Sorry for the long period of radio silence, just been busy getting ready for the continuation of the longest arbitration I have ever worked on, now in the midst of week no. 6! But thanks to Denise for this thoughtful take on the Howey test and its application to crypto. – Alan
In any classic securities regulation textbook, you’ll be sure to find a chapter called “Definition of a Security.” Besides your typical bonds and stocks, which are easily identifiable as securities, the most infamous (and a sure-to be on a law school final exam) question is: What is an investment contract and under what circumstances is it deemed to be a security? A quintessential catchall, the term “investment contract” has been liberally construed by courts to apply to a wide range of money-raising schemes that were found to be securities (even as far-reaching as interests in whiskey warehouse receipts).
This progeny of cases comes from the landmark case of SEC v. W.J. Howey Co. in which the Supreme Court established the “Howey test” for an investment contract. For those of you not familiar with the case or need a refresher, in Howey, a hotel operator sold interests in orange groves as an investment scheme, combining both a real estate contract for the sale of tracts of land with a service contract to cultivate the orange trees. The Court, focusing on the economic reality of the transaction, held that the circumstances surrounding the sale of the orange grove interests constituted an investment contract and therefore a security. To clarify the Court’s finding, it’s important to point out the following distinction: the underlying asset (the orange grove) itself was not held to be a security, but rather it was the way in which the tracts of orange groves were sold that rendered them an investment contract. Naturally, you may be wondering, what exactly do orange groves have to do with digital assets? As it turns out, the SEC believes they have a lot more in common than you would think.
Cryptocurrencies have been all the talk lately, but despite the growth of the decentralized finance (DeFi) movement, U.S. laws and regulations have been stagnant and haven’t kept up with the crypto craze. Now, with the mainstream acceptance of cryptocurrencies, there is also mounting pressure on federal agencies like the SEC to figure out a way to regulate them under existing laws. That’s where the Howey test comes in.
Without new legislation to rely on, the SEC has determined that a digital asset (such as a cryptocurrency) may be considered an investment contract and therefore a security under the Howey framework. As SEC commissioner Hester Pierce (a.k.a. “Crypto Mom”) explained, “when we think about a cryptoasset as being a security what we’re doing is we’re saying it’s being sold as part of an investment contract. It doesn’t mean that the asset itself necessarily has to be a security. It means that it was being sold as a security.” Putting aside Pierce’s remarks, SEC Chair Gary Gensler recently admitted that cryptocurrencies are like the “Wild West,” and continues to vocalize his desire for more Congressional rulemaking on digital asset regulation.
At the same time, though, Gensler expressed his view that there is no issue on how cryptocurrencies are currently treated under the securities laws, concluding that “certain rules related to crypto assets are well settled.” Referring again to the Howey test, he also remarked that “the test to determine whether a crypto asset is a security is clear.” Yet, it is actually the lack of regulatory clarity that has kept the cryptocurrency community in limbo on how to act and at the mercy of the SEC’s scattered method of regulation-by-enforcement. As a testament to that, the SEC has now brought several digital asset cases under the Howey framework, alleging that the digital assets at issue were investment contracts and therefore securities.
In one recent case (SEC v. Ripple) being dubbed the “cryptocurrency trial of the century,” the SEC filed an action against Ripple Labs and its founders for their unregistered offering of the XRP digital token in alleged violation of the securities laws. The SEC alleged that XRP is an investment contract due to its centralized nature and the way in which it was offered, sold, and promoted. In order to preserve the sanctity of the Howey test and its application to digital asset cases, the SEC did not allege that XRP (as in the digital token) was itself a security, but, rather, it was the circumstances surrounding XRP’s offering that made it one.
Yet, the SEC felt the need to further justify its position that XRP is an investment contract by also explaining why “XRP is not a currency.” This leaves us with one remaining question: if XRP (as in the digital token itself) is not a security, but it’s also not a virtual currency, then what exactly is it? According to the SEC, the answer is simple: it’s “software code.” Respectfully, I have to disagree with the SEC here. The essence of a digital token cannot be diluted to have such a rudimentary meaning. Applying this type of logic to the Howey case would the equivalent of reducing the orange grove’s meaning to an orange seed. The XRP digital token represents something beyond software code; it represents a virtual currency. So whether the SEC would care to admit it or not, the Howey orange grove analysis does not apply as neatly to the facts and circumstances surrounding XRP and its offering.
While the Ripple case guarantees to be an interesting outcome for the DeFi movement, the SEC doesn’t plan to stop there. The SEC has put a “spotlight” on initial coin offerings (“ICOs”) and continues to bring more cases of unregistered offerings of digital assets and their promoters (celebrities not excluded), such as against “Above the Law” star Steven Seagal. While new legislation such as the Securities Clarity Act is promising, as its name aptly suggests, more clarity in this area, in the meantime, the SEC will continue regulating the nascent cryptocurrency industry under 75-year old jurisprudence. It is my hope that we will soon see formal cryptocurrency regulations in place so that the SEC can start reviewing digital asset cases using an apples-to-apples analysis rather than settling on comparing them to orange groves.