[Aman Tiwari is a 3rd year law student pursuing B.L.S., L.L.B from Government Law College, Mumbai]
The past few months have been a rollercoaster ride for cryptocurrency investors. Slogans like “To the Moon” were circulating rampantly across social networking sites. It would only take a “tweet” by Elon Musk for the price of “Dogecoin”, a cryptocurrency, to increase or decrease manifolds. Amongst these tweets were dedicated groups of cryptocurrency traders engaged in a common form of market manipulation known as Pump and Dump (“P&D”) schemes.
1. Pump and Dump Schemes
A Pump and Dump Scheme in the traditional sense refers to the fraudulent practice of encouraging investors to purchase shares in a company to inflate the price artificially and then selling one's own shares while the price is high. Once the shares have been sold off, the prices eventually fall causing monetary losses to investors. P&D scheme constitutes as market manipulation under the Prevention of Fraudulent and Unfair Trade Practices relating to Securities Market, 2003 (“PFUTP Regulations”). The Securities Exchange Board of India (“SEBI”) is vested with the powers to regulate such unscrupulous activities in the securities market. SEBI framed the PFUTP Regulations to regulate market abuse such as manipulative, fraudulent, and unfair trade practices. A P&D scheme is punishable under Section 12-A of the SEBI Act, 1992.
Traditional P&D schemes usually took place over a period of time over phone calls through a specially designated place called “boiler rooms”. In SEC v. Stratton Oakmont, such boiler rooms were used by the perpetrators to organize large-scale P&D schemes. These P&D schemes generally took place in the less regulated “penny stocks” which had low market capitalization. To curb such schemes the U.S. Securities and Exchange Commission (“SEC”) launched regulations that protected investors against such schemes. Recently, the cryptocurrency market has seen a large number of P&D schemes running unbridled in the market. With the advent of the internet, these cryptocurrency scams can take place within minutes. The modus operandi of cryptocurrency P&D is slightly different from traditional P&D. Messaging services like Discord and Telegram are used to organize cryptocurrency P&D schemes which can cause huge losses to the unsuspecting investor. A select cryptocurrency coin is chosen to be artificially inflated through organized groups which mislead the people to invest in such coins.
2. Different types of Cryptocurrencies and their Regulation
The difference between cryptocurrencies and securities is that securities are regulated and issued by a central authority whereas cryptocurrencies work on a decentralized ledger system. There is no central authority regulating cryptocurrencies. Cryptocurrencies/Virtual can informally be categorised in three categories-
2.1 Traditional Cryptocurrency like Bitcoin and Ethereum which work on Distributed Ledger System which does not have any monetary reserve backing them,
2.2 Central Bank Digital Currency (“CBDC”) which is issued by the Central Bank of the Country. It represents the fiat currency of the country in digital form. A CBDC, unlike traditional cryptocurrency, is backed by monetary reserves,
2.3 Initial Coin Offering (“ICO”) tokens, the cryptocurrency equivalent to an Initial Public Offering which some companies like kodak use to raise funds and allow investments in their organisation. ICOs can be of two types depending upon their objectives.
Utility tokens: Utility tokens offer investors access to a company's products or services. They are not to be treated as investments in a company.
Security tokens: Security tokens represent an investment in a company. Just like shareholders in a company, token holders are given dividends in the form of additional coins every time the company issuing the tokens earns a profit in the market.
While considering the traditional cryptocurrencies, it can be an exasperating task to regulate pump and dump schemes. Since no central authority has control over it, such cryptocurrencies are susceptible to extreme volatility in their prices. Regulation by the government over the intermediaries facilitating cryptocurrency transactions to identify and suspend accounts participating in such schemes can be useful. Such regulations may help in reducing the frequency of P&D scams over the cryptocurrency exchange. However, this is not a fool-proof method. Scammers can always organise these activities over the cryptocurrency marketplaces in other jurisdictions which are unregulated. Bittrex, a cryptocurrency exchange has banned P&D schemes on its platform. The SEC warned the citizens in the USA against such schemes on cryptocurrency exchange platforms.
CBDC on the other hand is subject to all the laws framed by the Central Bank of the country by which it is issued. In India, The SEBI would not be regulating the CBDC. CBDC would rather be regulated by the Reserve Bank of India (“RBI”). The RBI has the complete autonomy to regulate the legal tender in the country as per Section 26 of the Reserve Bank of India Act, 1934. Therefore, CBDC will not be subjected to PFUTP Regulations.
Security Tokens under the ICOs fulfil all the conditions of a “security”. These conditions can be examined through the Howey Test. This test provides a universal framework to identify the applicability of securities laws to an unorthodox instrument.
3. What constitutes a Security?
SEC v. W.J. Howey Co., elucidated that an unusual instrument could be considered as “security” if the circumstances of the transaction so dictated. The Howey Test by the U.S. SEC provides a framework to distinguish between utility and securities tokens. In order for a financial instrument to be considered a security and fall under the ambit of the SEC, the instrument must meet these four criteria:
1. It must be an investment of money;
2. With an expectation of profit;
3. In a common enterprise; and
4. With the profit to be generated by a third party.
In Lithuania, ICOs or Security Tokens are treated as investments. In Countries like Japan and Canada, Investment/Security tokens are treated as securities; all transactions are permitted as long as they comply with securities laws.
To treat Security Tokens under the laws protecting against P&D schemes, they will have to considered as securities under the Securities Contract Act, 1956 which are defined as—
“Shares, scripts, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company [or a pooled investment vehicle or other body corporate]”.
It is clear from the definition that Security Tokens can be identified as other marketable securities. The Howey Test is clearly applicable to Security tokens. These tokens should be subjected to securities laws and provide a redressal framework against P&D schemes. However, legislative action for Tradition cryptocurrency like Bitcoin is yet to be seen by the Government of India. Internet And Mobile Association of India vs Reserve Bank of India quashed the ban on cryptocurrencies given by RBI through its circular preventing banks to engage with cryptocurrency exchanges. Cryptocurrencies were further treated as intangible assets having some exchange value. Legislation passed by the government can clear any ambiguities arising out of treating Traditional cryptocurrencies as either a medium of exchange or security. Various blockchain start-ups in India are raising funds through ICOs in jurisdictions where ICOs have clear established laws and proper regulatory authority. A clear amendment in the Securities Contract Act, 1996 is required which explicitly includes the terms Security Tokens as well. These Tokens clearly pass the Howey Test and should be subjected to PFUTP Regulations against P&D schemes in India.