Crypto vs. SEC Part 3

In June 2023, the SEC sued Coinbase alleging that some of the tokens listed on the Coinbase exchange were legally securities and by not following securities’ law, Coinbase was acting illegally. This series of posts proposes crypto asset taxonomies, which make it easier to apply the four Howey Tests, on which rests the definition of securities. Post 1 and Post 2 covered the investment of money and common enterprise criteria, respectively. This post covers the expectation of profits criteria.

Howey Test 3: Expectation of Profits

The third Howey Test evaluates whether the purchasers of the asset in question were motivated by the expectation of profits. Profits here are defined broadly to include any form of remuneration including dividends and interest.

A central question here is whether the object (tangible or intangible) purchased was meant for consumption or investment. In the real world, often both apply. For instance, a home purchase may be motivated by both livability attributes and resale value prospects. Some legal questions that courts have grappled with around this consumption vs. investment debate include:

1. Should the expectation of profits be interpreted to mean solely or predominantly?
2. Does the messaging in the promotional materials matter- for instance, whether a property developer emphasized resale value in its sales pitch versus livability dimensions?
3. Regardless of 2 above, does the way the purchasers are actually using the asset matter? For instance, even if the property developer pitched parcels of land as meant for consumption, what if all the buyers eventually resold, indicating that they viewed their purchase as investments?

Opining on the above legal issues is outside the scope of this post. Instead this post focuses on synthesizing a taxonomy for crypto assets that can make it easier to apply the third Howey Test.

Crypto tokens by purpose

Crypto tokens can be classified by their purpose as evidenced in the way the tokens were designed:

Utility Tokens- cryptocurrencies

Cryptocurrencies, whose primary purpose is to make payments, are the most popular form of utility tokens. Within any blockchain platform, there exist two types of cryptocurrencies:

1. Native cryptocurrencies-if we compared a blockchain platform to a nation, the native currency is the analog of the platform’s fiat currency. BTC is the native currency of the Bitcoin blockchain and ETH of the Ethereum blockchain. An example of a privately owned native currency is XRP, which operates on the XRP Ledger, a permissioned blockchain run by the enterprise software company Ripple Labs.
2. Limited use currencies are more like your subway card. Their primary purpose is to make payments but not every user on the blockchain accepts them. A popular example of this are stablecoins, which are used by traders who do not want to delay settlements by relying on the banking system.

Other utility tokens

This is a broad catch-all category. Governance tokens, which were described in the previous post , are an example of this. In November 2021, the Constitution DAO was created to buy a rare edition of the US Constitution. The DAO raised nearly $47MM via sale of governance tokens but was outbid at the auction. Had the DAO won, the token holders would not have owned the Constitution but could vote on decisions like which museum the artifact would be displayed at.

Ownership Tokens: non income generating

Ownership tokens record the ownership of an object on the blockchain ledger. The object being owned could be a digital media file (a jpeg, an audio file, a video etc.). Many non-fungible tokens (NFTs) belong to this category. However, the underlying object whose ownership is recorded by the token, could even be a physical object like a painting. In fact, if in the future, official property records are maintained on the blockchain, the legal proof of ownership might very well be a crypto token.

Ownership Tokens: income generating

These are just like the previous category but they have an income stream associated with it. The previous post referenced the The Bored Ape Yacht Club (BAYC). BAYC is a collection of 10,000 ape cartoons . The buyer of the NFT owns the commercialization rights to it. Assume that a streaming platform makes a web series with a share of the lifetime royalties contractually accruing to the NFT owner. Hence, any buyer of such an NFT in the secondary market would be not only buying the image but the associated revenue stream.

Financial Tokens

Financial tokens represent claim on a stream of cash flows.

The cash flows could be derived from a financial activity like interest earned by lenders on Compound and Aave, or trading fees earned by market-makers on Uniswap.

Alternatively, the cash flows could be derived from a commercial activity. An example is the tZERO token issued by Overstock.com in 2019. These tokens, which were issued in compliance with securities law, granted token holders the rights to receive a share of revenues of tZERO, a blockchain technology firm founded by Overstock.

Unlike ownership tokens where the token holder has direct ownership of the underlying income generating object, in financial tokens, any ownership is through an intermediary entity. For instance, in Compound, the loans are owned by a liquidity pool, which is similar to a fund entity in traditional finance.

We can say that as we move from left to right in the taxonomy referenced below, the likelihood of finding an expectation of profits increases (ceteris paribus):

Complexity arises where tokens fall into hybrid categories in the framework above. As an example, the governance token of a lending DeFi app could also be rewarded with a share of the interest earned from pool assets. Similarly, a token that confers ownership of an out-of-print book may later become an income generating token if the book finds a second life and is reprinted.

A far bigger issue is that regardless of the designed purpose of a token, people may simply be using it for speculation purposes.

In December 2020, the SEC sued the company Ripple Labs, alleging that the XRP token was a security. The XRP cryptocurrency was designed with the goal of helping banks move money between borders. Instead of maintaining local currency accounts in multiple countries, banks could simply hold a single currency XRP and Ripple Labs would ensure that the overseas payment will be in local currency. However, while many banks use Ripple’s enterprise software (a substitute for SWIFT), they do not use XRP. But XRP was traded on exchanges as a pure investment asset anyway. This is true for all cryptocurrencies including BTC and ETH-people rarely make payments with them.

The crypto industry can offer the following counterarguments with reasonable justification:

1. The intrinsic purpose of the tokens are evident in their technical design. For instance, given the complex math used in BTC and ETH for the purposes of recreating the functions of currency, it seems a bit silly to argue that they are investment vehicles in disguise. Similarly, there is no logic to innovating stablecoins if they were just money market funds by another name.
2. Finding expectation of profits on the demand side (instead of the supplier side) requires subjective judgments on people’s motivations, which may vary between people and over time. A person who is investing in BTC, may later use it to transfer money to Ukraine for supporting the war effort.

Summing up

The expectation of profits prong of the Howey Test can be viewed from the issuer and the purchaser’s perspectives.

From the issuer side, it is fairly easy to classify tokens into items of consumption vs. investment, based on the token purpose as evidenced by its technical design, though the design of some tokens may intersect categories.

Regardless of the issuer intent, the purchaser may be using the token as an investment item. However, assigning purpose based on the purchaser’s behavior is difficult because of the inherent subjectivity involved in discerning motivations of a globally dispersed group.

Given that it is determined that a specific token meets the expectation of profits criteria, the final Howey Test is whether the token purchasers are relying on the effort of others for those profits. The next concluding post covers this topic.