In our last blog post, we discussed the SEC’s position that Ethereum was ‘not a security’. With the commentary from the SEC, it’s worth re-visiting the four-prongs of the Howey test and the meaning of a security. Section 2(a)(1) of the Securities Act of 1933 contains a statutory definition of the term “security”. The definition includes a non-exhaustive list of various financial instruments including many traditional financial interests and something nebulously called an “investment contract”.
If the financial instrument falls outside of the standard and commonly understood categorization of equity, debt, or derivatives instrument, then the analysis turns on whether or not an “investment contract” exists. As a result of the inherent uncertainty that accompanies this definition, a determination rubric was developed through the common law by the Supreme Court and has since become known as the “Howey Test”. Under the Howey Test, an investment contract is (1) an investment of money; (2) made in a common enterprise; (3) with an expectation of profits; (4) to be derived from the efforts of others. If these prongs are met, then, according to the Supreme Court “it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value”.
What was Howey Doing?
In 1946, the Howey Company came up with an interesting scheme to profit from its citrus grove (yes, this all started over oranges). The Company planted the oranges on the property, kept half of the property for itself, and sold interests in the other half to the public to fund additional company development. Howey’s service company then offered the land purchasers a service contract to maintain the land they bought. Thus, the purchasers could simply be passive investors in the growth of the citrus grove while Howey did all the work to grow the value of the grove. Even though some purchasers chose not to accept Howey’s full offer to enter into a service contract too, the Court said that the mere offer was enough to constitute an unregistered, non-exempt securities offer as an “investment contract”. (So, what about token airdrops? That’s a story for future blog post…)
Pulling Apart the Prongs
The first prong of the test – an investment of money – is fairly straightforward. Under Howey and succeeding case law, an investment of money may be deemed to include capital, assets, cash, goods, services, or promissory notes (or, presumably, anything of value).
The second prong – a common enterprise – is, however, not as straightforward. The Supreme Court has yet to define a “common enterprise”. Consequently, federal courts of appeal have varying interpretations of the term. In total, we have three approaches that exist to examine the term under Howey. The first approach is horizontal commonality. Here, a common enterprise exists where multiple investors pool funds and the profits of each investor correlates with the other investors. As the case law has developed, it appears that there is no common enterprise where there is no sharing of profits or pooling of funds. The second approach is narrow vertical commonality, which finds a common enterprise if there is a correlation between the investor’s profits and the promoter’s. Finally, broad vertical commonality finds a common enterprise where “the investors are dependent upon the expertise or efforts of the investment promoter for their returns”.
The vertical approach is relatively easy to satisfy as we are only concerned with the fact that the investor depends on the promotor because the promoter often has more knowledge about the project than the investor and stands to benefit (in some sense) based off of their expertise putting them in alignment with the investors’ profit seeking goals. The horizontal approach is slightly more difficult to apply, as it depends on the coordination of multiple investors; however, for token sales (to refer to a modern and hot topic), it depends on the distributions of the tokens and who or what is receiving any proceeds from sale of tokens.
As to the third prong – an expectation of profits – the Supreme Court, in United Housing Foundation, Inc. v. Forman, stated that profits were “capital appreciation resulting from the development of the initial investment…or a participation in earnings resulting from the use of investors’ funds”. It is the return an investor seeks on their investment. In looking at the meaning of investment, the Forman Court determined that an investment depended on the investor. The Court differentiated between “consumption” and “investment” noting that an investment occurs when “the investor is ‘attracted solely by the prospects of a return on investment’” (emphasis added). Therefore, an investment exists if the investor decided to invest not for use but some return on investment.
The third prong is meant to be read together with the fourth prong – derived solely from the efforts of others. Under this prong, the success or failure of the enterprise must be significantly correlated with the efforts of the promoters. While the word “solely” seems to limit the breadth of possibilities, courts have broadened it to include essential or significant managerial or other efforts that are necessary for the enterprise to succeed. As the case law has developed, the simple four-pronged approach quickly becomes very intricate and nuanced.
Re-Examining the Test
The Howey Court’s definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”. Further keeping with such a broad definition, form over substance with an emphasis on the economic realities of the transaction, is stressed. This principal has been evident in the SEC’s approach to regulation, across a broad spectrum of policy areas, since its establishment.
The SEC’s analytical approach is clearly on a case by case basis. Applying these lessons in the modern context, in the decade since the launch of Bitcoin, for example, only two cryptocurrencies have been declared not securities: Bitcoin and Ethereum (Note: do not neglect the CFTC, FINRA, other federal or state regulatory bodies).
To date, it is easy to conclude that a majority of Initial Coin Offerings (ICOs) are securities simply by saying that: the investor invested Bitcoin or Ethereum into an entity formed to develop the promised platform that is not yet operational at the time of “investment” and the investor is relying on the development team of the entity to develop the platform; and, therefore, the investor is investing in a security. Thusly, each of the prongs of the Howey test could be concluded to apply. However, nuance matters, and never more so than in the increasingly complex world of digital currency adjacent offerings. If, for example, projects are open source and available on GitHub, then, in theory, anyone can comment or contribute to the project moving them from passive to more active investors. Of course, not every cryptocurrency purchaser knows how to code or has used GitHub. Nonetheless, it is clear to see that cracks can be formed in the SEC’s rather narrow approach to its “broad” securities test.
Further, the governance models used in Bitcoin and Ethereum are simply two governance models at the protocol level in an ecosystem which is still rapidly developing and iterating (for example, EOS, DFINITY, Augur, and other structural considerations like on-chain versus off-chain governance, Proof-of-Work, Proof-of-Stake, Delegated Proof-of-Stake, etc.). Further, the governance models for various projects are going to adapt if the project is to survive over time. The initial design of the network is important but is subject to change. After all, software is not static.
With the explosion of varying governance and economic models at the protocol level, is “common enterprise” and “derived solely from the effort of others” relevant? Is the Howey test really malleable enough to consider the governance and economic designs that are coming? We will be following these issues closely as we continue to see new projects emerge and existing models iterate.
Coupled with the SEC’s remarks, Justice Breyer’s remarks are a giant step forward for the crypto community. While these remarks are not binding law, it does show a shift in the regulators’ and justice department’s sympathies toward cryptocurrency as a legitimate form of value.
Commentary by Stan Sater & Yuri Eliezer, Esq. & Jeffrey Bekiares, Esq. Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]