Why Ethereum’s Switch to PoS Is Exempt from U.S. Securities Laws, by Jake Chervinsky

As well as Rodrigo Seira and Amy Aixi Zhang, who are the crypto counsel and policy counsel at Paradigm, Jake Chervinsky, executive vice president and head of policy at Blockchain Association, advisor at Variant Fund, and board member at DeFi Education Fund, rejected the idea that “staking somehow makes ETH a security” earlier this week.

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

Several significant Bitcoin maxis responded to the completion of Ethereum’s Merge upgrade in the early hours of September 15.

Saylor, a Bitcoin maxi who thinks that Bitcoin is the only legal cryptocurrency, barring fiat-backed stablecoins like Tether ($USDT), tweeted in response to SEC Chair Gary Gensler’s most recent remarks on proof-of-stake cryptocurrencies, in which he implied that he anticipates the SEC will eventually declare that $ETH is a security (in contrast to $BTC, which they have publicly called a commodity and is therefore exempt from U.S. securities laws

According to the Wall Street Journal (WSJ) article, “Ethereum’s significant software change on Thursday may have turned the second-largest cryptocurrency into a security” in the eyes of the SEC, as stated in Saylor’s tweet. Gensler reportedly stated yesterday that the native assets of PoS blockchains could pass the Howey Test even though he did not specifically mention Ethereum because it was possible to view staking as a “investment contract” because “the investing public is anticipating profits based on the efforts of others,” according to the WSJ report.

The Howey Test is described as follows by Investopedia:

“The Howey Test is the standard used by the U.S. Supreme Court to determine whether a transaction qualifies as a “investment contract,” in which case it would be regarded as a security and subject to the disclosure and registration requirements set forth by the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the Howey Test, if there is “an investment of money in a joint venture with a reasonable expectation of gains to be obtained from the labor of others, an investment contract exists.

The following day, Chervinsky, who previously served as General Council at Compound Labs before joining the Blockchain Association in Washington, D.C., defended Ethereum’s switch to PoS consensus on Twitter by arguing that, contrary to what some may believe, the Merge has not transformed $ETH from a commodity into a security:

Chervinsky continued, saying:

The general notion seems to be that staked assets may qualify as securities if you look closely enough since they resemble dividends or interest, which some real securities pay. The law doesn’t operate that way. That merely indicates that owners of staked assets anticipate profit, which by itself does not transform the assets into securities. One of four Howey test prongs, expectation of profit is arguably the least significant for volatile assets (i.e., non-stablecoins). People invest in a variety of assets with the hope of making a profit. Gold, vehicles, timepieces, etc.

In other words, not just stocks but all investable commodities have the expectation of profit. It shouldn’t matter to the securities analysis if the benefit comes from a rise in market price, a staking reward, or some other method.

A short while later, he went further and said that, rather than the Merge being a mistake, it is a gain for Ethereum because it lowers the likelihood that the SEC will categorize $ETH as a security:

The reason for this is that “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,” according to a blog post written by Rodrigo Seira, Amy Aixi Zhang, and Jake Chervinsky that was published on October 5.

The Howey Test was initially brought up:

The Securities Act of 1933 lists the several kinds of instruments that are considered “securitys,” and one of those is a “investment contract. An “investment contract,” as the Supreme Court described it in its landmark Howey decision, includes the following elements: (1) an investment of money; (2) participation in a joint venture; (3) a reasonable expectation of profits; and (4) earnings generated primarily from the labor of others. A contract, scheme, or transaction must satisfy each of the four requirements in order to meet this definition.

They continued by discussing the Howey Test’s application to Ethereum staking:

“Various commentators have suggested that Ethereum, or more precisely the act of staking Ethereum, could fit the definition of an investment contract under Howey because of the adoption of a proof-of-stake consensus mechanism. The argument is organized as follows: Staking ETH as a validator satisfies the Howey test because a validator is (1) “investing money” by setting aside 32 ETH to stake, (2) participating in a “common enterprise” made up of the different parties involved in the validation process, (3) expecting to receive rewards for staking, and (4) doing so with the expectation of profiting from the labor of other validators or other parties involved in the validation process.

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. Putting aside the question of whether a validator depositing ETH into a smart contract would qualify as a “investment of money,” Because no issuer or promoter with special access to information could or should be required to make disclosures, the conclusion would likewise lead to an irrational and superfluous application of securities rules.

In their paper’s conclusion, they stated that “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”” after “analyzing the economic realities of staking ETH on Ethereum’s proof-of-stake network” Also raised was the issue of whether depositing ETH to a stake would count as a “investment of money,” they added. Additionally, it was noted that “failure to satisfy any of the four Howey prongs would entail that the transaction is not an investment contract and, hence, not a securities transaction.”

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