[This post has been authored by Harshit Goyal, currently in his 3rd year at National Law School of India University, Bangalore.]
Imagine that you get to know about a cryptocurrency that had been launched recently and has been selling like hotcakes. The price of this token has been on a steep rise, and thus, you also decide to invest a dear amount in it. How will you feel if the value of this cryptocurrency plummets the very next day to rock bottom? Worse, how will you feel if you get to know that the law had done absolutely nothing to prevent such a situation?
Since India does not have any explicit law regulating the Initial Coin Offerings (the “ICO”), the Reserve Bank of India had sought to prevent the aforementioned situation to arise by prohibiting all the banking enterprises from providing any support to cryptocurrency. This prohibition had practically killed the scope of ICOs, as their very purpose is to raise money for the cryptocurrency. But after the striking down of this RBI circular by the recent judgment of the Internet and Mobile Association of India v. UOI (the “IAMAI judgement”), the possibility of ICOs has arisen again. Therefore, it becomes necessary to analyze how ICOs can be regulated, so as to prevent the deception of the investors from the sham ICOs. In this post, I will analyze how the SEBI Act can be used for such regulation.
Section 11(c) of the SEBI Act, 1992 mentions the jurisdiction of the SEBI over the registration and regulation of ‘collective investment schemes’. A division bench of Allahabad High Court has ruled that to gauge whether an instrument is a ‘collective investment scheme’ or not, the court shall use the Howey Test. I shall show that since ICOs satisfy the Howey Test, they can be brought under the jurisdiction of SEBI.
How ICOs satisfy the Howey Test
The Howey Test was created by the US Supreme Court to analyze whether an instrument can be classified as an investment contract or not. As per this test, a transaction is an investment contract if it has three important features: first, it involves a money investment; second, the investor has an expectation of profit; and third, the profit is generated by the efforts of the issuer of the instrument.
The satisfaction of the first prong has been enabled after coming of the IAMAI judgment. Before this, the RBI had prohibited all banks from providing any services concerning cryptocurrencies. Since the support of legal tender currency was revoked through this move, the only option left with an investor was to buy a cryptocurrency from another cryptocurrency. But after ruling the circular as ultra vires the Constitution, the Supreme Court had directed the de-freezing of all the accounts which enabled the investors to use the legal tender money to buy the coins. Hence, the first prong of the Howey test is satisfied by the ICOs in India, as it is everywhere else where the government has not explicitly restricted the use of legal tender money.
With regard to the second prong of the test, the US Supreme Court has said that it is sufficient if the instrument is purchased with the motive of earning profits, rather than using the same as a consumer for some utility. To analyze its application on cryptocurrency, it is important to understand the types of cryptocurrencies.
In general, cryptocurrencies are broadly divided into three heads: Asset-Tokens, Payment Coins and Utility Coins. An asset-token is a cryptocurrency that is similar to bonds and is traded to earn a capital appreciation. As they openly admit the re-investing of profits in order to generate more returns for investors, they are easiest to classify as investment schemes.
On the other hand, as the names suggest, utility coins and payment coins are used to buy some utility or are used for payment purposes, respectively. Even though they do not seem to be satisfying these feature prima facie, several such coins in their initial stages are used to gain profits. This is because ICOs are carried out to raise funds for the development of platforms. When these platforms and interfaces are built completely, these coins provide a significant appreciation in the amount. It is because of this fact that many such utility and payment tokens, including the recent example of ICO of payment coin ‘Grams’, are classified as an investment contract by the Securities and Exchange Commission of the USA. Therefore, so far as the ICOs are concerned, the cryptocurrency satisfies this feature as well.
The third prong of the Howey Test is that the profit must be result from the efforts of the instrument issuer. The analysis of the second prong shows that the profit usually expected out of ICOs is of two kinds. The first kind of profit, which relates to the asset-tokens, is based primarily on how well the promoter of the cryptocurrency manages the organization issuing such coins. The second kind of profit is the one which is generated because of the further development of the platform. Hence, both kinds of profits significantly rely on the efforts of the issuer of the coins. Even in general, the profitability of an ICO depends on the issuer because the most decisive factors for it are the quality of the whitepaper, the business plan and marketing and the decision regarding target offerees, which are all the mandate of the issuer. Therefore, the third aspect of the Howey test is also satisfied by the ICOs and thus, the ICOs can be said to be validly coming under the purview of the jurisdiction of SEBI.
In the trade of cryptocurrency, the protection of investors is necessary because of two reasons: One, that cryptocurrencies, in general, have a tendency of creating tulip-maniac economic bubbles and second, that because of the nescience of the investors, the chances of fraud through ICOs are huge. For example, recently, a fraudster raised crores of rupees through the offering of a ‘Kaun Banega Crorepati coin’. In another scam, a company called Bitconnect raised millions of dollars in very little time. The value of this coin plummeted suddenly, which ultimately led to a lot of bankruptcies and suicides. But since a lot of these scams were reported only on an ex-post basis through an FIR, the investigation never resulted in fruitful results.
Therefore, it becomes extremely important that the ICOs are held under control from the very beginning. Bringing ICOs under the jurisdiction of SEBI will help in achieving this result effectively. Apart from specific rules regarding the collective investment scheme, the SEBI has framed a plethora of other regulations to fully protect investors. Hence, it is the need of the hour that the SEBI recognizes its role in the cryptocurrency market and take active steps to protect the interest of the investors.