Mr. Gensler is Wrong - Ethereum PoS 'IS NOT' a Security
General Information
In a 2018 speech, William Hinman, the former director of the SEC's Division of Corporation Finance, stated:
Based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions
[Jima, L. Empower Oversight Calls for Investigation into Hinman’s Alleged Conflict of Interest in Ripple vs. SEC Lawsuit. (Accessed October 13, 2022)].
Now some four years later:
United States Securities and Exchange Commission (SEC) chair Gary Gensler has once again hinted that Ether is likely a security under U.S. law. His comments immediately came after Ethereum completed 'The Merge,' its shift to a proof-of-stake (PoS) transaction processing algorithm [...] Gensler has indicated in the part that ETH is more like a security than a commodity and that he regards only Bitcoin as a commodity in the legal sense. Ethereum’s shift to PoS this week might shift the pendulum more towards a 'security' definition, though.
[Southurst, J. Post-Merge, Gary Gensler again hints that ETH is a security. (Accessed October 13, 2022)].
Now:
[r]ather than earning ETH via block subsidies by performing mathematical functions with physical hardware (proof-of-work), under PoS Ethereum, 'validators' now only need to stake a minimum of 32 ETH to have a shot at the reward. That reduces Ethereum’s overall energy consumption by over 99%, supporters claim. However, it also makes ETH look a lot more like an investment, with stakers seeking a return on the money they’ve contributed. While not naming Ethereum specifically, Gensler told the Senate Banking Committee that digital asset exchanges and other online providers who offer PoS blockchain staking services look very similar to lenders. Gensler told the Wall Street Journal that “from the coin’s perspective…that’s another indicia that under the Howey Test, the investing public is anticipating profits based on the efforts of others.
[Id].
"A strategy advisor at VanECK, Gabor Gurbacs, wrote that Ethereum’s migration from PoW to PoS 'can draw regulatory attention.' Gurbacs said: 'To be clear, I am not saying that ETH is necessarily a security because of its proof model, but regulators do talk about staking in the context of dividends which if one feature of what securities laws call a common enterprise. There are other factors in the Howey test too” [Adejumo, O. Debate rages over whether Ethereum can be considered a security post-Merge. (Accessed October 13, 2022)].
But others, such as "Adam Cochran argued that the commission’s chairman statement is a 'baseless FUD from entities that don’t understand the tech, or gloss over legal elements.” [Id].
It is time now to demonstrate why Gensler's opinion on Ethereum being a security is shortsighted, flawed, and plainly and simply wrong.
First Prong of Howey - Investment of Money
To begin with it is necessary to review the seminal case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The Howey Test determines what qualifies as an 'investment contract' and would therefore be subject to U.S. securities laws. By now, most of us are quite familiar with the three prong test created in the Howey decision, to wit: "The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others" [328 U.S. 293, 301].
Regarding Ethereum, it becomes obvious that the first prong of the Howey test is satisfied. In State v. Gopher Tire & Rubber Co., 146 Minn. 52 (Minnesota Sup. Ct., 1920), cited in Howey made it clear that "[t]he placing of capital or laying out of money in a way intended to secure income or profit from its employment is an investment as that word is commonly used and understood" [146 Minn. 52, 56].
The Gopher Tire & Rubber Co. was extended in Uselton v. Commercial Lovelace Motor Freight, Inc., 9 F. 3d 849 (10th Cir. 1993) so that the investment of money can take the forms of 'goods or services' or other 'exchanges of value' and specifically applied to bitcoin and other cryptocurrencies in SEC v. Shavers, No. 4:2013cv00416 - Document 23 (E.D. Tex. 2013).
So Ethereum PoS does in fact satisfy the first prong of the Howey test, but Gensler's errors are found within the component parts of Prong 2 and Prong 3 which are heavily debated and litigated, albeit not by SCOTUS.
Second Prong of Howey - Common Enterprise
In essence, there are three separate and distinct tests to determine the presence of a common enterprise, to wit: horizontal commonality', 'broad vertical commonality' and, 'strict vertical commonality'. All three must be examined with respect to staking as different Courts throughout the U.S. employ different schools of thought in this regard.
Horizontal Commonality
When considering horizontal commonality, the courts require "a pooling of interests, usually combined with a pro rata sharing of profits" [See, Revak v. SEC Realty Corp., 18 F.3d 81, 87-88 (2d Cir. 1994); see, also Salcer v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 682 F.2d 459, 460 (3d Cir. 1982). In fact, the Court in Salcer extended this to go so far as to say the "investment must be part of a pooled group of funds" [682 F. 2d 459, 460]. And in Milnarik v M-S Commodities Inc, 457 F. 2d 274 (7th Cir., 1972) the Court found: "[...] the element of commonality absent here. Although the complaint does allege that Nelson entered into similar discretionary arrangements with other customers, the success or failure of those other contracts had no direct impact on the profitability of plaintiffs' contract" (emphasis added) [457 F. 2d 274, 276].
Given the foregoing, you would be hard pressed to find horizontal commonality present in the post-merge Ethereum PoS ecosystem. To run a validator node in Ethereum PoS, the 32 ETH you deposit to run the node are in no way pooled with other associated relevant assets. Rewards received by you are resultant from your node performing its task and inopposite your rewards are slashed when your node fails to appropriately perform. And finally, the success or failure of the node attributable to you has absolutely no impact whatsoever upon the interests of others in the ecosystem.
Broad Vertical Commonality and Strict Vertical Commonality
These two types of commonality can be easily discussed in mutual conjunction as regards their application to Ethereum PoS.
With regard to vertical commonality, the relationship between the investors and the promotor (issuer) is in issue with the key argument being that earnings are not required to rise and fall in tandem between the two classes of actors. In this area the case of SEC v. Glenn W. Turner Enterprises Inc. 474 F. 2d 476 (Ninth Cir., 1973) is illustrative.
In Glenn W. Turner the company was issuing payment to participants to bring additional people to set seminars where employees of Glenn W. Turner were closing the 'Adventures' and/or 'Plans' deals.
It is apparent from the record that what is sold is not of the usual "business motivation" type of courses. Rather, the purchaser is really buying the possibility of deriving money from the sale of the plans by Dare to individuals whom the purchaser has brought to Dare. The promotional aspects of the plan, such as seminars, films, and records, are aimed at interesting others in the Plans. Their value for any other purpose, is, to put it mildly, minimal.
[474 F. 2d 476, 478-9].
For purposes of the present case, the sticking point in the Howey definition is the word "solely," a qualification which of course exactly fitted the circumstances in Howey. All the other elements of the Howey test have been met here. There is an investment of money, a common enterprise, and the expectation of profits to come from the efforts of others. Here, however, the investor, or purchaser, must himself exert some efforts if he is to realize a return on his initial cash outlay. He must find prospects and persuade them to attend Dare Adventure Meetings, and at least some of them must then purchase a plan if he is to realize that return. Thus it can be said that the returns or profits are not coming "solely" from the efforts of others.
[474 F. 2d 476, 481-2].
"Thus the fact that the investors here were required to exert some efforts if a return were to be achieved should not automatically preclude a finding that the Plan or Adventure is an investment contract. To do so would not serve the purpose of the legislation. Rather we adopt a more realistic test, whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise" [474 F. 2d 476, 482].
"What he buys is a share in the proceeds of the selling efforts of Dare. Those efforts are the sine qua non of the scheme; those efforts are what keeps it going; those efforts are what produces the money which is to make him rich. In essence, it is the right to share in the proceeds of those efforts that he buys. In our view, the scheme is no less an investment contract merely because he contributes some effort as well as money to get into it. [Id].
"So here. Regardless of the fact that the purchaser here must contribute something besides his money, the essential managerial efforts which affect the failure or success of the enterprise are those of Dare, not his own" [474 F. 2d 476, 483].
Now applying this to Ethereum PoS, it is first important to note that in actuality there exists no promoter/issuer for Ethereum PoS. Not only is Ethereum PoS decentralized, it is open-source and has had thousands of programmers contributing to its development. These people who built and issued the code for Ethereum PoS (which by the way is protected free speech under the First Amendment) are not actually 'running' the system. Issuance of the code is clearly separate and distinct from implementation of the system. Also and importantly, those who contributed to the systems creation own no part of it so clearly it cannot be said that their fortunes are inextricably tied to that of others.
An interesting but flawed argument exists here for a finding of a common enterprise to arise from the validators 'running the network' as well as the cooperative mechanisms present for validating transactions. But this argument finds its flaw in the fact that the validations are distinct and came into effect after the development of the code.
Therefore for all of the various reasons set forth above, no common enterprise is exhibited in Ethereum PoS so as to trigger the second prong of the Howey test.
Third Prong of Howey - Expectation of Profit from the Efforts of Others
The core of this prong has been more fully defined by the Court in United Housing Foundation, Inc. v. Forman, 421 US 837 (1975). Therein, the Court, speaking through Justice Powell, stated in dicta:
The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. (emphasis added)
[421 US 837, 852].
At this juncture a subtle but critical nuance in the existing law must be discussed as the same is critical as to the ultimate determination whether staking transforms Ethereum PoS into a 'security'. To aid in this, it is instructive to review one Ninth Circuit case, to wit: SEC v. R.G. Reynolds Enters., Inc., 952 F.2d 1125 (9th Cir. 1991).
In the R.G. Reynolds case, the Court specifically held: "To determine whether a financial interest constitutes an 'investment contract,' we apply the three-prong test put forward in SEC v. W.J. Howey Co., 328 U.S. 293, 298-99, 66 S.Ct. 1100, 1102-03, 90 L.Ed. 1244 (1946)" (emphasis added) [952 F. 2d 1125, 1130]. Discussion of this nuance is necessary as some scholars and Courts erroneously find Howey to be a four prong test wherein 'reasonable expectation of profit' and 'derived from the efforts of others' are disjoined and separately reviewed.
Nonetheless, the R.G. Reynolds case makes clear that 'reasonable expectation of profit' and 'derived from the efforts of others' should be read in conjunction whereby the third (and final) prong of the Howey test is 'a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others'[United Housing Foundation, Inc. v. Forman, supra].
Now, applying this prong to Ethereum PoS begs the necessary question what exactly are the stakers being rewarded for? In other words what is the reward for operating a node by staking?
Clearly, no reward flows as a result of fostering system development; network development could cease but the system would continue to operate and profits would continue to flow to legitimate node operators. Node validators likewise are not selling system block space to system users - simply not their function.
So what are the node validators 'selling' in the post-merge Ethereum PoS ecosystem? Essentially they are selling transaction validation attesting to the fact a transaction took place within the system. So, each individual node validator is selling users their system uptime.
Viewed in this light, a node validator is slashed on an individual level if their own trust or system uptime are shown to be deficient. If one node validator is slashed that action does not affect the other validators. Therefore, if a node validator is rewarded for system participation and slashed for downtime or individual malfeasance, this answers the question as to what is for sale in the Ethereum PoS node validation staking system.
Given the foregoing, the next logical question in the progression becomes: Is the 'managerial effort' present in maintaining a server through validation sufficient self effort that the validator receives reward for their own actions and not the efforts of other node validators? We find the answer to this question in SEC v. Homero Joshua Garza, GAW Miners, LLC and ZenMiner (d/b/a Zen Cloud), No. 15-cv-1760 (D. Conn. filed Dec. 1, 2015).
In Garza, the SEC took the position that owning and managing Bitcoin rigs/servers in the normal course of business was 'the managerial effort', and the resultant sale of their access to future earnings constituted the sale of securities. In this regard as applied to Ethereum PoS, the entrepreneurial and managerial efforts to maintain consistent and proper uptime on an Ethereum PoS validator demonstrates material effort and consists of that being rewarded by the system. As such the act of staking does not render Ethereum PoS a security in this regard.
The Howey test criteria and the precedent set by prior SEC cases make it hard for the regulator to argue that Ethereum constitutes a security. While the SEC may attempt to expand its purview over crypto assets by declaring more of them securities, it looks less and less likely that Ethereum will appear in the organization’s crosshairs, even after the Merge to Proof-of-Stake takes place.
[Craig, T. Could Ethereum Be Classified as a Security Following the Merge?. (Accessed October 14, 2022)].
Final Thoughts
Some thirty-five plus years ago, I remember studying the Howey case in my Corporate Finance class in Law School. At that time I could hardly appreciate the overall significance of that case, nor imagine its application to a new class of assets - cryptocurrency. Hell, in the early 1980's home PC's were not yet the norm. Parenthetically, damn, I'm getting old.
In any event, I trust my argument laid out at length above, makes a good case for why post-merge Ethereum PoS is not a security under the Howey test. I found the experience in writing this article quite refreshing as an exercise for this old tired brain. Although I have not actively practiced law for many years, still, from time to time, when an interesting topic arises, I enjoy writing about it. But note, nothing herein constitutes a legal opinion to be relied upon - I don't do that - the above should be seen as merely a scholarly exercise.
Finally, I wish to express my thanks to Adam Cochran for the Twitter thread which provided me with a bare bones skeletal framework within which to develop the legal argument applying Howey to answer the base Ethereum PoS conundrum examinined herein.
So, Mr. Gensler, you are completely wrong about Ethereum PoS being a security, and should you desire to continue down your chosen power-grab path for having every crypto fall under the SEC's jurisdiction, you better come up with a new plan.
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