Passing the Howey Test: How to Regulate Blockchain Tokens
In June 1946 the Howey Company, a Floridian citrus farm cultivating vast acres of the state’s southern Lake County, decided to lease half of its property to “finance an additional development.” It wasn’t the first time an entrepreneurial farmer offered a tract of land as an investment contract. But it would be more consequential than any other, resulting in a landmark court-case. Indeed, the ruling of SEC v. Howey Co.may determine the fate of regulating blockchain tokens.
The Howey case challenged the prevailing view of what a security is and isn’t. When the Howey Co. sold several hundred acres of land to several businessmen “attracted by the expectation of substantial profits,” they began a specific enterprise between two entities: one party that provides the work (farming) while the other supplies the capital (via a lease contract). Thus, while “lacking the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees,” these purchasers became the nominal landowners thanks to the shuffle of papers and stroke of a pen.
In signing a decade-long service contract these men effectively became speculators–the land was the vehicle for investment. “With the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves,” the purchasers of Howey’s citrus-laced acres entered the hazy territory of investment contracts. This is where the complex legal process begins.
By failing to register these transactions to the Securities Exchange Commission (SEC), a requirement codified in the 1933 Securities Act, Howey Co. broke federal law. The SEC filed an injunction to prevent the selling of these contracts but was subsequently blocked by an appeal from the US District Court for the Southern District of Florida. The case went to the Fifth Circuit Court of Appeals where it was affirmed, removing the injunction over Howey’s contracts. However, in May 1946 the US Supreme Court granted certiorari (where an upper court hears a case first tried in a lower one) and soon upheld the SEC’s order–that Howey’s contracts were investment contracts and must be regulated as one. Justice Murphy, delivering the opinion of the Court, concluded that:
“The transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents…Thus, all the elements of a profit-seeking business venture are present here.”
SEC v. Howey Co. became an influential case, guiding the SEC’s framework to regulate securities to this day. As such, the ruling birthed the Howey test, a simple criterion to determine the purview of SEC jurisdiction over securities. “If that test be satisfied,” wrote Justice Murphy, “it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.” What matters is whether “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” A security has been sold, in other words, when the value of one’s transaction hinges on another’s work. It is, therefore, relevant to the future of blockchain tokens.
Put simply, blockchain tokens are assets on a blockchain protocol. Bitcoin, Ethereum, and Monero are the most popular and widely used blockchain tokens generated on decentralized applications (or, Dapp, pronounced ‘dee-app’), but the area is ripe for development. There are many projects exploring a variety of use cases of decentralized protocols, from the first-generation of digital currencies mentioned above to the creation of decentralized businesses models that build off of an existing blockchain, or even build their own. In this way, Dapps–like investment contracts in the twentieth century–have the potential to entirely transform the economic ecosystem (think of how bitcoin already generates a global marketplace without centralized authority). The bitcoin model–end-to end encryption, open-source, and peer-to-peer–is likely to form the future basis of the Internet, social media, and data storage. But the rise of digital tokens–the vehicle of decentralized ownership–poses complex legal questions regarding it’s jurisdiction and regulation.
Howey posed questions about the nature and definition of a security. Today, blockchain tokens bring similar inquiry: By owning tokens, am I investing in a speculative enterprise? What determines voting rights on the blockchain? What happens if someone steals my Sia coin?
These are all pertinent questions that developers, regulators, and users will be asking. And in every case the Howey test will be applied. But will it govern token ownership?
A recent white-paper (pdf) brings this issue to the fore. Composed by Coinbase in collaboration with Coin Center, Union Square Ventures and Consensys, “A Securities Law Framework for Blockchain Tokens” begins the translation of a twentieth-century court ruling into twenty-first century relevance.
The collaboration’s paper advocates that Dapps be designed with the Howey test in mind. Whether one likes it or not, they posit, Dapps are in the regulatory purview of federal securities law. If Dapp tokens are securities, the SEC has the authority to determine the legality of selling them to US citizens and whether owners of tokens must register with the SEC–an action at odds with nature of Dapps: Unlike Howey’s enterprise, Dapp’s are autonomous, distributed, and decentralized. Therefore, the paper offers an open-source framework to guide best practices of building an blockchain token that isn’t regulated as a security.
The upshot of this framework is that blockchain tokens, if designed properly, should be deemed as a simple contract, equivalent to a franchise agreement. By this measure, the analogy is fitting: holders of blockchain token are granted rights to contribute to a larger system, “rather than through a passive investment interest.” The advantage of classifying Dapp tokens as a simple contract disentangles token ownership from the legal complexities of holding a security. It further encourages the inevitable shift towards decentralization, improving the efficiency and security of digital protocols.
For some, the paper presents a controversial stance. Why should a US government agency shape best-practices? But for the integrity and the sustainability of Dapps, it is a pragmatic way forward.