Understanding "Howey Test": Which cryptocurrencies will be classified as securities by the SEC?

Original Title: "Understanding How the SEC Qualifies Cryptocurrencies as Securities in the Case of Howey Test"

Original Author: Haruka Yingning

All along, the sword of Damocles, SEC regulation, has been hanging over the head of cryptocurrency. This article will start with the development history of US securities law and explain the most important qualification standard for securities in securities law - the Howey Test, providing a reference for determining whether various cryptocurrencies should be considered securities.

One, US Securities Law

During the worst period of the Great Depression, the US Congress and President Roosevelt enacted the first federal securities law.

The Securities Act of 1933 is about companies raising funds from the public. Investors can decide which risks to take; companies issuing securities to the public must provide comprehensive, fair, and truthful disclosure of information to protect the rights of investors. Roosevelt called this law the "Securities Truth Act".

In 1934, Congress passed the Securities Exchange Act. The law covers intermediaries such as the trading platform itself and proprietary traders. The basic idea is that the public should receive disclosure and protection not only when securities are initially issued, but also when they are traded in the secondary market.

In 1940, Congress passed the Investment Company Act and the Investment Advisers Act, which required funds and advisers to register in order to manage other people's money and prevent more opportunities for conflicts of interest.

The Securities Act of 1933 and the Securities Exchange Act of 1934 in the United States have a very broad definition of securities, which includes not only securities used for investment in the general sense, such as stocks and bonds, but also various non-standard securities, such as "proof of income or participation in income sharing arrangements", "investment contracts", and "all income or tools that are generally considered to be securities".

US Supreme Court Justice Thurgood Marshall described the scope of securities law by saying, "Congress roughly outlined the definition of securities, and the purpose of Congress in enacting securities laws was to regulate investments, regardless of the form or name of the investment."

II. Criteria for determining securities - Howey Test

The Howey Test is a standard used to determine whether a particular transaction constitutes a securities offering, which was used in the SEC v. WJ Howey Co. case heard by the US Supreme Court in 1946.

Hawthorne Company is a real estate company located in Florida, USA. It has developed large areas of orange groves and sells the general land to investors. The company signs a land purchase agreement with investors and also signs a management service agreement with them, which involves handing over the sold land to the defendant company for management.

The more criteria that are met in the Howey Test, the closer the specific transaction's attributes are to securities.

（1）金钱投资（Investment of Money）

translates to:

(1) Investment of Money

This requirement requires buyers to provide funds to the project initiator in the form of cash as consideration.

（2）Investment in Common Enterprise

This requirement aims to distinguish investment contracts from one-on-one private contracts. In accordance with this requirement, the Supreme Court requires that joint ventures must have "horizontal commonality", "broad vertical commonality", and "narrow vertical commonality".

The 'horizontal commonality' requires the pooling of funds to bind the wealth of each investor with the fate of other investors, usually combined with proportional distribution of profits; the 'broad vertical commonality' requires whether investors can benefit depends on the efforts of the project initiator; the 'narrow vertical commonality' requires that the returns of investors and the efforts of others are combined with the final business results.

（3）Expectation of Profit for Investors

Here, "income" can refer to the capital appreciation generated by the initial investment or business operations, or the income generated by the use of buyer funds. Price appreciation generated by the supply and demand of underlying assets that are completely influenced by external market forces (such as general inflation trends or economic development) does not fall under the "income" of the Hao Wei test.

（4）收益仅来自他人的努力（Derived From The Efforts of Others）

(4) Income solely derived from the efforts of others

This requirement demands that the project initiator, organizer, or other related third party has made necessary management efforts, and that these efforts will have a critical impact on the success of the business. Investors only need to pay the specified fees and costs, and do not actually participate in the operation and management of the project.

The core concept of Hao Wei's testing and setting of the above requirements in the encryption industry is to "protect the legitimate rights and interests of investors."

The reason why Standard 2 requires "common enterprise" is because the Supreme Court believes that in the scenario of "common enterprise", the cost of individual due diligence and communication is high, and individual investors have no incentive to coordinate with other investors to obtain information, nor can they prevent collective bargaining between the collective and the project initiator. Therefore, investors can only rely entirely on the initiator to obtain returns, and the initiator plays a pivotal role in the project, forming an unequal position between the initiator and the investor.

In order to make up for this power disparity, defining investment contracts as securities is more advantageous for investors to evaluate and price investment projects, and protect the interests of investors. For example, Standard 4 clarifies "the efforts of others" in order to clarify the responsible party of the investment contract, so that when implementing securities disclosure obligations, the obligation to disclose information can be accurately located. [1]

Three, US Securities and Exchange Commission (SEC) and Cryptocurrency

On April 3, 2019, the US Securities and Exchange Commission (SEC) released a digital asset investment contract analysis framework based on the Howey Test, providing official guidance for determining whether a digital currency is a security. The SEC believes that most digital currencies on the market currently meet the two criteria of "investment of money" and "in a common enterprise".

Regarding the other two standards, the US Securities and Exchange Commission pointed out that if the development of a digital currency relies on the efforts of a company or centralized entity, and buyers have an expectation of reasonable profits from the investment, then this digital currency is considered a security. It should be noted that if a digital currency is decentralized enough, has a clear application scenario, and its price changes are related to the application situation rather than the investors' expectation of profits, then this digital currency is not a security. The US Securities and Exchange Commission has stated that Bitcoin and Ethereum are not securities. [2]

3.1  BTC

The former director of the Division of Corporation Finance at the US Securities and Exchange Commission (SEC), Bill Hinman, stated in a 2018 speech that Bitcoin (BTC) is not a security and falls under the jurisdiction of the Commodity Futures Trading Commission (CFTC). The CFTC is primarily responsible for regulating the derivatives market, including futures, swaps, and certain types of options. This also aligns with the idea that BTC mining is similar to other commodities such as gold and oil.

3.2  ETH

3.2.1  ETH（IC0）

The initial token issuance (IC0) of Ethereum began in August 2014. The 42-day IC0 raised 31,000 bitcoins and sold 60,102,216 ether, which was approximately $18.4 million at the time. Based on the history of this IC0, it should be classified as a security.

3.2.2  ETH（PoW）

Ethereum's POW phase is similar to Bitcoin.

3.2.3  ETH（PoS）

Ethereum completed the mainnet and beacon chain merge on September 15, 2022, and transitioned to a Proof of Stake (PoS) consensus mechanism. The operation process of PoS is that the staker deposits 32 ETH into a smart contract and receives a voucher to prove their right to withdraw the staking.

It can be seen that, firstly, the smart contract did not use these 32 ETH. In the case of investment, the company will spend this asset and invest it in production. Due to the existence of proof of extraction, the identity of all pledgers is identifiable, and it is not a bound fate community, nor does it have the characteristic of "horizontal commonality". Secondly, Staking rewards are issued by the PoS algorithm, not by service providers (such as Coinbase), so the rewards do not come from the efforts of others. If it is regarded as an investment, ETH should be handed over to the verification node, and the verification node obtains the income by investing these assets in production, and then distributes part of the income to the pledgers.

3.3  Stablecoins

On February 14th, the enforcement staff of the US Securities and Exchange Commission (SEC) issued a "Wells notice" to Paxos, the issuer of the BUSD stablecoin. Later that afternoon, the New York State Department of Financial Services ordered Paxos Trust Co. to stop issuing more BUSD Tokens.

Regarding stablecoins in the cryptocurrency industry, current SEC Chairman Gary Gensler mentioned in his speech on September 8, 2022 that stablecoins have features similar to money market funds, other securities, and bank deposits, and may compete with them, which will raise important policy issues. It is important to ensure that we have appropriate investor protection and safeguards against illegal activities. Stablecoins are mainly used as a means of participating in cryptocurrency platforms or as settlement tokens within cryptocurrency platforms. Whether they are shares of money market funds or other types of securities depends on their attributes, such as whether these tools pay interest directly or indirectly through affiliated companies or other means; what mechanisms are used to maintain their value; or how stablecoins are offered, sold, and used in the cryptocurrency ecosystem.

3.4  Other Tokens

The Chairman of the U.S. Securities and Exchange Commission (SEC), Gary Gensler, has repeatedly stated that most virtual assets are securities.

It is supported by a 1990 opinion by US Supreme Court Justice Thurgood Marshall that when someone raises funds from the public and the public participates in the profits, it constitutes a security.

SEC regulates these virtual assets that are considered securities, including requiring issuers to comply with securities regulations for disclosure and registration requirements to ensure that investors have sufficient information to make informed investment decisions. In addition, SEC also regulates fraud and manipulation in the virtual asset market to protect investors' rights.

Coinbase believes that Staking does not meet the four criteria of the Howey Test.

The pledge service does not constitute a monetary investment, and the pledger retains full ownership of their assets; the provider of the pledge service is not an ordinary enterprise, and the entire process is executed through smart contracts on a decentralized network; the pledge reward is a wage for blockchain validators, not an investment return, and does not belong to "reasonable profit expectations"; the provider of the pledge service only uses public software and computers to perform verification services, and does not perform any management work. These are IT services, not investment services, so rewards are not paid based on "other people's efforts".

The purpose of the Securities Law is to correct information asymmetry and protect the legitimate rights and interests of investors. However, there is no information asymmetry in pledging because all participants have equal access to verify transactions with the same information on the public and transparent blockchain. Attempting to impose the Securities Law on the pledging process is of no help to users. On the contrary, unnecessary and aggressive authorization will prevent users from accessing basic encryption services and push them towards offshore and unregulated platforms. [3]

References:

[1] Zhang Chao. The Legal Nature and Regulatory Paradigm Shift of Security Token Offerings: An Analysis Framework of US Digital Asset Investment Contracts [J]. Financial Law Review, 2020(01):85-100.

[2] Xiao Feng. Blockchain: Distributed Business and the Future of Smart Numbers. CITIC Press, 2020.

[3] Paul Grewal. Coinbase's staking services are not securities. And here's why.

https://www.coinbase.com/blog/coinbases-staking-services-are-not-securities-and-heres-why, 2023-2-10

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