Understanding "Howey Test": Which cryptocurrencies will be classified as securities by the SEC?

Author: Yingning Haruka

The cryptocurrency market has always been overshadowed by the sword of Damocles, namely SEC regulation. This article will start with the history of the development of U.S. securities law and explain the most important qualitative standard for securities in securities law—the Howey Test, providing a reference for determining whether various cryptocurrencies should be considered securities.

I. U.S. Securities Law

During the peak of the Great Depression, the U.S. Congress and President Roosevelt enacted the first federal securities law.

The Securities Act of 1933 pertains to companies raising funds from the public. Investors can decide which risks to undertake; companies issuing securities to the public must provide comprehensive, fair, and truthful information disclosures to protect investors' rights. Roosevelt referred to this law as the "Truth in Securities Act."

In 1934, Congress passed the Securities Exchange Act. This regulation covers intermediaries, such as the exchanges themselves and broker-dealers. The basic idea is that the public should receive disclosures and protections not only at the time of the initial issuance of securities but also when securities are traded in the secondary market.

In 1940, Congress passed the Investment Company Act and the Investment Advisers Act, requiring funds and advisers to register to manage others' funds and to prevent more opportunities for conflicts of interest.

The definitions of securities in the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934 are very broad, including not only securities used for investment in the general sense, such as stocks and bonds, but also various non-standard securities, such as "profit-sharing or participation certificates," "investment contracts," and "all profit or instruments generally recognized as securities."

U.S. Supreme Court Justice Thurgood Marshall described the scope of securities law by stating, "Congress has roughly outlined the definition of securities, and the purpose of enacting securities laws is to regulate investment, regardless of the form or name of the investment."

II. The Judgment Standard for Securities—The Howey Test

The Howey Test is a standard used to determine whether a specific transaction constitutes a securities offering, established in the 1946 U.S. Supreme Court case SEC v. WJ Howey Co.

Howey Co. was a real estate company in Florida that developed large orange groves and sold general land to investors. The company signed a land sale contract with investors while also signing a management services contract, entrusting the sold land to the defendant company for management.

The more criteria that are met in the Howey Test, the closer the attributes of the specific transaction are to being classified as a security.

(1) Investment of Money

This criterion requires that purchasers provide funds to the project initiators in the form of cash as consideration.

(2) Common Enterprise

This criterion aims to distinguish investment contracts from one-on-one private contracts. Regarding this criterion, the Supreme Court requires that a common enterprise must have "horizontal commonality," "broad vertical commonality," and "narrow vertical commonality."

• "Horizontal commonality" requires that the wealth of each investor is tied to the fate of other investors through the pooling of funds, usually combined with proportional profit sharing;
• "Broad vertical commonality" requires whether the investors' ability to earn profits depends on the efforts of the project initiators;
• "Narrow vertical commonality" requires that the investors' profits and the efforts of others are combined with the final business results;

(3) Expectation of Profit

Here, "profit" can refer to capital appreciation from the initial investment or from operating the business, or profits generated from the use of the buyer's funds. Price appreciation resulting solely from external market forces (such as general inflation trends or economic development) affecting the supply and demand of the underlying asset does not fall under the "profit" of the Howey Test.

(4) Derived From The Efforts of Others

This criterion requires that the project initiators, organizers, or other related third parties have made necessary management efforts, and that such efforts will critically affect the success of the venture, with investors only needing to pay specified fees and costs without actually participating in the operation and management of the project.

The core idea behind the Howey Test's established criteria is "to protect the legitimate rights and interests of investors."

For example, the requirement for "common enterprise" is due to the Supreme Court's belief that in a "common enterprise" scenario, the costs for individuals to conduct due diligence and communicate are high, and individual investors lack the incentive to coordinate with other investors to obtain information, nor can they prevent collective negotiations between the project initiators and others. Therefore, investors can only rely entirely on the initiators to obtain profits, placing the initiators in a crucial position in the project and creating an unequal status between them and the investors.

To remedy this power imbalance, defining investment contracts as securities is more beneficial for investors to assess the pricing of investment projects and protect their interests. Similarly, the explicit mention of "the efforts of others" in the fourth criterion aims to clarify the responsible parties for investment contracts, allowing for accurate identification of the information disclosure obligors when implementing securities disclosure obligations.[1]

III. The U.S. Securities and Exchange Commission (SEC) and Cryptocurrencies

On April 3, 2019, the U.S. Securities and Exchange Commission (SEC) released a framework for analyzing digital asset investment contracts based on the Howey Test, providing official guidance for determining whether digital currencies fall under the category of securities. The SEC believes that most digital currencies currently on the market meet the two criteria of "investment of money" and "investment in a common enterprise."

Regarding the other two criteria, the SEC pointed out that if the development of a digital currency relies on the efforts of a company or centralized entity, and purchasers have a reasonable expectation of profits from the investment, then such digital currency is considered a security. It is important to note that if a digital currency is sufficiently decentralized, has a clear application scenario, and its price changes are related to its application rather than the investors' expectations of profits, then it does not fall under the category of securities. The SEC has stated that Bitcoin and Ethereum are not considered securities.[2]

3.1 BTC

Bill Hinman, former Director of the SEC's Division of Corporation Finance, stated in a 2018 speech that Bitcoin (BTC) is not a security and is regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is primarily responsible for regulating the derivatives market, including futures, swaps, and certain types of options. This also echoes the fact that BTC mining is similar to commodities like gold and oil.

3.2 ETH

3.2.1 ETH (ICO)

The initial coin offering (ICO) for Ethereum began in August 2014, raising 31,000 Bitcoins over a 42-day period, selling 60,102,216 Ether, which amounted to approximately $18.4 million at the time. From this ICO history, it should be classified as a security.

3.2.2 ETH (PoW)

The POW phase of Ethereum is similar to that of Bitcoin.

3.2.3 ETH (PoS)

Ethereum completed the merge of its mainnet and beacon chain on September 15, 2022, transitioning to a proof-of-stake (PoS) consensus mechanism. The operation process of PoS is that stakers deposit 32 ETH into a smart contract and simultaneously receive a certificate to prove their right to withdraw from staking.

It can be seen that, first, the smart contract does not use the 32 ETH; in an investment scenario, a company would spend this asset on production. Due to the existence of withdrawal certificates, all stakers' identities are identifiable, not a bound community of fate, and do not possess the characteristics of "horizontal commonality." Second, staking rewards are issued by the PoS algorithm, not by service providers (such as Coinbase), so the rewards do not come from the efforts of others. If viewed as an investment, ETH should be given to validating nodes, which earn profits by putting these assets into production and then share part of the profits with the stakers.

3.3 Stablecoins

On February 14, the SEC enforcement personnel issued a "Wells notice" to Paxos, the issuer of the BUSD stablecoin, and that afternoon, the New York State Department of Financial Services ordered Paxos Trust Co. to stop issuing more BUSD Tokens.

Regarding cryptocurrency stablecoins, current SEC Chairman Gary Gensler mentioned in a speech on September 8, 2022, that stablecoins have characteristics similar to and potentially competing with money market funds, other securities, and bank deposits, which will raise significant policy issues. It is important to ensure that we have appropriate investor protections and safeguards against illegal activities.

Stablecoins are primarily used as a means to participate in crypto platforms or as settlement tokens within crypto platforms. Whether they fall under the shares of money market funds or other types of securities depends on their attributes, such as whether these instruments directly or indirectly pay interest through affiliated companies or other means; what mechanisms are used to maintain value; or how the tokens are provided, sold, and used within the crypto ecosystem.

3.4 Other Tokens

SEC Chairman Gary Gensler has repeatedly stated that most virtual assets are securities.

He cited a 1990 opinion from U.S. Supreme Court Justice Thurgood Marshall as evidence: when someone raises funds from the public and the public participates in its profits, it constitutes a security. The SEC regulates these virtual assets deemed to be securities, including requiring issuers to comply with securities law disclosure and registration requirements to ensure that investors have sufficient information to make informed investment decisions. Additionally, the SEC also regulates fraudulent and manipulative practices in the virtual asset market to protect investors' rights.

IV. Is Staking a Security?

Coinbase believes that staking does not meet the four conditions of the Howey Test.

1. Staking services do not constitute an investment of money, as stakers retain full ownership of their assets;
2. The providers of staking services are not ordinary businesses; the entire process is executed on a decentralized network through smart contracts;
3. Staking rewards are wages for blockchain validators, not investment returns, and do not fall under "reasonable profit expectations";
4. The providers of staking services only use public software and computers to perform validation services and do not engage in any management work; these are IT services, not investment services, so rewards are not paid based on "the efforts of others."

The purpose of securities law is to correct information asymmetry and protect the legitimate rights and interests of investors. However, there is no information asymmetry in staking, as all participants have equal access to the same information on a public and transparent blockchain to verify transactions. Attempting to impose securities law on staking processes does not help users at all. On the contrary, unnecessary aggressive regulation will hinder users' access to basic crypto services and push them toward offshore, unregulated platforms.[3]

References:

[1] Zhang Chao. The Legal Nature of Security Tokens and the Shift in Regulatory Paradigms—Analyzing the U.S. Digital Asset Investment Contract Framework[J]. Financial Law Review, 2020(01):85-100.

[2] Xiao Feng, "Blockchain: Distributed Business and Intelligent Future," CITIC Press, 2020.

[3] Paul Grewal. Coinbase's staking services are not securities. And here's why.

https://www.coinbase.com/blog/coinbases-staking-services-are-not-securities-and-heres-why, 2023-2-10