[co-author: Stephanie Kozol]
On March 9, New York Attorney General Letisha James filed a complaint against leading cryptocurrency exchange KuCoin, alleging violations of the Martin Act, which prevents security sales fraud. AG James claimed that Ethereum — the second-largest cryptocurrency by market capitalization — is a security in the first regulator-initiated court claim.
AG James’ complaint alleged that KuCoin engaged “in the business of effecting transaction in securities” based on its sales of Ethereum. Starting in 1936, New York courts defined a security as “any form of instrument used for the purpose of financing and promoting enterprises, and which is designed for investment.” Based on this test, AG James argued that Ethereum is a security because the promoters (1) raised funds to develop the Ethereum network; (2) retained large positions of Ethereum to fund Ethereum’s development; (3) referred to Ethereum as an investment on the Ethereum website; and (4) used Ethereum to generate staking rewards for investors.
“Staking” refers to an environmentally-friendly security mechanism that allows cryptocurrencies to secure their networks, thus incentivizing good behavior on the Ethereum network. Holders of a cryptocurrency “stake” Ethereum in exchange for the ability to “validate” transactions on the blockchain, while earning additional Ethereum for doing so. The mechanism works because if a “validator” validates a malicious transaction, their staked Ethereum is taken away. Ethereum formerly relied on a “proof-of-work,” a carbon-intensive consensus mechanism used by Bitcoin — the only cryptocurrency regulators view as a commodity. However, Ethereum switched to a proof-of-stake mechanism in 2022 to become more sustainable and increase network performance.
Why It Matters
Securities regulators have long alluded to the belief that cryptocurrencies relying on proof-of-stake mechanisms for validation could meet the definition of an investment contract. AG James’ action constitutes yet another action by state and federal regulators that, despite concerns from industry participants, seeks to require cryptocurrency market participants to comply with securities laws.