Regulating The Unregulated: Cryptocurrency as ‘Securities’ Under The SCRA 1956

By Devansh Sharma

INTRODUCTION

Mr. Shaktikanta Das, ex-governor of the Reserve Bank of India (RBI), at the World Economic Forum in Devos, observed that instruments like cryptocurrency with no underlying value could cause potential harm to emerging market economies like India. In 2018, RBI issued a circular directing all its regulated entities to “i) not deal in virtual currencies nor to provide any services for facilitating any person or entity in dealing with or settling virtual currencies and ii) to exit the relationship with such persons or entities if they were already providing such services to them.” However, the Hon’ble Supreme Court (SC) in the case of Internet and Mobile Association of India v. Reserve Bank of India (IMAI) struck down the above-mentioned circular, holding it to be violative of Article 19(1)(g) of the Constitution of India resulting in upholding the validity of cryptocurrency. The SC observed that cryptocurrency is unregulated but not illegal. It further acknowledged the power of RBI to regulate matters of Virtual Digital Currencies (VDCs) including cryptocurrency.

Pursuant to the IMAI judgment, RBI observed that its regulated entities were cautioning their customers regarding the purchase of cryptocurrency. Therefore, in 2021, RBI issued a circular clarifying that trading in cryptocurrency is not illegal. Even the Central Government in the year 2021 proposed to introduce the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021(Bill). The Bill proposed to prohibit all private cryptocurrencies in India while allowing certain players to promote their underlying technology and uses. However, to date, neither the regulator nor the Central Government has provided any clarity on whether cryptocurrency can be termed as 'Securities' under the Securities law regime of India. The lack of such clarity has given rise to the siphoning of funds worth lakhs and crores of rupees, leading to financial losses for investors in India.

In this blog, I shall argue that ‘cryptocurrency’ should be included in the definition of ‘Securities’ under Section 2(h) of the Securities Contract Regulation Act 1956 (SCRA), as the term ‘Securities’ allows for the inclusion of any instrument that can be bought and sold as an investment. The implication of reading cryptocurrency under the definition of securities would lead to it forming a part of the Securities market, thus allowing only the Securities Exchange Board of India (SEBI) regulated entities to list cryptocurrency. Such a move would also help to reduce the number of fraudulent transactions in cryptocurrency. Further, I shall also analyse the judgment laying down the test for determining the essentials of an ‘investment contract.’

CRYPTOCURRENCY & ITS FEATURES 

Cryptocurrency was founded by an anonymous person named Satoshi Nakamoto in January 2009. Cryptocurrency is created through a computer-generated process called mining and is subsequently, traded to allow market forces to facilitate appreciation and gain value. After the advent of the first cryptocurrency, i.e. Bitcoin, more than 5,000 virtual currencies like Litecoin, Ripple, and Ethereum emerged in the cryptocurrency market worldwide. In India, cryptocurrency acts as an alternative to existing forms of investments like trading in stocks, gold, and debentures. Individuals or companies willing to engage in cryptocurrency business have the option to list their cryptocurrency on recognized exchanges like CoinDCX, WazirX, Binance, etc. As mentioned above, cryptocurrency has been classified as VDCs but it hasn’t been recognized as valid legal tender in India. However, due to its vast popularity, the revenue of the cryptocurrency market in India is projected to reach US $ 343.5 million in 2024 with over 22.20% expected users by the year 2028.

The purpose of having cryptocurrency is to cut down the involvement of any centralized authority in a transaction between the parties. This is also known as decentralization. The key feature of being decentralized is that trading in cryptocurrency becomes devoid of any third-party involvement, i.e. financial institutions, and government. This assures that the transaction takes place directly between the payer and the payee through a registered intermediary. However, due to the non-involvement of any governmental or regulatory authority such transactions are susceptible to acts of fraud and cheating. In recent times, investors in India have been dealing with the fate of the unregulated cryptocurrency market which has led to siphoning of funds worth lakhs and crores of rupees.

CRYPTOCURRENCY-  A FINANCIAL LOSS FOR INVESTORS? 

In India, the regulatory framework concerning cryptocurrency is highly ambiguous and unclear. Therefore, it becomes necessary to regulate the unregulated cryptocurrency market, where it is easy for scammers to devise new and innovative ways to siphon investors' money. For instance, a 28-year-old college student in Nagpur, Maharashtra was duped in a cryptocurrency fraud worth Rs 23 Lakhs. The scammer approached him as an investment advisor via telegram and promised high returns and profits. The investor ended up investing an amount worth Rs 23 Lakhs after receiving an initial return of Rs 1400. However, the investor was defrauded and could not recover either the invested amount or any promised profits. Again, in the year 2022, the Morris Coin Scam gathered the limelight as one of the largest cryptocurrency frauds in India. A cryptocurrency was listed on a fake cryptocurrency exchange namely, Franc Exchange. The accused lured the investors with the promise of daily returns where the minimum deposit was worth Rs 15,000. With investments worth Rs 1,200 crore and over 900 investors being duped in the scam, it was recognized that the cryptocurrency was not registered with any exchange.

It shall be observed that there is no legal clarity on who can list cryptocurrencies or who are the eligible investees. This has allowed scammers to lure retail investors into fraudulent schemes and later siphon the money of such investors. The immediate consequence of recognizing cryptocurrency as a security would make it a part of the ‘Securities market.’ Hence, cryptocurrency, which if listed, would then become a part of the regulated market where the authorization of SEBI is required for any eligible investee to list its Securities. This will authorize only SEBI-regulated entities to list their Securities in the Securities market and would reduce the number of fraudulent transactions in cryptocurrency.

CRYPTOCURRENCY AS ‘SECURITIES’- INCLUSIVENESS OF S.2(H) SCRA

A ‘security’ is an instrument that assures for the recovery/repayment of money. Hence, it is a word of general import signifying an assurance. The term ‘Securities’ under Section 2(h) of the SCRA has been defined as follows - “Securities” include- i) Shares, scripts, stocks, bonds, debentures, debentures stock or other marketable securities of like nature in or of any incorporated company [or a pooled investment vehicle or other body corporate]. The Section uses the term ‘include’ instead of ‘means’. This shows that the definition of the term ‘Securities’ is not exhaustive. Hence, due to the non-exhaustive and inclusive characteristics of the term ‘Securities’, the Hon’ble SC, different High Courts (HC), and SEBI have been able to include/interpret instruments like Global Depository Receipts (GDR), Floating Rate Notes (FRN), and Optionally Fully Convertible Debentures (OFCD) within the aforesaid definition.

The Hon’ble Gujarat HC in the case of Essar Steel Limited v. Gramercy Emerging Market Fund while deciding whether FRNs can be included in the definition of ‘Securities’ under the SCRA observed that- 

“There is virtually limitless scope of human ingenuity especially in the creation of the numerous schemes devised by those who seek the use of money of others on promise of profits. The inclusive definition of the term ‘security’ is wide enough to include within that definition many types of instruments that might be sold as an investment. Whether a transaction involves a ‘security’, the transaction has to be examined to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a 'security'.” (emphasis supplied)

The aforesaid reasoning has also been followed by SEBI in the Sahara Indian Real Estate Corporation case. In common parlance, “the term ‘investment’ means every application of money that is intended to fetch returns by way of interest income or profits. Hence, to constitute an investment, the amount laid down should be capable of resulting in an income or return or profit to the investor, and in every case of investment, the intention and positive act on the part of the investor should be to earn such income, return or profit.” (emphasis supplied)

Considering the aforementioned reasoning, it is imperative to note that scammers can lure investors into fraudulent schemes of cryptocurrency because it acts as an alternative form of investment that provides returns or profits at a higher pace as compared to traditional forms of investment like stocks and mutual funds. Moreover, cryptocurrency is highly volatile because it acts as a lucrative investment option for investors. In other words, the fluctuation in the price of cryptocurrency is due to the higher returns or profits it offers to an investor. Thus, cryptocurrency has emerged as a form of investment where the issuer of the instrument is in the quest of raising money, and the investors are expecting higher returns/profits from the investment so made. Therefore, as cryptocurrency acts as an instrument that is capable of being bought and sold as an investment, it should be included in the definition of ‘Securities’ under Section 2(h) of the SCRA.

HOWEY: A TEST FOR CRYPTOCURRENCY

Another possible solution is to refer to the Howey test in the U.S. and hold cryptocurrency as a security issued in the form of an ‘investment contract.’ However, the pre-requisite for qualifying cryptocurrency as an ‘investment contract’ or security is that it passes the triple test laid down in the case of SEC V. Howey (“Howey case”). A scheme or a transaction to be termed as an ‘investment contract’ shall satisfy a three-fold test i.e., “1) an investment of money, 2) in a common enterprise, and 3) with profits to come solely upon the efforts of others.”

At this juncture, it is quintessential to observe that the Howey test applies to any contract, scheme, or transaction, immaterial of whether it has any of the characteristics of typical securities. Therefore, it becomes important to find out whether the aforementioned test shall apply to transactions involving trading of cryptocurrency. 

APPLICATION OF THE HOWEY TEST

Applying the above test, it is evident that when a cryptocurrency is floated on a cryptocurrency exchange, investors invest large sums of money in the quest for high profits. Therefore, cryptocurrency passes the first limb of the test. However, it fails to pass the second limb of the test.

The ‘common enterprise’ jurisprudence is a matter of conflict in the U.S. courts. It has led to the emergence of the ‘horizontal commonality test’ and the ‘vertical commonality test’ to determine the existence of a ‘common enterprise.’ Under the former, “there must be multiple investors and pooling of funds in the common enterprise.” Whereas in the latter, “there is a relationship between the investor and the promoter whereby the investor’s profits are dependent upon the expertise of the promoter.” Therefore, the essence of the former test is the ‘pooling of funds.’ However, unlike a share of a company under which the proceeds of investment go to a single entity. A cryptocurrency has no common enterprise in as much as the money spent in it does not go into any enterprise as the latter does not exist. Therefore, the test of ‘pooling of funds’ in a common enterprise is not met. Similarly, under the ‘vertical commonality test,’ there is no controlling or managerial entity/group upon whose expertise the investor’s profits are dependent. Lastly, the volatile characteristic of cryptocurrency shows that profits made by a particular investor depend upon the efforts of others. In other words, investors' actions of buying and selling cryptocurrency at a time when the price of the latter is high shows that profits are dependent upon the efforts of others. Hence, cryptocurrency passes the third limb of the Howey test.

Therefore, a cryptocurrency cannot be regarded as a security as per the test laid down by the U.S. SC. Although it passes the first and the third limb of the test, cryptocurrency investment cannot be categorized as an investment in a ‘common enterprise.’

CONCLUSION

In India, the cryptocurrency market has emerged as a lucrative investment option for investors. However, the lack of legal clarity on who can list cryptocurrencies or who are the eligible investees has also allowed scammers to devise fraudulent investment schemes and siphon the money of investors. Therefore, considering the wide import of the term ‘Securities’ under the SCRA, it is necessary to include cryptocurrency under the aforementioned definition to protect the interest of the investors and reduce the number of fraudulent transactions in cryptocurrency. Furthermore, a reference to the test devised by the U.S. SC in the Howey case shows that cryptocurrency shall not qualify as a security as per the said test.

Disclaimer

The views expressed in this article are solely those of the author(s). This article is intended for educational/information purposes only. The source of this article is publicly available information and under no circumstances should the contents of the article be construed to be professional advice by the authors.