Courts and the SEC use the Howey Test—originating from a 1946 Supreme Court opinion—to determine whether a new digital asset project is an investment contract and must register as a “security” under the federal securities laws. However, some types of assets may be ill-suited to the Howey Test. Digital assets may be one such example. Therefore, determining the parameters of appropriate, healthy regulation of digital assets is challenging.
The Howey Test
In SEC v. Howey, defendant Howey was an entity selling citrus groves to the public. These citrus groves were actually investment contracts because they were offered to investors for money who expected Howey to make them a profit.
There are four Howey factors:
- Investment of money.
- In a joint enterprise.
- With an expectation of profits.
- Derived solely from the efforts of others.
These factors are now referred to as the Howey Test. They are frequently used to assess whether a digital asset project is an investment contract—therefore, making that digital asset subject to SEC regulation as security.
From Orange Groves to Digital Assets—Tokens
Now that we know a citrus grove can be “packaged and sold as . . . a security,” the question is what else is potentially subject to SEC regulation. Courts have found various assets to be secured, such as whiskey casks and chinchillas.
Finally, we arrive at digital assets. The SEC has long determined that Bitcoin is not a security—a common understanding that was soon extended to Ethereum. These determinations were mainly made because these digital assets are sufficiently decentralized, so no single entity or individual controls them.
The “Security” versus “Commodity” Argument
The issue is whether the Howey Test is appropriate for digital assets and whether some digital assets are more like commodities than securities.
Commodities are regulated by the Commodity Futures Trading Commission (“CFTC”), and securities are regulated by the SEC. SEC regulation of securities is arguably more stringent, with additional requirements, burdens, and ongoing disclosure and reporting obligations.
Commodities are goods, property, or other assets purchased or sold in an exchange—including raw materials or agricultural products. Commodities do not provide for an issuer return but are mined or grown. Therefore, their value is “intrinsic based on market supply and demand.”
On the other hand, securities are offered and sold to the public in a public offering. Purchasing security gives the holder a right or interest in the issuing company and various benefits, including dividends, ownership, voting, governance, etc. The value of security is often dependent upon the success of the company.
Case Study: Ripple Labs’ XRP
The SEC has long stated that “XRP is a security.” From the investment of money for XRP and the expectation of profits from Ripple Labs to the fact that XRP runs on its blockchain, the SEC makes many good arguments for regulation of XRP as a “security.”
Specifically, the SEC’s complaint alleges that Ripple raised funds—starting as early as 2013—through the sale of its token—called XRP—in an unregistered offering to investors in the United States and abroad.
Howey for Crypto?
Many argue that the Howey Test and its four prongs are incompatible with an emerging crypto industry. Kristin Smith, head of the Blockchain Association, told CNBC the following:
Right now, the regulatory landscape has significant grey areas. There should be an open dialogue between crypto companies and the SEC to best address these outstanding issues. Further, SEC regulation of digital assets may be inconsistent with decentralization. Decentralized applications and projects are meant to function without an oversight body. Under certain circumstances, SEC oversight contradicts many novel digital asset projects.
The Howey Test is increasing in popularity thanks mainly to the surge in the crypto industry’s favor. The SEC uses the factors of the Howey Test to assess whether a digital asset is an investment contract or security. The Howey Test may be incompatible or even inconsistent with blockchain technology. Until there is clear guidance from Congress, individuals and companies wishing to get involved in the crypto industry will risk potential regulatory and enforcement action.