Howey Doin?
Remember how in the movie Spider-Man (2002), Tobey Maguire, after being bitten by a spider, wakes up, transformed? He puts on his glasses, only to realize that they make his vision really blurry. He has new powers now and he does not need the glasses anymore; his vision is restored. Here is that clip, if you want to watch, or re-watch it.
The purpose of this series, in conjunction with this entire newsletter, is to give you what we believe is the legal equivalent of that new and improved vision; a clearer view through a new lens. If you just choose to look at the world through that lens, we believe what you will see may surprise you.
More specifically, in this series, we will explore the legal implications of restoring the word investing to its original, much narrower interpretation. Once we do that, several quite interesting outcomes emerge:
Howey is not the right test to determine whether or not cryptocurrencies traded on secondary markets are securities;
With Howey discarded as the most appropriate tool, we must go back to fundamentals and remember that the primary purpose of the Securities Act, first and foremost, is to protect investors;
With investor protection as our true North Star, it must be guided by the question: what is investing? (This doesn’t seem that remarkable, does it? You’d be surprised.)
Once investing is properly defined, it becomes clear that substantially all of the cryptocurrencies (including Bitcoin) are not investments. They are just speculative tools.
Despite not being investments from a financial standpoint, they are nevertheless investment contracts. (We know, this sounds oxymoronic. Please bear with us.)
“Investors” need protection not because there is information asymmetry (even though that could still exist), but because selling speculation as investment is akin to false advertising (which seems rampant these days!); and
If one truly cares about the technology aspect of crypto, rather than speculative use, the primary regulatory solution to protect investors is actually remarkably simple. In fact, it was already in place a century ago (before the SEC was contrived).
Just in case you scrolled through the disclaimer quickly… we are not lawyers, and this is not legal advice. If you are of the view that analyzing legal positions is only what a lawyer can do, please enjoy this free post; it’s on us, as will be the case with the first post of every monthly series, and save yourself the monthly subscription fee. No harm, no foul.
If, however, you believe robust analysis can come from anywhere, you are in the right place. Our point of view is admittedly, and proudly, multi-disciplinary. We believe that in order to apply the law correctly, when it comes to money-related matters, one must understand economics, finance, and history; all of which is necessary to understand the context. One should then insist on logic and internal consistency and be accepting of where that naturally leads them.
A Potential Obstacle in Crypto Disputes - The Howey Hammer
If the only tool you have is a hammer, it is tempting to treat everything as if it were a nail.
-Abraham Maslow
Howey clearly became the hammer for the SEC. Perhaps this influenced the views of the commentators who seem to assume that Howey is the starting point. For example, Matt Levine, a columnist for Bloomberg News covering finance and business in the Money Stuff newsletter, which is excellent by the way (Levine is one of the best modern-day writers on finance, and has previously been a lawyer, investment banker and law clerk according to his Wikipedia profile), in the context of discussing whether or not Bitcoin lending is a security, stated:
The rule in the U.S. is that an “investment contract,” meaning “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others,” is a security, and generally can’t be sold to the public without registering it with the Securities and Exchange Commission, delivering a prospectus with audited financial statements, etc.
The link at the top takes the reader to another Money Stuff post, which discusses Howey. But if you didn’t click that link, and you were not familiar with the subject, you might think the definition of an investment contract already exists in some statute, but it is not. Howey, of course, is the famous Supreme Court case where the Court has defined the term.
The point here is not to nitpick Levine’s writing, he truly is great. Entertaining and educating at the same time, he has a knack for making complex topics simple. The point is that even the best thinkers sometimes write with implicit assumptions. When enough people (including the SEC) do this over and over, it’s easy for Howey to be used as the de facto legal framework for investment contracts. But it has its limits, and its usage should not be automatic.
The funny thing is, Howey wasn’t even meant to be that popular, at least according to Joseph Long, the former Assistant Counsel to Oklahoma Securities Commission. He recognized that Howey may potentially be overused and called for putting purpose above all, more than five decades ago. In his aptly titled article, An Attempt to Return Investment Contracts to the Mainstream of Securities Regulation (paywall), he stated:
This paper will outline the present test for "investment contracts" as it was originally proposed and summarize the gloss that has been placed on it by subsequent courts. An attempt will be made to show that the present test was the result of a crazy-quilt development where the courts tended to follow the language of prior decisions without giving thought to the purpose behind the various securities acts or even their differences in language.
He continues:
There has been considerable gloss placed on the original Howey test by subsequent courts and authors. The United States Supreme Court has cited the Howey case as controlling in several more recent decisions. None of these reconsider the basic questions raised by that case or help clarify the language used … As will ultimately be seen, had the Howey test been properly implemented, it would have provided a useful shorthand method by which most investment contracts could have been identified. Although useful, the test would not have been completely comprehensive, nor totally accurate.
Well, this was in 1971 and there have obviously been many more cases relying on the Howey framework since.
Then, Long completes the touchdown pass for the win:
Do the cases reveal an orderly development of the definition as the result of conscious decisions on policy questions? Or do they merely reveal a haphazard application of prior judicial language without thought to underlying policy. If the latter is true, and it is submitted that it is, then even if the Murphy test represents no departure, the entire structure of cases rests upon a potentially weak foundation. In such event, the entire area should be re-examined and measured in terms of the policy underlying the securities acts. (emphasis added)
Indeed. It’s the policy underlying the Securities Act that counts, and that, of course, is investor protection.
Going through the seven state cases cited by the Supreme Court one by one, Long then presents a detailed analysis and convincingly argues that the Supreme Court’s assertion that “[b]y including an investment contract within the scope of § 2(1) of the Securities Act, Congress was using a term the meaning of which had been crystalized by this prior judicial interpretation” doesn’t really pass muster. He states:
The foregoing discussion should indicate beyond any doubt that there was no fixed definition of an investment contract in the state cases by 1933. As to the specific elements of the Murphy test, the cited cases support only one of the three suggested elements. All of the state cases, both cited and uncited, seem to agree that an investment contract requires an expectation of profit on the part of the investor. (emphasis added)
Right there…the ‘expectation of profits’ prong is really what carries the day, which we will argue, exists in spades with crypto. The rest wasn’t really there prior to Howey. Instead of displaying Howey on a pedestal, we should let the underlying policy objectives guide us. Once we do that, there is a very strong argument that crypto, even when completely decentralized and trading on secondary markets, is a security.
Pardon the long cites above, but we felt they were necessary. In case you are inclined to think that our arguments are novel, our response is no, not really. This will be true for much of what we will be discussing in our newsletters. Both in finance and law, there is generally not much that has not already been discovered, there is only the forgotten. Many will not have the time or ability to go back and review the state cases cited in Howey, so we found an article - Long’s article we cited above- that has already done that for you.
Well, of course, Long’s insightful article is probably gathering dust, and the mighty Howey Hammer is going strong. Today, as we find ourselves in the middle of a significant number of crypto debates, the parties are going back and forth on Howey this and Howey that, but nobody that we are aware of is asking what appears to be the much more fundamental question:
Is Howey the correct test?
It’s as if there is a tacit agreement between the litigants. Everybody agrees on Howey being the starting point and endless debates ensue, including, of course, what common enterprise means, one of the most controversial prongs of Howey. We should always be trying to get to the truth, shouldn’t we? That means we cannot assume Howey is the right framework. Howey, like everything else, should earn it. If it will be applied, it should be applied when it makes sense, and not universally.
Well, as a general rule, if everybody is shying away from asking a question, there really are only two possibilities. It may be that the question is not worth asking, or, alternatively, the question is a true game changer and people just don’t want to open up a can of worms. When it comes to the application of Howey to secondary crypto trading, we strongly believe it is the latter. The rest of this series (10 posts in total, including this one) will be our attempt to convince you why Howey is not the correct test.
Here is what we have planned for you:
June 4, 2023: The Most Insightful 2x2 Table
June 7, 2023: What Is Investing?
June 10, 2023: The Impetus for the Securities Laws
June 18, 2023: What Howey Is and What It Is Not
June 21, 2023: Is John Deaton Right or Wrong?
June 24, 2023: Commentary on Why Cryptoassets Are Not Securities
June 27, 2023: The Real Problem
June 30, 2023: There is a Better Way
Let’s kick it off! See you in a couple of days.
