SEC: Most Stablecoins Are Not Securities

The US SEC’s Division of Corporation Finance recently issued a statement that certain stablecoins, which it called “covered stablecoins”, are not considered as securities. The “covered stablecoins” are those which:

• Are designed to maintain a stable value relative to the United States Dollar, or “USD,” on a one-for-one basis,
• Can be redeemed for USD on a one-for-one basis (i.e., one stablecoin to one USD), and
• Are backed by assets held in a reserve that are considered low-risk and readily liquid with a USD-value that meets or exceeds the redemption value of the stablecoins in circulation.

The SEC identified certain characteristics of the “covered stablecoins”, and their marketing, which it opined, would make those “covered stablecoins” non-securities.

Characteristics of Covered Stablecoins

The covered stablecoins display these characteristics:

• designed and marketed for use as a means of making payments, transmitting money, or storing value
• designed to maintain a stable value relative to USD
• backed by USD and/or other assets that are considered low-risk and readily liquid so as to allow a Covered Stablecoin issuer to honor redemptions on demand
• held in a reserve with a USD-value that meets or exceeds the redemption value of the Covered Stablecoins in circulation
• Covered Stablecoin issuer mints and redeems Covered Stablecoins on a one-for-one basis with USD at any time and in unlimited quantities
• Minted and sold directly by issuer or intermediaries to customers
• Fixed minting and redemption price allows players to arbitrage pricing imbalance in the marketplace, quickly restoring price stability

Marketing of Stablecoins

Importantly, the SEC opined that the “covered stablecoins” are non-securities if their marketing:

• is designed to have a stable value relative or corresponding to USD (e.g., one Covered Stablecoin to one USD);
• does not entitle a Covered Stablecoin holder to the right to receive any interest, profit, or other returns;
• does not reflect any investment or other ownership interest in the Covered Stablecoin issuer or any other third party;
• does not afford a Covered Stablecoin holder any governance rights with respect to the Covered Stablecoin issuer or the Covered Stablecoin; and/or
• does not provide a Covered Stablecoin holder with any financial benefit or loss based on the Covered Stablecoin issuer or any third party’s financial performance.

Stablecoin Reserve

The SEC said that it was common for stablecoin issuers to use the proceeds of sale of stablecoins, to acquire assets, which are held in a pooled account. (i.e. the “reserve”)

These assets are usually low risk and quickly convertible to liquid, to allow the issuer to comply with redemption requests.

The assets in the reserve must equal or exceed the value of the stablecoins.

Assets in the reserve:

• cannot be mixed with or commingled with assets of third parties.
• cannot be lent, pledged, or rehypothecate
• cannot be used for business purpose
• must be protected from claims of third parties

The assets in the reserves may have earnings, such as interest. However, these earnings belong only to the issuer, and not to the stablecoin holders.

The Reves Test for Stablecoins

The SEC decided to analyze stablecoins using the Reves test, due to the similarity of stablecoins to notes and other debt instruments, which could qualify as securities.

The Reves test was formulated in the case of Reves v Ernst & Young, and puts forth the “family resemblance” test based on 4 factors:

• Motivations of buyer and seller
• Plan of distribution of the instrument
• Reasonable expectation of investing public
• Risk reducing features.

The SEC’s Corporate Finance Division opined that the “covered stablecoins” were not securities, because:

1. Sellers use the proceeds to fund a Reserve and buyers are not motivated by an expected return on their funds;
2. Covered Stablecoins are distributed in a manner that does not encourage trading for speculation or investment;
3. A reasonable buyer would likely expect that Covered Stablecoins are not investments; and
4. The availability of a Reserve adequately funded to fully satisfy redemptions on demand is a risk-reducing feature of Covered Stablecoins.

The Howey Test for Stablecoins

The SEC’s Division of Corporate Finance also applied the Howey test to stablecoins.

The Howey test analyzes arrangements and instruments not described in the legislation, based on “economic realities”. (It was put forth in the case of SEC v. W.J. Howey Co)

The elements of the Howey test are:

1. An investment of money
2. In a common enterprise
3. Premised on a reasonable expectation of profits
4. Derived from the entrepreneurial or managerial efforts of others.

However, the SEC’s division found that buyers do not purchase Covered Stablecoins with a reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others, because these instruments are not marketed as investments or with any emphasis on the potential for profit.

Under the Howey test, therefore, stablecoins are not seen as securities.

Implications of the SEC Statement

Stablecoins, pegged to assets like the U.S. dollar, have been in a regulatory gray area.

By declaring stablecoins such as USDT and USDC as non-securities, the SEC exempts their issuers (Tether and Circle) from securities law compliance for core operations.

This lowers legal risks and operational costs, fostering stability in the stablecoin market.

The decision doesn’t address broader regulatory questions, such as anti-money laundering (AML) or consumer protection laws overseen by agencies like the Treasury’s FinCEN.

It may also reduce the likelihood of SEC enforcement actions against stablecoin issuers.

However, issuers are still vulnerable to state-level regulations or international scrutiny.

(The US SEC is the US federal level securities regulator, but states also have their own securities regulators.)

What was Reves v Ernst & Young About?

The facts of the Reves v Ernst & Young case are as follows:

• Parties: Petitioners were noteholders (led by Bob Reves) of the Farmers Cooperative of Arkansas and Oklahoma (Co-Op). The respondent was Ernst & Young’s predecessor, Arthur Young, the Co-Op’s auditor.
• Background: The Co-Op sold uncollateralized, uninsured promissory notes payable on demand to raise funds for its operations. These notes were marketed as an “Investment Program” to both members and non-members, offering a variable interest rate higher than local banks.
• Bankruptcy and Lawsuit: In 1984, the Co-Op filed for bankruptcy, rendering the notes nearly worthless. Noteholders sued Arthur Young, alleging it violated the antifraud provisions of the Securities Exchange Act of 1934 (15 U.S.C. § 78j(b)) and Arkansas securities laws by failing to follow generally accepted accounting principles (GAAP). They claimed Arthur Young’s audits concealed the Co-Op’s insolvency, misleading investors.
• Procedural History: The District Court ruled in favor of the noteholders, awarding $6.1 million. The Eighth Circuit reversed, holding that the notes were not securities under the 1934 Act, as they did not meet the Howey test for an “investment contract.” The Supreme Court granted certiorari to resolve the federal issue.

The main issues in that case were:

• Primary Issue: Are the Co-Op’s demand notes “securities” within the meaning of Section 3(a)(10) of the Securities Exchange Act of 1934?
• Sub-Issue: What legal test should be applied to determine whether a note is a security, given the statutory inclusion of “any note” but judicial exceptions for certain notes?

The petitioners’ (Reves et al) arguments can be summarized as follows:

• The notes were securities because they were sold as investments, with buyers expecting profits from the Co-Op’s operations, akin to stocks or bonds.
• The 1934 Act’s definition of a security includes “any note,” and the notes’ marketing as an “Investment Program” supported their classification as securities.
• Arthur Young’s failure to disclose the Co-Op’s insolvency violated antifraud provisions, as proper audits would have deterred note purchases.
• The Howey test (from SEC v. W.J. Howey Co., 328 U.S. 293) was misapplied by the Eighth Circuit, as it is designed for “investment contracts,” not notes.

Whereas, the respondent (Arthur Young) forwarded these arguments:

• The notes were not securities but commercial instruments, similar to consumer or short-term notes excluded from securities laws.
• Applying the Howey test, the notes lacked a “common enterprise” and expectation of profits from others’ efforts, as they were payable on demand with fixed interest.
• Even if securities, the notes fell under the 1934 Act’s exclusion for notes with a maturity of less than nine months.
• Arthur Young’s audits complied with professional standards, and any misstatements did not directly cause the noteholders’ losses.

The SEC, as amicus curiae, raised these arguments:

• Supported petitioners, arguing that the notes were securities based on their economic reality and investor expectations.
• Urged a flexible test to distinguish investment notes from commercial ones, aligning with Congress’s intent to broadly regulate securities to protect investors.

The supreme court held that the co-op notes were securities.

• There was a presumption about the notes: The 1934 Act’s definition of a security includes “any note” unless context requires otherwise. Notes are presumed to be securities unless they fall within an exception.
• Howey Test rejected: The Court rejected the Eighth Circuit’s use of the Howey test (which defines an investment contract as involving a common enterprise and expectation of profits from others’ efforts) for notes, as it is not tailored to the distinct characteristics of notes.
• Adoption of Family Resemblance Test: The Court adopted the Second Circuit’s “family resemblance test” to determine whether a note is a security. A note is presumed a security unless it bears a strong resemblance to a category of non-securities, such as:
  • Notes delivered in consumer financing.
  • Notes secured by a home mortgage.
  • Short-term notes secured by a lien on a small business.
  • Notes evidencing a “character” loan to a bank customer.
  • Notes formalizing open-account debt in ordinary business.
  • Notes evidencing loans by commercial banks for current operations.
• Four-Factor Analysis: If a note does not resemble these categories, courts apply four factors to assess its resemblance to non-securities:
  • Motivations: Whether the seller’s purpose is to raise capital for business and the buyer’s is to earn profits (investment context) versus facilitating commercial transactions.
  • Plan of Distribution: Whether the notes are offered broadly to the public (like securities) or to a limited group (like commercial notes).
  • Investor Expectations: Whether reasonable investors view the notes as investments.
  • Risk-Reducing Factors: Whether alternative regulatory schemes (e.g., banking laws) or other factors reduce the need for securities law protection.

Ultimately, the above test was applied by the supreme court as follows:

• Motivations: The Co-Op sold notes to fund operations, and buyers sought higher interest, indicating an investment motive.
• Plan of Distribution: The notes were offered to 23,000 members and non-members over 15 years, resembling a public offering.
• Investor Expectations: Marketing as an “Investment Program” led buyers to view the notes as investments.
• Risk-Reducing Factors: No alternative regulations (e.g., FDIC insurance) protected buyers, as the notes were uncollateralized and uninsured.
• The notes did not resemble non-security categories and were thus securities.

The court’s use of the “family resemblance test” was a step forward, breaking free from the limitations of the Howey test.

The family resemblance test is highly adaptable, allowing courts to evaluate new and novel financial products, including cryptocurrencies.

Implications of the family resemblance test on stablecoins

1. Motivations: Stablecoin issuers (e.g., Tether, Circle) often raise funds to support operations or liquidity pools, while buyers use stablecoins for trading, payments, or yield farming.
   • If used for investment (e.g., earning interest in DeFi protocols), stablecoins lean toward securities.
   • However, their use as a medium of exchange (like cash) suggests a commercial purpose.
2. Plan of Distribution: Stablecoins are broadly distributed globally via exchanges, resembling public offerings characteristic of securities.
3. Investor Expectations: Buyers may view stablecoins as investments if marketed with promises of stability or yield (e.g., Tether’s past reserve claims).
   • However, their peg to fiat currencies may lead others to see them as currency substitutes.
4. Risk-Reducing Factors: Stablecoins lack robust alternative regulation in the U.S. (unlike bank deposits under FDIC).
   • Proposed stablecoin laws (e.g., 2025 legislative efforts) may fill this gap, but currently, securities laws may apply to address risks like reserve mismanagement.

Stablecoins may resemble securities when used for investment but not when used as currency.

Courts apply Reves contextually, as seen in SEC v. Terraform Labs (2023), where stablecoins were partly deemed securities based on their role in investment schemes.

If stablecoins are securities under Reves, issuers must register with the SEC, file disclosures, and comply with antifraud rules, increasing costs.

Thank you for reading.

Disclaimer

This article was prepared for educational purposes. Please do not treat it as legal advice. Please check with a licensed lawyer before making any decision on the contents herein.