The interaction of securities regulation and technology creates a vast array of complex issues, including whether certain things constitute securities at all. For example, the United States Securities and Exchange Commission (‘SEC’) has struggled to decide whether cryptocurrencies are securities under United States law. In July 2017, the SEC issued a report suggesting that certain cryptocurrencies could be considered securities; whether this conclusion is correct is likely to be challenged in court for years to come.
In my new article, Securities Regulation in Virtual Space, I explore an important and related issue of how United States federal securities regulation may apply to securities existing entirely within virtual space. In this context, ‘virtual space’ is used to designate any software-created environment, including those found within video games, virtual worlds, virtual reality, and the virtual elements of augmented reality. They can range from something as simple as a video game chess board to a complex virtual reality environment. If securities existing entirely within virtual space are deemed securities under federal securities law, software developers, platform owners, and users would become subject to the registration requirements and anti-fraud provisions of that body of law, along with the rest of its provisions.
Whether securities can exist entirely within virtual space under United States federal securities regulation depends on the definitions of that term found within section 2(a)(1) of the Securities Act of 1933 (‘Securities Act’) and section 3(a)(10) of the Securities Exchange Act of 1934 (‘Exchange Act’). Notably, both of these definitions, which have been interpreted to be substantially similar, provide that investment contracts are a type of security. Although Congress did not define the term ‘investment contract’ under the Securities Act or Exchange Act, the Supreme Court of the United States in SEC v. W.J. Howey Co. provided a definition for purposes of United States federal securities law. Writing for the majority in that case, Justice Frank Murphy stated that in determining the existence of an investment contract, ‘[t]he test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.’
Based on this definition, securities may well exist within virtual space. For example, a video game or augmented reality game developer could create a game in which an individual uses real world currency to purchase virtual currency that would then be used to purchase passive investments in a virtual business, with the expectation that the management of the virtual business generates a virtual profit that the investor could eventually convert back into real world currency. With that said, the definitions found in the Securities Act and Exchange Act both begin with the prefatory language ‘unless the context otherwise requires.’ This means that investments that would otherwise meet the definition of a security will not be considered a security if the context suggests that they should not be subject to federal securities regulation.
I believe the virtual context requires that securities existing entirely within virtual space should be excluded from the scope of federal securities regulation. In drafting federal securities laws in the 1930s, Congress was concerned about real world securities markets, rather than what might be going on within any sort of fantasy play. Also, under the United States Constitution, Congress must explicitly speak to create law, which it has not done in regard to securities within virtual space. Moreover, when statutes can be applied criminally, which is the case in United States federal securities regulation, they must be interpreted narrowly according to the rule of lenity. Finally, applying federal securities law to virtual space is also inappropriate because it hinders the creativity and regulatory experimentation that can and should occur within these virtual environments.
Concerns do exist regarding the exclusion of such securities from the application of federal securities law. For example, investors would receive less protection, and virtual space would become subject to a complex patchwork of Blue Sky laws. In addition, applying federal securities law would at minimum ensure that these rapidly developing and evolving virtual environments are subject to some system of coherent regulation. Ultimately, however, the arguments for excluding such securities from the application of federal securities law outweigh the arguments for applying it.
Eric Chaffee is Professor of Law at the University of Toledo.