Decentralized governance and the Howey Test

Don’t want to read? TLDR here
Twitter: https://twitter.com/tradfichad

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”
- Sathoshi Nakamoto

The motivation and vision for crypto assets is clearly laid out above in Satoshi’s quote. Intermediaries are a necessity in our current financial system. However, that also means that we as participants are required to trust that they will not become bad actors. We have seen examples of this in the Global Financial Crisis of 2008 as well as the many cases of governments wielding their god-like powers to seize assets or make your money worthless in whim.

More recently, we have examples of SEC vs Ripple, the clamp down on BlockFi and the investigation by the SEC into NFTs as securities. It seems only inevitable that the SEC will start to come down hard on DeFi to impose its authoritarian regulations upon us.

Sina Kian has written an amazing piece on why cryptocurrencies should not be securities. The arguments are extremely compelling and any rational mind would agree that this broad application of the Howey test is unfair and draconian. Kraken Chief Legal officer Marco Santori goes so far as to criticise this as arm-chairing lawyering.

In this article, I aim to explore how can ensure future projects do not suffer the same fate and stay a step ahead through governance and decentralization. To do so, we first need to understand how the Howey Test defines a security — An “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

Understanding the Howey Test

To qualify as a security/investment contract, all three of the following must be met:

1. The investment of money
2. Common enterprise
3. Reasonable expectations of profits derived from efforts of others

The main point of contention as highlighted by the SEC is around item number 3.

• Does the purchaser reasonably expect to rely on the efforts of an Active Participant (“AP”)?
• Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?

The determination of “expectations of profits” exists very much on a sliding scale for the SEC based on a bucket list of items. While most token transactions are currently deemed “utility” in nature, there will always exist a natural appreciation in the value of the underlying utility which could in eventuality be interpreted as capital appreciation.

Working with the Howey Test

In most situations, it would be hard to avoid the issue of “investment of money” and “common enterprise” as projects will inevitably need to fund raise and have some skin in the game in order to reflect an element of common interest with the wider community.

However, where projects can most likely succeed in distinguishing themselves from a security is by ensuring that “reliance on the efforts of others”, is kept to a minimum. A summary of what this could entail by the SEC is listed below:

Reliance on the efforts of others

• AP responsible for development, improvement, operation and promotion of network to achieve its intended purpose. AP assumes lead role in taking the network forward and is performs essential duties as opposed to the wider decentralized community.
• AP creates or supports a market for the price of the digital asset by controlling the issuance or engaging in activities to support market price i.e. burning, buybacks, etc.
• AP has a continuing managerial role in administrative activities and plays a central role in deciding governance, code updates, validation of transactions, etc.
• AP will undertake efforts to promote its own interest and enhance the value of the network/asset.

Decentralized governance— A potential solution?

As shown above, so long as a project can demonstrably show that the AP does not hold majority responsibility of roles, it is possible for that “reliance on the efforts of others” is no longer met. In other words, demonstrating sufficient decentralization.

1. Demonstrate in quantifiable terms that the AP does not have majority control of governance and management. Ensuring the right distribution of tokens can therefore show how much quantifiable power an AP has in the decision making process of a project. A two token structure (utility token + governance token) helps separate the elements of incentives and control.
2. Democratizing core decision making is another element that should be sufficiently demonstrated. This means that governance proposals and voting will play an increasingly important role in how a project is managed and executed going forward. At the same time, it should be also ensured that no one party or group can assume too much voting power.
3. As noted in the Howey test, the alignment of incentives between AP and the project may be interpreted as “reliance on the efforts of others”. Given that projects typically provide compensation in the form of native tokens, there will need to be some revision to incentive structures and additional consideration as to what degree native tokens should comprise of this mix.
4. In a truly decentralized fashion, team composition will need to be fluid. Similar to how a government is run, leaders are elected and can be easily replaced with no significant impact. As such, projects thinking about longevity should therefore have clear guidelines, structures and roadmaps to ensure that the community can take it forward even without the core team.
5. To support team fluidity, a proposition could be that former core team members or other external experts hired as advisors. The challenge is however is the prevalence that advisors are commonly compensated in native tokens. To demonstrate non-partisanship, Non-executive directors are hired to provide oversight. A critical difference is that they are typically paid a fixed fee for these services.

There is a lot which can be said about how this can be used effectively as a tool to prevent the tyranny of unfair regulation. However, I will leave it up to readers to interpret and discuss the implications of this.

A few final points which have come out of the Howey test which I think reflects good practice in general:

1. Artificial price support mechanisms. Good projects should not have to rely on this. The biggest worry is that such practices can often create artificial pump and dumps, turning the wider community into exit liquidity.
2. Utility vs Financial gain. Projects should focus and place emphasis on the utility rather than sending out messaging to the wider community around financial gain. While it may be simply out of goodwill to include others in the building of “generational wealth”, the SEC does not take lightly to this as it is often an indicator of a Ponzi scheme. Furthermore, as much as we say something is NFA, projects would be wise adhere to this rule themselves.