Open Access Research Article
THE CASE FOR SEBI S RECOGNITION OF CRYPTO-INVESTMENTS AS SECURITIES: A COMPREHENSIVE RESEARCH STUDY
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THE CASE FOR SEBI'S RECOGNITION OF
CRYPTO-INVESTMENTS AS SECURITIES: A COMPREHENSIVE RESEARCH STUDY
AUTHORED BY - KESHAV SINGH RATHORE
Abstract
The advent of blockchain technology
has revolutionized the investment landscape, introducing various novel
instruments of investment in recent years. These include Initial Coin Offerings
(ICOs), Non-Fungible Tokens (NFTs), Security tokens, and Cryptocurrencies,
among others.
However, it is important to recognize
that these investment forms have also become fertile grounds for fraudulent
actors who exploit investors' greed and financial vulnerabilities through
pyramid schemes and false promises.
India, with its historical
experiences with pyramid schemes, has a vested interest in safeguarding the
interests of its citizens. Notably, the decentralized and unregulated nature of
Crypto-Assets poses significant challenges in combating such scams.
This paper critically examines the
necessity for the Securities and Exchange Board of India (SEBI) to regulate and
supervise Crypto-Investments, with a specific focus on protecting the interests
of Indian crypto-investors.
Through comprehensive analysis, this
study aims to shed light on the compelling reasons for SEBI's involvement in
ensuring a secure and transparent environment for crypto-investments in India.
Introduction
Crypto-assets are getting more and
more sophisticated day by day, ranging from Cryptocurrencies to ICOs, Security
Tokens, and very recently NFTs.
Blockchain Technology has allowed for
constant Fintech evolution, which means it is expected in the future for this
technology to create even more of these investment types, which are too
unimaginable for us to predict.
It is also a fact that all
investments are done out of expectation of Profit, and this expectation of
profit which in modern slang is termed “FOMO” is often exploited by issuers of
Ponzi schemers.
Ponzi schemes in the past have happened
in various forms in India like Chit- Funds, Real Estate Schemes, Malicious
companies, etc. Although Stock Markets are rarely prone to ponzinomous
activities, it is because Stock Markets are highly Regulated by SEBI(Securities
Exchange Board of India). SEBI mandates that all market intermediaries such as
stock brokers and advisors be registered[1].
It also sets disclosure requirements for companies, which mandates companies to
provide accurate information about their financials, business operations, etc[2].
However, if the Securities and
Exchange Board of India is genuinely committed to safeguarding the interests of
crypto-investors, it raises a relevant question as to why it has not yet
recognized crypto-assets as securities and implemented equivalent regulatory
measures for organizations issuing Crypto-Assets.
Blockchain Technology
To understand the nature of
crypto-assets, we must first understand blockchain technology. Blockchain in
the most simple terms can be defined as a decentralized distributed ledger,
where all information before being stored in the ledger is verified by a huge
number of validators.
This mechanism allows for five
revolutionary features:
- Transparency- Since every
transaction is validated by thousands of validators, it makes every piece
of information recorded transparently. Not only that, all transactions
that have ever been recorded in the Bitcoin network are public for anyone
to see. An exception to this might be a Private Blockchain.
- Security- Except for human
errors, blockchain uses encryption and a consensus mechanism to ensure
security. This makes it extremely hard for hackers to steal sensitive data
unless because of human error.
- Speed- Blockchain has allowed
sending of digital assets to be sent to someone living thousands of
kilometres away in seconds. This mode of sending value is extremely fast
compared to traditional forms of payment, where it might take hours if not
days to send money to someone located internationally.
- Cost- It is extremely cheap
since it doesn’t require a lot of human intervention, unlike traditional
forms of payment.
- Trust- It is quite trustable owing to the fact that it
is secure and transparent and decentralized. Especially for people living
in some countries that have lost faith in corrupt centralized
institutions.
Blockchain technology was first
manifested by Stuart Haber & W. Scott Stornetta in a paper called “How to
time-stamp a digital document”[3]
Although they were the ones who
invented the concept, it was not implemented until a person/group of persons
with the assumed name of ‘Satoshi Nakamoto’ published a whitepaper with the
name “Bitcoin: A Peer-to-Peer Electronic Cash System”[4]
and invented the first blockchain-based digital asset called ‘Bitcoin’.
The intelligent peer-to-peer design
of Bitcoin allowed it to grow extremely popular, which in turn popularised
Blockchain Technology and its thousands of use cases.
Today, it is being used as a
distributed ledger to contain information that was traditionally hard to store,
like the data on ownership of real estate, medicinal/health data, and logistics
since the data is secure and can’t be altered.
Similarly, blockchain has been very
much useful in creating different forms of investments such as Cryptocurrencies,
Decentralised digital platforms, NFTs, ICOs, and Security coins.
Here’s a list of some of the
crypto-based assets:
- Cryptocurrencies-
Cryptocurrencies are digital assets that are backed up by blockchain
technology, which makes these assets distributed and decentralized, making
them uncontrolled by any governmental institution. Instead of relying on a
government or law enforcement, they work because people have faith in the
technology itself. In order for cryptocurrencies to be used, a digital
wallet is usually needed. Most cryptocurrencies like Bitcoin and Ethereum
use a concept called mining where ”miners” validate every transaction
before it is stored in the ledger.
- ICOs(Initial Coin Offerings)-
ICOs are a method for organizations to raise funds by issuing digital
tokens in the market in exchange for funds. The ICOs are bought by people
in expectation of profit in the future upon when the organization becomes
profitable. They are similar to IPOs in structure.
- NFTs(Non-Fungible Token)- It is
a non-replaceable, unique token existing in a blockchain Ledger which
usually has an image attached to it, which has monetary value and can be
traded. Its value depends on a number of factors including the image
attached to it, the issuing organization, the total number of issued
tokens, the utility of the tokens, and of course nature of the investment
market. Ownership of the tokens, with the use of digital wallets, gives a
sense of ownership of the image attached to the token, contributing to the
overall value of the NFTs.
- Security Tokens- A Security is it token that exists in a
blockchain ledger, which is issued by a listed company, and replaces the
need for issuance of traditional shares while providing the same rights to
the owner, such as fractionalized ownership of the company, voting rights,
traceability, etc. Unlike other forms of crypto-assets, it represents
rights of ownership in a listed company.
The thing about these investments is
that they are highly unregulated since no authority in India recognizes these
investments as securities.
Rationale for the Recognition of
Crypto-
Investments as Securities
Securities are tradeable financial
assets that have a monetary value, which may represent fractionalized ownership
of a Public Listed Company. Often in a layman’s terms, securities are traded in
the stock market in hope for a profit and they are issued by companies to raise
capital for their business operations. Section 2(h) of The Securities Contracts
(Regulation) Act, 1956 mentions that securities include “Shares, Scripts,
Stocks, Bonds, Debentures, Debenture stocks and other marketable securities”[5].
However, a really imperative question
here is, should crypto-assets be included in the definition of security?
- From Layman’s perspective, most
crypto assets are:
a.
Tradeable
b.
Have a monetary value
c.
Includes expectation of profit
d.
Issued to raise capital for business operations
One can argue the only disqualifying
factor here is that ownership of a crypto-asset does not represent ownership
rights in the issuing organization. But it is clear that Debentures, Bonds, and
Mutual Funds which are included in the ambit of Securities as per The
Securities Contracts (Regulation) Act, 1956, don’t give ownership rights in a
company either, yet they still qualify as securities.
2. From a Legal Perspective:
Although Section 2(h) of The
Securities Contracts (Regulation) includes “Other Marketable Securities” the
meaning of “Other Marketable Securities” isn’t made clear. One may be free to
speculate that the term includes the ambit of Crypto-assets.
Nonetheless, it is clear from Section
2(ib) of The Securities
Contracts (Regulation) Act, 1956 that any unit or instrument issued by
any collective investment scheme for investors is a security.
This begs the question, are all
collective investment schemes securities?
For this, we must understand what a
collective investment scheme is.
A collective investment scheme under Section
11AA of the Securities and Exchange Board of India (SEBI) Act, 1992 includes
- When payments are pooled
together by investors for a scheme.
- Done with a view to receive
profits.
- The investment is managed on
behalf of investors.
- The investors don't control the operations of the
Scheme.
If the above-mentioned criteria are
satisfied, it may actually bring a lot of Crypto-assets under the authority of
SEBI. The Allahabad High Court has already made it clear that to understand a
collective investment scheme, the Howey test may be used[6].
Howey test is defined in the next page.
U.S. Regulations
Previously we discussed the Howey
Test. To understand it, we must first understand what is the U.S. Securities
and Exchange Commission.
The Securities and Exchange
Commission is an independent governmental organization in the United States of
America. that protects the interest of the Investors of the country. It was
established after the wall street crash of 1929 as there was a lack of law
enforcement. It was established through the Securities Act of 1933, followed by
the Securities Exchange Act of 1934.
An Investment Contrat has been
undefined by the Securities Act, however, the United States Supreme Court has
in the case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946) defined it as “An
investment contract means a contract, transaction, or a scheme whereby a person
invests his money in a common enterprise and is led to expect profits solely
from the efforts of the promoter or a third party, it being immaterial whether
the shares in the enterprise are evidenced by formal certificates or by nominal
interests in the physical assets employed in the enterprise” [7]
The test proposes the following
requirements for an instrument to be an investment contract. According to it,
the investment contract should involve-
- An investment of money.
- Is a common enterprise.
- Reasonable expectation of
profit.
- To be derived from the efforts of others. [8]
Comparative Analysis
If someone was to comparatively
analyze the aforementioned Howey Test and the requirements set by the SEBI Act,
1992 for Collective Investment Schemes, one would find a lot of similarities,
for instance-
a)
There must be a collection of money for the purpose of investment.
b)
Collection of Money should be done with anticipation of profit.
c)
Investors should not be the same as the owners of the scheme.
Further, it was made clear by a Bench
of Allahabad High Court in the Judgement “Paramount Bio-Tech Industries Ltd. v.
Union of India” that in order to understand whether a financial instrument is a
Collective Investment Scheme or not, Howey Test may be used. This is another
reason to understand the Howey Test while exploring the legality of
Crypto-investments in India.
However, the minimum amount of
pooling of funds for a Collective Investment Scheme should be 100 Crore rupees[9]. As per
the amendment done to SEBI (Collective Investment Schemes) Regulations, 1999,[10] on March
14, 2022, several new additions have been made, such as
a. A Collective Investment Scheme
should have a minimum subscription
amount of at least Rs 20 crore and a minimum of 20 investors, none of which
should hold more than 25 percent of assets of the management of the scheme.
b.
A Collective Investment Scheme should not be open for more than 15 days.
c.
The Collective Investment Management Companies should have a minimum net worth
of 50 crore rupees.
While
for the U.S, there are so far no such requirements in the Howey test, one may
argue that it adds to the advantage of the SEC in order to bring crypto-based
investments inside its ambit, while the eligibility requirements of Collective
Investment Schemes add too many conditions, which narrow down the scope of
controlling Crypto-Investments by the SEBI.
Misuse
A Ponzi/Pyramid scheme is a Type of
scheme that causes profits to a minority of early investors, at the expense of
the money of later investors.
A Ponzinomous scheme works in a way
that it appears to be successful and trustable in the beginning stage of the
scheme. It does so by paying extremely high profits to initial investors, so as
to appear a trustable, repeatable form
of investment, which in turn, gathers
even more investors out of popularity.
Once it gathers more investors, it
takes their money and pays it to early investors. Unlike the stock market, it
does not rely on building any genuine value whatsoever. Its only concern is the
advertisement of the scheme and its only business product/service is the scheme
itself.
Unlike publicly listed companies which rely on
share market funds to expand their business operations, a ponzi/pyramid in
simple language transfers money from B to A
and makes it look like profit.
In Crypto-Investments, Ponzi/pyramid
Scheme stake advantage of economic ‘Bubbles’, which are phases of extreme
popularity and positive attitude of investors. These phases are very common in
Crypto-Markets. In these phases, investors often out of greed overlook
the nature of the schemes, which results in an unstable market condition, often
followed by a crash.
Although one might argue that the
stock market works in a ponzinomous way as well I strictly disagree with that
because of the following reasons:
a.
In a thriving business, the later investors do not suffer loss. While a
Ponzi scheme is always bound to be doomed no matter what. There will always be
a number of later investors that will most certainly suffer a loss.
b.
Due to the loss suffered by a
majority of the investors, it may create a sentiment of mistrust and a
“Bearish” market, which may prevent organizations that are
genuinely creating value, collect necessary funds, hindering their business
activities.
Cases of Misuse
According to a report by ‘INC 42’,
Indian Crypto Ponzi schemes alone have accounted for a loss of more than 72000
Crore Rupees[11]. That is
indeed a huge amount considering that it is roughly the same number as the GDP
of Tripura.
Following this I have discussed a few
Ponzi schemes, presented both nationally as well as internationally.
1.
Morris Coin scheme-
Estimated to have defrauded investors of 1200
crore rupees, it was a scheme that, under the pretext of claiming to be an ICO (Initial
Coin Offering), collected deposits from investors for ponzi activities. [12]
The company invested its time and
money, heavily in marketing, often using celebrities, and influences to
advertise their ICO, in order to gain the trust of investors. They also used
WhatsApp messages to lure people in the scheme. The scheme showed typical
hallmarks of a pyramid scheme, offering 270 rupees for 300 days if there was an
investment of 15,000 rupees.
As is usual in a pyramid scheme, the initial
investors were provided a lot of gains as promised, which made the scheme look
trustable, However, this did not last for long since the money was then transferred
to the bank accounts of the promoters of the scheme. The promoters of the
scheme kept on claiming that once the ICO tokens are listed on an exchange
called “Franc Exchange” their value would increase for which they required the
investors to hold the tokens for 300 days[13].
The Franc Exchange was a fraudulent exchange and their tokens were never listed
in any exchange.
2.
Bitconnect-
One of the biggest crypto-scams in
India, which raised roughly 18,000 Crore rupees from investors in India and all
over the world.[14]Its
influence was so massive that even a jury in San Diego, USA, indicted the owner
of Bitconnect with an ‘orchestration of a Ponzi Scheme’[15].
Proceeding which the founder, Satish Khumbani fled India to an unknown place.
It operated the same way most Ponzi
schemes operate, i.e. by returning profits to early investors using the money
of later investors. It claimed the returns were made through profits made by
investing the collected funds in crypto-markets through advanced trading
software, which in reality did not exist.
Although at the beginning of the
scheme, it did give extremely high returns and turned some into even
millionaires, it was at the cost of thousands of other innocent investors.
3.
StepN-
Posing as a move-to-earn game, StepN
emerged as an incredibly sophisticated Ponzi scheme, giving people high returns
for owning an NFT and doing activities like Walking, Running, Jogging, etc.
This made it seem to be a good health-promoting game with good intentions,
which gives incentive to people to do exercises by paying them returns. The
returns were of course paid by the money of later investors, as there is no
other source of income for the business[16].
Its official website still claims an
approximate number of 12,000,000,000 calories have been burned by its investors[17]. But what
it does not reveal its website is that their token called “Green Satoshi Token”
has crashed from its peak of 7.8337 dollars to 0.012 dollars[18]. What
made it so convincing was its incredible partnerships which made it
near-impossible to recognize it as untrustworthy. It had a partnership with a
major shoe company Asics[19]
and with a football club Atlitico de
Madrid[20],
and was invested in by Binance, a
major venture-capitalist organisation[21].
In the year 2022, StepN admitted
recording the growing of their user base from 1000s to Millions[22].
Although StepN is a global-based
company, out of the Millions lured by the Ponzi scheme, the number of Indian
users is unimaginable and uncounted for. However one cannot rule out the
possibility that at least some crores of rupees of Indian wealth must have been
lost to a scheme as such. Crypto-based ponzi schemes are becoming more and more
clever and sophisticated day by day, disguising themselves as Health Apps,
Games, Trading Softwares, etc. Their collaborations with celebrities and big
companies make it near impossible for a common citizen to detect their
ponzinomous activities. In times like these, SEBI must emerge as a guiding and
protecting authority before such schemes cause irreparable financial, mental,
and emotional health damage to thousands of Indians.
Way Forward
I have speculated a few actions that
can be possibly executed to have control over such issues-
- Amendments to be made to the Securities and Exchange
Board of India(SEBI) Act, 1992-
Whereby in Section 11AA,
sub-section(1) a proviso added by the Securities Laws(Amendment) Act, 2014,
which requires for a Collective Investment Scheme to involve an amount of 100
crore rupees, should be removed and replaced with a reasonable amount with
lower limits. This should be done so as to include crypto-investments with
lower amounts involved to be included in the act’s ambit. This is necessary
since blockchain has allowed the pooling of money for even the smallest of
businesses.
- Mandate Registration of Crypto-Investment Schemes-
This should be done regardless of
whether or not the scheme is based outside of Indian boundaries, as long as it
involves Indian Investors, registration with SEBI should be mandatory. Although
this might create enforcement issues, which I have talked about in the next
point.
- Collaborate with the U.S. Securities and Exchange
Commission and Governmental securities authorities of other countries-
This may help with sharing of
information and investigation of fraud. This is a crucial step because most of
the crypto-schemes have global investors. Which also raises the issue of
enforcement of authority, therefore collaboration with governmental departments
of other countries makes the most logical sense.
- Set up a Crypto-Investigations Department in the SEBI,
or, Include Crypto-Based Investments in the Investigations Department(IVD)
of SEBI-
Such a department should especially
target Crypto-Based Pyramid Schemes. Further, the investigations department
shall collaborate internationally to early-detect fraudulent crypto-schemes and
protect the interest of Indian Investors.
Conclusion
It is impossible for blockchain
technology to not integrate into our lives in the near future because of its
revolutionary features.
But as long as blockchain technology
is here to stay, so are crypto-based investments, and therefore crypto-based
frauds.
These shall only grow in frequency if
not stay stagnant. This is apparent from the trends that have been seen in the
current and the last decade, which has witnessed an increasing frequency of
crypto-based frauds and Ponzi schemes.
Therefore the sooner the Securities
and Exchange Board of India takes action against it, the lesser shall be the
number of people suffering from repercussions like debt, financial instability,
mental and emotional instability, and most importantly loss of wealth from
India’s economy.
[1] Section 12(1) of the The Securities and
Exchange Board of India Act, 1992
[2] SEBI(Listing Obligations & Disclosure
Requirements) Regulation, 2015)
[3] Stuart Haber, W. Scott Stornetta, How to Time-Stamp a
Digital Document, published in Journal of Cryptology, 1991. See http://www.staroceans.org/e-book/Haber_Stornetta.pdf (last accessed on 28/06/2023)
[4] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic
Cash System,2019, See https://bitcoin.org/bitcoin.pdf (last accessed on 28/06/2023)
[5] Section 2(h)(i) of The Securities Contracts
(Regulation) Act, 1956 “”securities” include—shares, scrips, stocks, bonds,
debentures, debenture stock or other marketable securities of a like nature in
or of any incorporated company or other body corporate”
[6] M/S Paramount Bio-Tech Industries Ltd vs UOI on 25
November, 2003 (Civil Misc Writ Petition No 51911 of 1999)
[7] SEC v. W.J. Howey Co.,
328 U.S. 293 (1946). See https://supreme.justia.com/cases/federal/us/328/293/ (last accessed on 28/06/2023)
[8] Jay B. Sykes, Securities Regulation and Initial Coin
Offerings: A Legal Primer, published in Congressional Research Service, 2018.
See at https://sgp.fas.org/crs/misc/R45301.pdf(last accessed on 28/06/2023)
[9] Section 11AA of the Securities and Exchange Board of
India (SEBI) Act, 1992
[10] See https://www.sebi.gov.in/sebi_data/meetingfiles/mar-2022/1648551129812_1.pdf last accessed on 28/06/2023
[11]Suprita Anupam, 12 Crypto
Scams & INR 72,000 Cr+ Lost: Why India’s Probes Into Biggest Crypto Scams
Have Failed, 15 Apr 2022. See https://inc42.com/features/12-crypto-scams-inr-72000-cr-lost-why-indias-probes-into-biggest-crypto-scams-have-failed/ (last accessed on 28/06/2023)
[12] ‘Morris coin scam: How were investors cheated of ?1200
crore?’, 20 Jul 2022, See https://www.livemint.com/market/cryptocurrency/morris-coin-scam-how-were-investors-cheated-of-rs-1200-crore-11658325798710.html(last accessed on 28/06/2023)
[13] Aakanksha Chaturvedi, ED seizes assets worth Rs 14
crore in Morris Coin crypto scam, 12 Jul 2022,See https://www.businesstoday.in/crypto/story/ed-seizes-assets-worth-rs-14-crore-in-morris-coin-crypto-scam-341169-2022-07-12 (last accessed on 28/06/2023)
[14]Viraj Gaur, BitConnect: Revisiting the $2.4 Billion
Crypto Scam as Founder Flees India, 03 Mar 2022, Seehttps://www.thequint.com/tech-and-auto/tech-news/bitconnect-revisiting-the-24-billion-crypto-scam-as-founder-flees-india (last accessed on 28/06/2023)
[15] BitConnect Founder Indicted in Global $2.4 Billion
Cryptocurrency Scheme, 25 Feb, 2022,
See https://www.justice.gov/opa/pr/bitconnect-founder-indicted-global-24-billion-cryptocurrency-scheme (last accessed on 28/06/2023)
[16] Kevin T. Dugan, ‘The Last Fad of the Crypto Bubble Making money by walking
seemed too easy. I fell for it anyway’, ‘Intelligencer’ newspaper by New York
Magazine, 6 July 2022 see https://nymag.com/intelligencer/2022/07/move-to-earn-the-last-fad-of-the-crypto-bubble.html (last accessed on 28/06/2023)
[19] Vincenzo Cacioppoli, New StepN partnership with Asics,
20 Aug 2022, See https://en.cryptonomist.ch/2022/08/20/new-stepn-partnership-asics/ (last accessed on 28/06/2023)
[20] Cam Thompson, Run-To-Earn Game StepN Teams With Atlético de Madrid
and Crypto Exchange WhaleFin for NFT Sneaker Collection, 18 Aug 2022. Seehttps://www.coindesk.com/business/2022/08/18/run-to-earn-game-stepn-teams-up-with-atletico-de-madrid-and-crypto-exchange-whalefin-for-nft-sneaker-collection/ (last accessed on 28/06/2023)
[21] Binance Labs Makes Strategic Investment in STEPN, 6
April 2022. See https://www.binance.com/en/blog/ecosystem/binance-labs-makes-strategic-investment-in-stepn-421499824684903657 (last accessed on 28/06/2023)
[22] Posted by STEPN, Public Beta Phase VI (stepnofficial).”Growing our user
base from a few 1000s to Millions!” 31 Dec 2022, 5:48 p.m. Tweet. See https://twitter.com/stepnofficial/status/1609162114349862913 last accessed
on 28/06/2023
Article Information
THE CASE FOR SEBI S RECOGNITION OF CRYPTO-INVESTMENTS AS SECURITIES: A COMPREHENSIVE RESEARCH STUDY
Authors: KESHAV SINGH RATHORE
- Journal IJLRA
- ISSN 2582-6433
- Published 2023/07/05
- Issue 7
About Journal
International Journal for Legal Research and Analysis
- Abbreviation IJLRA
- ISSN 2582-6433
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