simplified terms—and is decentralized, are proof-of-stake activities exempt from securities law as well? The underlying technology isn't really that different for staking: the protocol cannot be changed, and one of the only major differences is that block rewards are randomized proportional to staked assets. That said, footnote 8 of the Division's statement exempts "proportional" mining models. The logic of the Division's analysis lends itself well to an analogous argument that staking should be exempt from securities laws.
Commentary
Commissioner Crenshaw's bleak and dismissive statement as to the new Staff guidance appears as to be an attempt to defend the SEC's complete failure to develop any meaningful legal analysis of when or why activities involving cryptocurrencies are subject to the securities laws.
Ms. Crenshaw trivializes the new guidance by pointing out that its application to mining activities is subject to a "limitation: one actually would have to conduct a Howey [test] analysis to know if a specific mining arrangement constitutes an investment contract" and, thus, a security subject to the securities laws. In other words, she argues that the new guidance does not actually represent any change in the law. What this criticism misses is that no one ever disputed the continuing validity of Howey and its potential application to cryptocurrency activities. The criticism of the SEC under Chair Gensler was that no attempt was ever made to explain in what situations Howey might be relevant to cryptocurrency. To the extent that the SEC applied the analysis, it determined the Howey test was satisfied if a purchaser of crypto hoped to make money or had any possibility of making money by the purchase. That cursory analysis simply is bad law, and not remotely an accurate statement of Howey.
Commissioner Crenshaw's second criticism, consistent with the first, is that the statement is too limited because it requires a "facts and circumstances" analysis. But that is simply the way the securities laws work; they always require a facts and circumstances analysis. In fact, the definitions section of the Securities Exchange Act (SEA Section 3) begins with the prefatory statement that the following terms have the following meaning "unless the context otherwise requires[.]"
If Commissioner Crenshaw wanted to really challenge the SEC statement, she might have made an argument (i) explaining why she believes the described mining activities are securities under Howey or (ii) pointing to other relevant analysis published under the previous administration as to why the described mining activities are securities under Howey. She does neither of those things.