What is the Howey Test & How Does it Relate Cryptocurrency?

Cryptocurrencies occupy a bizarre and gray portion of the legal landscape. This is partly due to their novelty. Quite simply, blockchain technology and its accompanying cryptocurrencies haven’t been a part of the landscape long enough for banks and regulatory agencies to make much sense of them.

This is also partly due to their anti-authoritarian nature. In the ur-example – Satoshi Nakamoto’s white paper introducing Bitcoin – one of the fundamental reasons a cryptocurrency has for existing is skirting third-party regulation.

Indeed, that’s what separates cryptocurrencies from other financial instruments. Via a distributed ledger on a blockchain, the currency provides its own internal regulation and enforcement.

That’s the ideal situation, anyway. In the real financial world, the situation is considerably more complex. The U.S. Internal Revenue Service has already clarified that trading cryptocurrencies is a taxable event.

Moreover, the U.S. Securities and Exchange Commission (SEC) has deemed that cryptocurrencies pass the Howey Test, are therefore securities, and are therefore subject to securities regulation.

Let’s take a look at the Howey Test, how it applies to cryptocurrencies, and how it impacts the market moving forward.

The Howey Test

The genesis of the Howey Test was a 1946 Supreme Court case. In the case, the titular W.J. Howey Company sold citrus grove plots to outside investors. Howey and the investors reached an arrangement whereby the buyers would immediately lease the groves back to Howey, which would harvest and sell the resulting citrus products.

The Supreme Court ruled the citrus groves, in this case, to constitute an investment contract and, thus, a security. It applied four main criteria in making this decision, which subsequently became known as the Howey Test.

In order for a financial instrument to be dubbed a security and fall under the purview of the SEC, the instrument must meet these four criteria:

• It must be an investment of money
• With an expectation of profit
• In a common enterprise
• With the profit to be generated by a third party.

The citrus grove in the precedent was bought with money and an expectation of profit by a pool of common investors, and its success depended on Howey’s ability to profitably make money from selling its citrus products.

Stocks are a more familiar type of security, and they also pass the Howey Test. A share in U.S. Steel is bought with money in the hopes that the share will eventually be worth at least as much as its initial purchase price. This is done in a pool with other investors, and they are at the mercy of U.S. Steel’s board of directors when it comes to profits.

That last bit is key. The hammer of securities regulation comes down when the investor can’t do much of anything to impact whether an investment turns a profit. Ostensibly, the registration and financial reporting requirements that go along with regulation are to protect investors from predatory scams.

Again, that’s how it works in an ideal world, with large companies employing the kind of high-priced attorneys and accounts needed to comply with regulation.

Cryptocurrency initial coin offerings turn that established system on its head. The developers of coins are not huge multinational corporations but small startups – sometimes, just a single person. They do not have the financial, political, or legal clout to do their own research, so to speak, on whether their initial coin offering complies with applicable security regulations.

In fact, up until 2017, it wasn’t clear whether cryptocurrencies were securities at all.

The DAO

A German group founded The DAO and held a token sale in 2016. This token was then attacked by hackers, forcing a fork in the Ethereum blockchain.

While the SEC chose not to take enforcement actions against The DAO, it issued a statement in July 2017 that clarified that henceforth, all cryptocurrencies were to be treated as securities.

“These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology,” the SEC wrote. “In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.”

The apparent blockbuster in the legalese was that unregistered crypto initial coin offerings were illegal, and so U.S. citizens are barred from participating in them. Cryptocurrency developers working in coffee shops and basements had been lumped in legally with major corporations and banks.

This provoked an immediate outburst from the cryptocurrency community, who said that bringing initial coin offerings under the aegis of the SEC risked stifling growth in the potentially explosive industry.

First of all, critics argue, it is not immediately clear that all tokens are securities. The SEC’s report was worded in such a way to deem The DAO a security, but not necessarily all cryptocurrencies. Some may fall short of the Howey Test, although the onus is on developers to prove that.

Secondly, the barriers to entry for coin developers are substantially raised if they indeed are securities. Coins often depend on an initial coin offering for an injection of liquidity to give the project a head start. If those offerings cannot be held without first diving through expensive regulatory hoops, the project risks dying on the vine.

Moving Forward

Like most aspects of the crypto sphere, it is unclear what exactly comes next. The SEC hasn’t issued any more detailed reports on cryptocurrencies, and that might be deliberate; at least some industry watchers are applauding the SEC for using a relatively light touch to allow wiggle room for the crypto community to sort out what, exactly, it is.

Moreover, by not painting all crypto coins with the same brush, the SEC has put the ball in developers’ courts to prove that they are not, in fact, operating a security.

That’s an expensive ball, indeed, and it certainly puts a damper on the Wild West atmosphere of initial coin offerings – at least in the U.S.

This might indeed work in favor of the market as a whole. Coinmarketcap.com alone lists more than 1,600 coins, some of them extremely problematic in terms of use case and even sincerity.

The word “scam” gets tossed around in the crypto sphere far more often than it should due to projects that seem to appear, pump, and disappear without a trace. Shady developers and pump-and-dump groups lurk in the nonregulated shadows.

A measure of legitimacy, and perhaps institutional money, might come with more stringent regulatory rules.

The cost, of course, is the laissez-faire development atmosphere.

References

1. https://bitcoin.org/bitcoin.pdf
2. https://www.irs.gov/newsroom/irs-virtual-currency-guidance
3. https://caselaw.findlaw.com/us-supreme-court/328/293.html
4. https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html
5. https://www.sec.gov/litigation/investreport/34-81207.pdf
6. https://www.cnbc.com/2018/03/07/the-sec-made-it-clearer-that-securities-laws-apply-to-cryptocurrencies.html
7. https://blog.xtrabytes.global/general-crypto/understanding-the-howey-test/
8. https://www.coindesk.com/every-token-snowflake-secs-ico-guidance-isnt-enough/
9. https://www.sec.gov/news/public-statement/corpfin-enforcement-statement-report-investigation-dao
10. https://www.coindesk.com/simplest-way-understand-dao-security/
11. https://coinmarketcap.com/all/views/all/

Source: https://blockonomi.com/howey-test/