Digital Assets—Investment Contracts or Howey Test Unicorns? (Part 2 of 6)
In this second installment in his six-part series, Professor Ari Gabinet details the Howey test, a legal standard used to evaluate whether a transaction constitutes an investment contract. Professor Gabinet draws on his expertise in securities law, accrued through experience as a private practice litigator, a private sector in-house counsel, and as a district administrator of the SEC.
The legal test determining whether a particular transaction constitutes an investment contract comes from the U.S. Supreme Court’s decision in SEC v. WJ Howey Co., 328 U.S. 293 (1946). Under the Howey test, contracts and schemes involving items as diverse as chinchillas, condominium units, pay phones, prepaid phone cards and gold bullion have been held to be “securities.”
Howey involved contracts for the sale of strips of land comprising a citrus grove coupled with a service contract. Under the contract, the Howey would cultivate the entire grove, sell fruit produced on it and remit to the landowners their share of the net proceeds. The buyers were not entitled to enter or use the land themselves.
The Court determined that the primary purpose of the contracts was to provide the buyers with the opportunity to earn part of the revenue stream from the cultivation and sale of the fruit by the Howey, not the ownership and occupancy of the real estate. As such, it embodied the essence of investments – “schemes devised by those who seek the use of the money of others on the promise of profit.” Howey, 328 U.S. at 299.
As subsequently refined, the elements of the Howey test are:
(i) an investment of money
(ii) in a common enterprise
(iii) with profits to be derived solely from the efforts of others
See Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994).
As is sometimes the case with evolving markets, the exigencies of the market sometimes result in SEC enforcement actions getting ahead of development of comprehensive regulatory guidance. Such is the case with digital assets. As noted, the proliferation of blatantly fraudulent coin offerings naturally triggered enforcement actions. But as the cases became more complicated, the SEC’s actions became more deliberative; when the question arose in an enforcement case whether a major cryptocurrency was a security under Howey, the SEC stopped short of full enforcement action.
In 2017, the staff had initiated an enforcement investigation to determine whether the unregistered public offering of a prominent cryptocurrency, violated section 5 of the ‘'33 Act. Rather than bring an enforcement action, the SEC issued its Report of Investigation pursuant to Section 21(a) of the Securities Exchange Act of 1934: the DAO (Exchange Act Rel. No. 81207) (July 25, 2017) (the “DAO Report”). A report under section 21(a) of the ’34 Act is a device the SEC uses to publish information about an enforcement investigation without actually taking enforcement action in the matter. They are sometimes used to address emerging issues or positions that the SEC is taking for the first time.
In the DAO Report, the SEC assessed whether DAO, an unincorporated organization designed to automate and facilitate cryptocurrency transactions, had engaged in an unlawful unregistered offering of securities in selling its digital asset to the public. The SEC concluded that DAO tokens were used to fund the creation of the DAO blockchain environment, the operation of which would provide returns to DAO token holders. Applying the Howey test, the Commission concluded that DAO tokens were securities given the token holders’ purchase of DAO tokens in exchange for the prospect of a return from the DAO system, dependent on the managerial work of its founders.
The application of Howey to digital assets at either end of the spectrum is straightforward. Where the asset is generated by the autonomous operation of an algorithm on a blockchain created independently of the issuance of tokens and without publicly solicited capital, the Howey test would not be satisfied. Bitcoin is a clear exemplar of this category. It was created by the autonomous operation of a blockchain and algorithm that were created without investment of capital from the people who would ultimately own bitcoin. Bitcoins themselves were not created through the entrepreneurial or managerial efforts of the creator of the bitcoin system. The bitcoin environment was, following its launch, self-operating and the creation of bitcoins did not depend on any further work by its creator. Nor does the value of bitcoin derive from any ongoing activities of its creators or promoters—its value comes entirely from its perceived utility as a currency (or, at this point, an investment whose price at any moment depends on buyers’ predictions that other people will want to buy it).
On the other end of the spectrum are the simple frauds; promoters who offer digital tokens in exchange for cash, falsely promising to use the cash to build a business of some kind in which the tokens will either represent a share of ownership and or profits, or a digital currency for use in the putative business. In such cases it is not difficult to categorize the digital assets as securities, either because they are simply shares of stock by another name, or because they indeed are described as investments in the creation of a business, to be run by third parties, that will generate hypothetical profits. The SEC’s complaint relating to the offering of FLiK tokens is an example; there the SEC alleges that the defendants sold FLiK tokens purportedly to fund development of a streaming music platform offered on a blockchain but misappropriated the proceeds of the offer for personal use. See SEC v. FLiK et al., Complaint, Case 1:20-cv-037739-SJC (N.D.Ga. filed September 10, 2020).
In between lie the more difficult cases. Two SEC enforcement cases involving unregistered offerings of securities in the form of digital assets have seized the attention of entrepreneurs in the cryptocurrency world. SEC v. Kik Interactive, Inc., 2020 U.S. Dist Lexis 181087 (S.D.N.Y. September 30, 2020), and SEC v. Ripple Labs, Inc., et al, 20 Civ. 10832 (filed December 22, 2020), demonstrate the SEC’s enforcement posture on the central issue of when the public offering of a digital asset is a security offering that must comply with the registration and exemption requirements of the ‘33 Act.
Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review is grateful for his support as our Faculty Advisor.