A Trillion Dollar Question
Part I - What do Obama and horses have to do with Howey?
On June 6, 2023, the SEC charged Coinbase, Inc. with operating its crypto asset trading platform as an unregistered national securities exchange, broker and clearing agency. Interestingly, this legal action came just one day after the SEC sued Binance. As a result of these lawsuits, the list of tokens considered unregistered securities expanded to a staggering $120 billion worth of crypto.
Sometimes, what you choose to do is as crucial as what you choose not to do. When the SEC targets specific tokens, it implies that they are prioritizing those cases over others. Bitcoin appears to be in a relatively safe position, as the SEC's focus seems to be elsewhere. Ether, on the other hand, remains in a state of limbo regarding its classification as a security. However, there is some commentary indicating that the SEC may not be actively pursuing regulatory action against Ether, either. Bitcoin and Ether account for just below 70% of the crypto market cap as of today, which stood at about $1.2 trillion according to CoinMarketCap.
Consequently, when a resolution is eventually reached, whether through court decisions, new legislation, or a combination of factors, society as a whole will have made determinations considering approximately one trillion dollars worth of “assets.” As a result, new millionaires will be minted, while others may experience a decline of their financial standing in life. Clearly, the importance of getting this right can not be understated.
What is the tool that the SEC is relying on in these actions? It’s the Howey test, named after the infamous Supreme Court decision in 1946. William John Howey would be proud. He is long gone, in fact, he didn’t even see the Supreme Court deciding on his orange grove scheme, but his legacy lives on.
So, it is fair to assert that a trillion dollars worth of wealth is contingent on the Howey Test. However, that raises an important question:
What if the Howey Test is not the appropriate criterion?
If the Howey test is indeed applicable, then we can confidently rely on the concept of legal precedent to guide us in resolving similar issues.
However, if the Howey test is not the appropriate standard, it would be concerning as it would imply that the destiny of one trillion dollars is being decided incorrectly.
Is it incorrect to apply the concept of legal precedent? Well, that depends. Let’s refer to how Thomson Reuters Legal defines legal precedent:
Legal precedents are when a case’s circumstances and legal requirements match those of a contemporary legal dispute; unless a party can demonstrate that it was incorrectly resolved or that it differed materially, the precedent will typically govern the outcome of a later similar case. (emphasis added)
In one of our posts last month, we expressed skepticism regarding the efficacy of using the Howey test as a reliable legal precedent. Our statement was as follows:
So, have we truly aligned the facts of Howey to the contemporary legal disputes around whether or not secondary market crypto transactions are securities?
We don’t think we have. Investing in the 1930s was about buying cash-flow-generating assets at the right price. That is the backdrop against which the federal securities laws were enacted. Inherently, when buying crypto, you are speculating, not investing, for the simple reason that most cryptos, standing alone, do not generate any cash flows. You might say, “Well, what about staking contracts, they generate cash flows?” That’s correct, and those staking contracts can potentially be investments (depending on their risk profile) - not the cryptos themselves.
As such, the Howey test could potentially be the correct starting point for staking contracts. That doesn’t mean that they are the correct starting point for secondary crypto purchases.
Don’t misunderstand us, we value the importance of legal precedent. However, we believe that legal precedent should not be applied blindly as a one-size-fits-all solution. Ask yourself this: What will be the state of gas stations when California transitions entirely to electric vehicles by 2035? One estimate suggests the following potential outcome:
California’s shift away from gas-powered vehicles could mean as many as 80 percent of gas stations would be unprofitable by 2035.
Certainly, one can argue that gas stations have historically been relevant and may continue to be so in the future. However, attempting to rationalize and justify this perspective solely based on past performance overlooks the present reality: the market has evolved and moved on. If you blindly apply what worked in the past and decide to enter the gas station business, you will likely be disappointed.
Here is another example to consider. Political observers will likely remember one of the most memorable lines from the Obama-Romney debate, often referred to as the “fewer horses and bayonets” line:
Perhaps the outcome of the elections had already been decided by then. Nevertheless, it undeniably stood out as the most memorable moment of the third Presidential debate, prompting a remarkable number of tweets per minute, with a staggering 105,767 tweets. Of course, Obama was entirely accurate when he said:
So the question is not a game of battleship where we are counting ships, it is: What are our capabilities?
That emphasized the importance of focusing on our capabilities rather than fixating solely on the quantity of our military assets. The number of battleships may have been a good proxy for military capabilities in the past, but that doesn’t mean it’s a sufficient proxy now. The overarching question is capabilities, but how we measure them will naturally change over time. It's conceivable that at some point, it may primarily (maybe even solely?) rely on artificial intelligence (AI). However, the essential aspect is that we will always need to consider and value our capabilities, regardless of the method or tools we employ to evaluate them.
As we argued, the range of the Howey test is limited. It specifically pertains to assets that generate cash flows in primary market transactions. Once we venture outside that realm, such as in the case with secondary crypto transactions, the Howey test, in its original form, ceases to become the right tool. That doesn’t imply that an asset has evaded the SEC’s jurisdiction by failing the Howey test. Rather it signifies that the test, as proposed, isn’t applicable in the first place. You don’t have to use the entire toolbox to fix something (please bear with us until later in the series)
Therefore, the crucial question is not whether secondary crypto transactions pass or fail the Howey test in its original form. Instead, the question revolves around whether these transactions qualify as investment contracts. In the same way Obama honed in on our defense needs, we must hone in on the needs of the investing public.
If we insist on Howey being the right test, we are effectively using it as legal precedent, which, in turn, means that we are answering the following question in the affirmative.
Does Howey’s circumstances and legal requirements match those of Coinbase?
Let’s take a step back and rethink this. In our opinion, this question dives not only into the legal realm, but also, into the domain of finance. In fact, we don’t think we can properly answer the legal question without answering the finance question. The finance question, of course, is: What Is Investing?
We contend that a majority of individuals who purchase cryptocurrencies have limited awareness of the associated legal implications. Their primary motivations seem to be centered around the desire for substantial monetary gains, commonly referred to as “Lambos” in the crypto community.
Warren Buffet astutely observed the unfortunate reality that not having money is one thing, and seeing others having money is another. So, people want to HODL, because not having a Lamborghini is one thing, but seeing your neighbor proudly parking their Lamborghini in their garage can be even more disheartening:
Remember, our goal is to give you what we believe is the legal equivalent of a new and improved vision; a clearer view through a new lens. We are confident we can all get there, once we take our Howey glasses off and put our investor protection glasses on. When we put those glasses on, important questions by judges do not remain answerless, Howey turns into a flexible toolbox (wasn’t this the whole idea anyway?) and Bitcoin becomes a security.
So, here is what we have planned for you this month:
Part II - A Frustrated Judge
Part III - Howey Goes To IKEA
Part IV - A Contrarian View: Bitcoin IS A Security
See you in a few days!
