Jul 7, 2022
Digital Assets as Securities or Commodities? A Closer Look
Recently, US government agencies and the crypto industry have been addressing the question of the appropriate role of securities Law and regulation of digital assets. There are varying opinions on the topic and different perspectives on the legal precedent, however the current legal status remains unclear. This has created a situation in which the U.S. Securities and Exchange Commission (SEC) has aggressively attempted to claim jurisdiction over the cryptocurrency sector with a “regulation through enforcement” approach in the Court system.
A major aspect of the SEC claim of jurisdiction to regulate some (if not all) digital assets is a reliance on a legal precedent known as the Howey Test. This test has been used by the SEC to classify many crypto tokens as regulatable securities, which some argue has created legal uncertainty and hindered the growth of the sector and capital inflows. Understanding this test and possible alternative approaches is important to a full assessment of what the future of securities law in regards to digital assets might be in the future.
The Howey Test
The Howey Test is derived from the case of SEC v. W.J. Howey Co., which reached the Supreme Court in 1946. Howey Company sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey. Company staff would tend to the groves and sell the fruit on behalf of the owners. Both parties shared in the revenue. Most buyers had no experience in agriculture and were not required to tend to the land themselves.
Howey had failed to register the transactions and the SEC intervened. The court’s final ruling determined that the ‘leaseback’ arrangements qualified as investment contracts — commonly referred to as ‘securities’.
In doing so, the Supreme Court established four criteria to determine whether an investment contract exists.3 An investment contract is:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
Image Source : Nick Grossman; The Slow Hunch
In the case of Howey, the buyers of the Florida citrus groves saw the transactions as valuable primarily because the labor and expertise were provided by others. Buyers only needed to invest capital to access an income stream. This classified the transaction as an investment contract under what is now known as the Howey Test, and therefore it needed to be registered with the SEC.
The Howey Test and Crypto
Digital currencies such as bitcoin are notoriously difficult to categorize. They are decentralized and, as such, elude regulation in many ways. Nonetheless, the SEC has taken an interest in digital assets and has sought to clarify when their sale meets the definition of an investment contract.
According to the SEC, the “investment of money” test is easily satisfied with the sale of digital assets because fiat money or other digitals assets are being exchanged for the assets. Likewise, the “common enterprise” test is also easily met.
The common enterprise test is easily met, as when looking at the definition of a “common enterprise”, it is when “the fortunes of the investor are interwoven with and dependent upon the efforts and success of those offering or selling the investment.” For some digital assets, such as DAO’s or cryptocurrencies, the fortunes of the investor are dependent on whether developers of a project can achieve goals they set for themselves (usually in a roadmap), as well putting in effort to continually evolve the project to remain innovative
In most cases, whether a digital asset qualifies as an investment contract largely turns on whether there is an “expectation of profit to be derived from the efforts of others.”
For example, the purchasers of a digital asset may be relying on the efforts of others if they depend on the project’s backers to develop and maintain the digital network (especially in the early stages), rather than these tasks being performed by a dispersed community of unaffiliated users. The test is also met if the project’s backers take steps to support the price of the digital asset, such as by creating scarcity through token burning. Another way the “efforts of others” test is met is if the project’s backers continue to act in a managerial role.
These are but a handful of examples outlined by the SEC. If the success of a project depends on the ongoing participation of its backers, the purchaser of the associated digital asset is likely relying on the “efforts of others” according to the agency and U.S. courts.
Crypto & The SEC — Why it Matters
A host of implications are raised if the SEC determines a cryptocurrency token is a security. Effectively, it means the SEC can determine whether or not a token can be sold to U.S. investors and compels the project to register with the SEC.
A significant application of the Howey Test came in The DAO Case in 2017 when the SEC ruled that the sale of DAO tokens in exchange for Ether violated federal securities law. Instead of taking enforcement action, the SEC warned that securities laws applied to token sales — effectively firing a warning shot at the cryptocurrency industry.
Because of the Howey Test, most ICOs that take place today are likely to be off-limits to U.S investors. In 2018, then-SEC Chair Jay Clayton said every ICO he’d seen could be classified as a security.
Does Crypto Really Pass the Howey Test?
So do sales of a cryptocurrency token actually meet the Howey Test from an objective standpoint? Well, it depends.
In a 2018 interview with CNBC, Jay Clayton, who was then chair of the SEC, made a firm statement about the debate into whether cryptocurrencies fall under the purview of the SEC:
“Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin. That type of currency is not a security.”
Highly decentralized cryptocurrencies like Bitcoin and Ethereum likely don’t pass the Howey Test. While Bitcoin meets the test’s first prong, it doesn’t satisfy the second and third elements. With Bitcoin, there is no common enterprise where investors are pooling their funds, there’s no promoter or issuer, and an investor’s success isn’t reliant on the efforts of others.
As opposed to being a security, Bitcoin, which has never sought public funds to help develop its technology, is considered an asset in a similar vein as gold or diamonds.
Now let’s consider a few other cryptocurrency categories:
Initial Coin Offerings
ICOs are an entirely different matter. ICOs are essentially early stage investment offerings on digital assets. In 2018, Clayton made a now-famous statement when he declared during a Senate hearing that “every ICO I’ve seen is a security.”
“A token, a digital asset, where I give you money, and you go off and make a venture, and in return for giving you my money, I say ‘you can get a return’ that is a security, and we regulate that,” Clayton told CNBC.
So how do ICOs factor under the Howey Test? According to the SEC, the test’s first prong is usually satisfied in offering and selling a digital asset because the asset is acquired in exchange for some form of value. For the second element, courts have generally found that a “common enterprise” exists. This means that when determining whether a digital asset meets the Howey Test, the key determination comes down to if any profits were expected from the investment and if those profits came from the efforts of others. If a digital asset meets these final elements of the Howey Test, it is a security and must adhere to SEC regulations.
Utility Tokens
A common reason that a token doesn’t pass the Howey Test is that it’s classified as a utility token. Utility tokens, known as user tokens or app coins, are more like digital coupons that give investors access to a future product or service, or can be redeemed for discounted fees. Filecoin and Siacoin are examples of utility tokens.
However, the SEC has indicated that just because a project has a utility token framework, it doesn’t automatically exclude it from being considered as a security.
Image Source: CryptoPotato
NFT’s are also becoming a part of the discourse in securities law due to the fact that they are driven by the relatively new technology of ‘smart contracts’. Whether NFTs representing a project could in some cases be considered a ‘common enterprise’ is still untested. There is some reason to believe fractional NFTs (where one token is broken into fractions and distributed to a group of holders) could be considered unregistered securities and subject to security regulations by the SEC.
NFT’s could potentially be categorized as “securities”, if they were designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such. This is because if owning this type of NFT were dependent upon receiving a return or profit, it could be considered an “investment contract” under the Howey Test.
A common way to get around this risk for many projects issuing NFT based tokens is by attempting to design them as utility tokens using methods like gamification (where decisions made by users impact the value the token may have in the future as in a video game). In such cases the utility and game theory involved is thought to limit the ‘common enterprise’ involved. This will potentially work in other specific scenarios where NFTs are used specifically to facilitate transactions of assets. According to expert Dr. Ozair, Professor at Rutgers Business School in New Jersey, there are many use cases yet to be considered for NFTs when it comes to security classification.
As for NFTs governed by DAOs status under securities regulations, the self-governance layer involved means members are actively involved and thus the ‘efforts of others’ limb of the Howey test may not be met. As Dr. Ozair states “A DAO is a governance mechanism and doesn’t constitute security. Hence, an NFT structured with a layer of DAO will not fall under securities laws.”
The bottom line: There’s no one-size-fits-all regulation when it comes to digital assets.
So can we reform Howey to exclude Crypto?
Take recent cases such as Ripple vs. the SEC, here we see the effect of the SEC actually classifying a major crypto as a security. What makes this case so special is what distinguished XRP from the top two cryptos which it lagged behind on major exchanges. XRP was not a mineable currency, meaning it had a limited amount of coin in circulation to begin with, along with the fact that more than 50 percent of created XRP is actually in circulation, the rest of the supply being held by Ripple itself.
The main argument from the SEC was that these two factors contributed to making XRP a security due to the “centralized nature” of the cryptocurrency. Referring to the stockpile of currency that Ripple itself holds and the fact that new XRP cannot be generated by mining, which gives it more ability to act as an intermediary exchange currency rather than a real crypto currency (a fact that was intended for its original purpose).
There are counterpoints to that particular argument however. The main one being that XRP is decentralized; simply because Ripple holds XRP doesn’t mean they have explicit control over profits that users make, and to that end Ripple could cut their ties to XRP fully and the entire infrastructure of XRP would still work fully because it has no dependence on Ripple. XRP was also never marketed as an investment, to be an investment would imply that there is an expected profit, and XRP was marketed as only a liquidity tool.
In addition there is an argument that there is a lack of Common enterprise in the Ripple case, since Ripple did not require investors to pool money towards a common business goal.
For Cryptos like XRP, it is arguable that the Howey test actually would prove that XRP isn’t in fact a security, yet it was used to in fact prove that it was a security. The whole point of the Howey test is to protect investors from Centralized parties promoting an investment contract, and if many Cryptos can’t truly fall into the jurisdiction of the SEC via the Howey test then it does not necessarily cover them.
However there are some potential reforms/alternative approaches to using the Howey test that might help to safely regulate this new market.
- New Subclass
A new subclass of crypto can be created in order to essentially limit the Howey Test to that class. In essence Howey targets crypto that is specifically used as a method of investment and that expects to return a profit, (see for example the 2017 case of Kik vs. SEC.) This would make it easier to separate crypto that is meant to act as a real cryptocurrency with utility of some form from crypto that acts as an investment contract. By separating the type of crypto assets that are more prone to resulting in consumers losing their investments, it makes the SEC’s reason to go after bigger or more popular cryptos less compelling since the goal of “protecting investors” would be covered by the new subclass which can comply with all securities regulation.
- Token Taxonomy Act
A more recent effort to rewrite the Securities act of both 1933 and 1934 to exclude Cryptos from being classified as securities was undertaken by two senators, Warren Davidson and Darren Soto. The senators agree with the current dissatisfaction of Crypto-enthusiasts that the Howey Test is in fact not fit to regulate this new decentralized market. They aim to pass this bill into law that would operate much like the regulatory measures put in place to govern the early internet; as stated by Warren Davidson “in the early days of the internet, Congress passed legislation that provided certainty and resisted the temptation to over-regulate the market. Our intent is to achieve a similar win for America’s economy and for American leadership in this innovative space.”
The main effects of this bill would ensure that Crypto gets its own set of specified regulation that doesn’t involve the Howey test, a legal definition of crypto currencies and lighter regulations would most likely ensue.The bill introduces some important measures within it. The most recent rendition of the bill has “clarified jurisdictions” of both the CFTC and the FTC as the main regulatory agencies who would play major regulatory agency roles in this prospective future.
Along with clarifying governmental roles, it also sets out to introduce “regulatory certainty” for blockchain industries and regulators alike, most likely penalties and such. It also clears up confusion about State jurisdiction rulings and conflicting State initiatives to provide streamline regulation on both levels of government.
What To Expect?
There is a power struggle for the jurisdiction to regulate cryptocurrency taking place in the USA between the SEC and the Commodity Futures Trading Commission (CFTC). In the immediate future, it seems likely that both will have a role in any regulation. A recent statement by SEC chair Gary Gensler hinted that there will be further collaboration between the SEC and the CFTC regarding the regulation of crypto. The main goal of the joint effort is to distinguish legally between commodities and security tokens which will make it easier to divy responsibility between the two agencies.
SEC Chair Gensler has expressed the opinion that most crypto assets fall under securities classifications (including Bitcoin and Ethereum) and he believes that investors are not sufficiently protected under the current unclear regulatory system, pointing to the recent collapse of the Luna tokern and UST stablecoin.
Hester Peirce, the lone Republican on the SEC, has recently warned against the agency over-regulating. Peirce commented during a Bloomberg event in New York that the agency’s approach to crypto is overly focused on enforcement and risks stamping out innovation. Hester Peirce, who’s often urged a more hands-off stance to virtual tokens, warned that it’s important the regulator allow space for the industry to try new things and not overreact to the recent implosion of stablecoin TerraUSD.
“It’s natural for there to be failures … The notion that you can regulate a market by bringing enforcement actions, which will then craft a framework within which everyone else can operate, is ludicrous to me, and that’s the approach we’ve been taking.”
Responsible Financial Innovation Bill
The recently revealed bipartisan Responsible Financial Innovation Bill seeks to set out a comprehensive legal framework for digital assets in the USA. Under the new bill, Bitcoin and Ethereum (and potentially some other cryptos) would be considered as commodity tokens and fall under the CFTC’s jurisdiction.
The new bill by Sen Lummis and Gillibrand would categorize the multitude of protocols, currencies, and assets. It states that Bitcoin and Ethereum are commodities as they are sufficiently decentralized, and would fall under the CFTC for purposes of regulation of its trading.
The bill also provides clarity on the ambiguity around what constitutes a security. The SEC has in the past used this ambiguity to imply everything was a security and effectively regulated accordingly by a “regulation through enforcement” approach. Clarifying this ambiguity, the new bill defines a framework for differentiating which digital assets are commodities and which are securities.
To be classified as a security, the digital asset must provide the holder with a debt or equity interest in a business entity, liquidation rights or entitlement to interest or dividend payments from a entity, profit or revenue share in an entity… derived “solely from the entrepreneurial or managerial efforts of others,” or any other financial interest in the entity.
In addition, Digital assets not fully decentralized and which benefit from entrepreneurial and managerial efforts that determine the value of the assets but are not debt or equity or don’t create rights to profits or other financial interests in a business entity are NOT securities if disclosures are filed with the SEC twice a year.
In a positive development, the SEC appears to carry the onus of proving a digital asset is a security in court. There is a presumption that an ancillary asset is a commodity, but that can be appealed in court by the SEC — so if the agency wants to claim that a given digital asset is a security and not a commodity, it needs to go to court.
In summary, the majority of large digital assets would be classified as commodities under the Bill. However, if a digital asset can be proven to pass the Howey Test, then it would be a security and fall under the Securities and Exchange Commission (SEC).
Because of the CFTC dominated regulation proposed, this would mean that the Howey Test would still be used to determine the status of a particular cryptocurrency as either security or commodity. The bill explicitly classifies many cryptocurrencies such as Bitcoin and Ethereum as commodities but those that are classified as securities will have to fall under SEC guidelines.
The cryptos classified as commodities were done so by looking at the power of the consumer who holds the crypto, as well as the purpose of the crypto. The reason this bill is significant is because it would set clear boundaries for the SEC’s jurisdiction and also actually provide an alternate governing agency if a cryptocurrency is not to fall under the security label.
For the tokens that do get classified as a security, there’s hints of a more flexible innovation framework. That is, the bill would require lighter reporting to the SEC that is onerous but at least possible for startups — disclosures will need to be filed with the SEC twice a year.
Lummis believes that the bill will be passed because “digital assets are a nonpartisan issue,” however most commentators are highly skeptical that this bill will be passed in its current form, if at all. If some form of this Bill does pass into law it would remove a great deal of “regulatory uncertainty” preventing legacy institutions from joining the crypto sector. This certainty could be a catalyst for a large influx of capital flowing into the sector.
How Do Other Countries Treat Crypto?
There is also useful guidance to be found in how countries internationally deal with the regulation of crypto technology and assets. It seems most countries still do not view crypto as legal tender but opt to classify it as property (i.e. UK, Singapore, China). Because they are classified as legal property in most places in one way or another, this makes them subject to many regulations that most taxable property has, and means they are not regulated as securities.
For example in Australia and Germany Crypto assets are subject to Capital Gains tax. Many countries such as China, India and South Korea are moving towards requiring that transactions in Crypto be approved by the central bank or financial commissions. Some more progressive approaches are seen in Japan where crypto is regarded as “legal property” or Canada where the first Exchange-Traded Fund was approved, both countries still require registration with agencies (Local for Canada while Japan has a central agency). They also calculate taxation payable based on the classification of Crypto as commodities (in Canada) and “miscellaneous income” (in Japan).
The Bottom Line:
Regardless of what the court ruling may be in the Ripple Labs lawsuit, in the near future we are likely to have a significantly more clear regulatory landscape around whether cryptocurrencies are (or are not) treated as securities. More regulatory powers in the U.S. are beginning to see the need for a new set of regulation specific to the new decentralized technology that blockchain utilizes. It is arguable that a strict application of the Howey Test as the SEC seems determined to achieve would overregulate this market and stifle innovation and limit the development of a burgeoning crypto economy in the U.S. It will likely be necessary to consider new regulatory approaches and greater cooperation between financial regulatory agencies in order to maintain a competitive advantage as compared to countries with more innovative and clear regimes.
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