Howey Doin?
Howey Doin?
Part VII - Commentary on Why Cryptoassets Are Not Securities
FCP Note: This post is our commentary on the following thought leadership piece:
Title: Why Cryptoassets Are Not Securities?
Author: Jai Massari
Outlet: Harvard Law School Forum on Corporate Governance
Publication Date: December 6, 2022
The original text can be found here.
In what follows, the quoted text is the original and the black text below is our commentary. To make it easy for the reader, we inserted commentary only after the paragraph in the original text is finished, even if our commentary related to an earlier sentence in the paragraph. This was a short article, therefore, for completeness, we reproduced the entire article. All emphases are original unless otherwise noted.
FTX’s collapse reiterates the need for comprehensive U.S. regulation of crypto markets. This regulation must have a solid legal foundation, a key pillar of which is a workable framework to distinguish cryptoassets[1] that are securities from those that are not. A new paper provides this framework, by showing why fungible cryptoassets are not themselves securities under existing U.S. federal securities laws. But also why ICOs and similar token sales should be regulated as securities offerings.
In 2014 the sponsors of the Ethereum Network sold 60 million ether tokens to fund the development of the network, which launched a year later. Because of similarities with a traditional common stock IPO, the ether “initial coin offering,” or ICO, raised a fundamental question: are cryptoassets securities under U.S. federal securities laws? The answer to this question, which we have been debating ever since, determines not only whether and how cryptoassets can be sold to the public but also whether we must hold and trade them under the existing rules and market structure developed over the past 80 years for securities.
The Securities and Exchange Commission’s primary theory on whether a cryptoasset is a security appears to be based upon whether the blockchain project associated with a cryptoasset is, at any point in time, “sufficiently decentralized.”[2] If so, the cryptoasset is not a security. This theory was first proposed by the SEC staff in 2018 to address ICOs, which were then all the rage, and was followed by more detailed staff guidance in 2019. But the theory has not aged well. It is impractical—if not impossible—to apply to today’s real life blockchain projects. It is not supported by existing judicial precedent, including the now crypto-famous Howey Supreme Court case.[3] And it has resulted in market distortions that harm both market participants and long-term innovation in the crypto industry.
Indeed, that seems to be the SEC’s primary theory. If you had a chance to review our earlier posts, you know our position on this: We don’t believe decentralization is an escape route from the reach of securities laws. It may appear so because the SEC, incorrectly, starts its analysis with Howey. As we argued in a previous post, our view is that Howey is limited only to a subset of transactions, more specifically, it applies to cash-flow-generating assets in primary market transactions only. Instead of insisting on Howey, the arguments should be guided by the main policy goal: investor protection. Howey is just a tool, it’s not a rule, nor an all-encompassing precedent.
By the way, we don’t like the term cryptoasset either. We believe that label creates an illusion, a false perception, that cryptocurrencies are comparable to how we generally understand the word asset in finance; an asset is something that generates cash flows. Sure, one might object that there can be assets that don’t generate cash flows, or that an accountant would consider it as an asset because it does have value. Neither of these statements is incorrect, but that’s how slippery slopes work; they look ok when you take your first steps, and then, you start slipping and it gets much harder to avoid the danger. Once the distinction between balance sheet assets (anything that has value) and assets that generate cash flows is lost, it becomes really slippery. Crypto may have value, but it can not be valued. This nuance is overlooked by many, which leads to the perceived equivalence between stocks and crypto.
An intriguing new paper, The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities,[4] points us to the right path. The paper analyzes the relevant caselaw and concludes there is scant legal basis to treat fungible cryptoassets as securities, and it sets out analytical approach that is far more satisfying. The paper separates capital raising transactions by blockchain project sponsors or other insiders in which a cryptoasset may be sold—which are typically securities transactions—from the treatment of the cryptoasset, which is not a security. This analytical framework addresses the now apparent challenges created by the SEC staff’s approach and appropriately focuses the SEC’s regulatory jurisdiction on capital raising transactions.
While we agree that separating capital raising transactions (primary market) from secondary transactions is useful, that, in and of itself, does not imply that the former are securities transactions and the latter are not. A stock certainly does not miraculously stop becoming a security once it leaves the primary markets and starts trading on the secondary. We think the last sentence in the paragraph above is where a critical mistake is being made, namely:
It’s Howey that focuses on capital raising transactions, not the SEC’s regulatory jurisdiction.
Why would the SEC’s regulatory jurisdiction be limited to capital raising transactions? Once again, stocks provide the perfect counterpoint. They don’t leave the SEC’s investor protection net once they start trading on the secondary markets. Why would they? Purchasers of stock on the secondary market still need proper information disclosure. This is precisely why the Securities Exchange Act of 1934 was passed by Congress. As SEC Chairman Gary Gensler noted: “The basic idea was that the public deserves disclosure and protections not only when a security is initially issued, but also on an ongoing basis when the security is traded in the secondary markets.” Thus, the author’s position effectively contradicts the current disclosure regime we have in place, one that certainly is good policy.
The author has a point, it’s just not one she is making. It is Howey, the tool, that is limited, not the SEC’s reach. Our view is guided by a much more fundamental need, which also happens to be the SEC's mission: protecting investors. As the case of stocks clearly demonstrates, the handoff from primary to secondary markets does not obviate the need for information disclosures.
This is the point where the skeptics will likely concede on that issue, but still try to distinguish crypto from stocks. They will say: “Ok, maybe in the context of stocks, investors still need information disclosures, but why would they need it if the cryptoasset is sufficiently decentralized? This was precisely the line of questioning Sen. Toomey followed at the congressional hearings recently:
So why is this happening? Why are the senators asking these questions and the SEC Chairman Gary Gensler’s answers are not considered satisfactory? A similar thing happened when Chairman McHenry pressed Gensler on whether or not Ethereum is a security. What really is happening here?
Well, here is our take. Other than a few exceptions, people are not asking the right question. They are not properly questioning whether or not Howey is the right test to begin with. They don’t recognize that the only question that matters is: How do we make sure investors are protected?
Investors need to be protected in capital-raising transactions because many of them come together to buy something that the promoter is selling, and they don’t have enough bargaining power to extract the proper disclosures from the promoter. As a stock moves from the primary market to the secondary market, that problem goes away, i.e., the second prong of Howey becomes moot, but investors still have a disadvantage vis-à-vis with the people that are running the company. They still need to be protected. Material information that impacts the cash flows of the enterprise may not have been made available absent the securities laws, which would have led to investors not being able to make informed investment decisions.
What happens in the case of Bitcoin? It trades on the secondary markets, and there is no Bitcoin “enterprise.” Bitcoin can sustain its price only when enough people support it, so in some indirect way, it does arguably depend on the efforts of others. Yet, it’s decentralized, and its price does not depend on a group of entrepreneurs in the middle whose decisions impact cash flows. There are no cash flows to begin with! The fourth prong of the Howey also becomes moot.
Yet, does that mean Bitcoin fails Howey and thus not a security? Our perspective is different. The prong becoming moot doesn’t mean Bitcoin escapes the securities laws. Failing the test is not the same as not taking the test. The real question is whether investors still need protection. Do they?
Yes. In secondary transactions where the cryptoasset is fully decentralized, the information asymmetry issue may indeed go away. However, that does not mean investor protection is not needed. Now comes the most important disclosure of all: “Investors'' need to understand that they are speculating and not investing. Thus, it’s not really about closing the information gap and putting promoters and buyers on equal footing, it is about building consensus on what investing means in the first place.
The challenge that we are facing here is that the SEC commissioners themselves are not in full agreement on this point. Here is SEC Commissioner Hester Peirce discussing secondary crypto transactions:
For the reasons outlined above, we disagree.
The paper’s approach is the right one and should be taken on both by the US Congress as it considers legislation to regulate the crypto industry and by courts as they consider high-stakes cases that hinge on the securities law treatment cryptoassets. Doing so will avoid the flaws of the SEC’s well-intended but flawed current approach. And, together with legislative initiatives to regulate crypto markets and intermediaries, it will better protect market participants and more responsibly support innovation.
Sure, crypto regulation will help, but only if we can agree on the following: By design, most cryptocurrencies are not investments. Regulation may help weed out some of the fraudulent activity, but it would be missing the most important disclosure: Telling “investors” that they are not investing.
The SEC’s Decentralize-and-Morph Approach
In the wake of the 2014 ether ICO and the following ICO boom,[5] the SEC staff provided the crypto industry with an analytical framework meant to clarify when and whether a cryptoasset is a security. First set out in a 2018 speech by SEC Corporation Finance Division Director William Hinman, and then described in more detail in 2019 staff guidance,[6] the core idea is that where a blockchain project is sufficiently decentralized, the cryptoasset associated with the project will not be or represent an “investment contract” under the so-called Howey test, named after a 1946 Supreme Court case. And therefore the cryptoasset would not be a security.
The mistake that Hinman, this paper, and many others are making is insisting on using a tool rather than solving the real problem: ensuring investor protection.
Under the 2019 SEC staff guidance, the decentralization level of a project is to be determined based upon fifty or so factors that involve characteristics both intrinsic and extrinsic to the project. These factors range widely and include, for example, whether so-called “active participants,” which can include a “promoter, sponsor, or other third party,” from time to time have a role in developing, marketing, improving or operating the blockchain project; whether an active participant “owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly;” and whether the cryptoasset “is transferable or traded on or through a secondary market or platform, or is expected to be in the future.”[7]
These factors are meant to be evaluated at a particular point in time. Accordingly, the decentralization level of a blockchain project could, and indeed would be expected to, change over time. As a result, a cryptoasset could start its life as a security—for example when it is first sold to investors by the project’s sponsors—and then, at some point later, it could morph into a non-security as the project becomes sufficiently decentralized. This very morphing was, according to Mr. Hinman, what had happened in the case of ether and the Ethereum Network, which had achieved the Holy Grail of sufficient decentralization at some unspecified time sometime between the network’s launch in 2015 and the time of his speech in 2018. (Mr. Hinman did not reveal when.)
Classifying cryptocurrencies based on project decentralization was a deft bureaucratic solution to a practical problem. It helpfully provided some reassurance that the two largest cryptocurrencies, bitcoin and ether, were not—or at least were no longer—securities. Under the opposite view, the initial sales of these assets to the public could have violated registration and disclosure requirements for public securities offerings. And intermediaries, such as cryptocurrency exchanges and dealers as well as early investors in the tokens, could have been engaged in illegal unregistered securities exchange, brokerage, dealing or underwriting activities. Given the billions of dollars of value transacted in these two tokens, the SEC staff’s approach avoided catastrophic consequences for holders of these cryptoassets and for firms providing services and building on the related blockchains.
Is Ether a security? If we assume Howey is how we answer that question, this is what happens:
But in practice, outside of Bitcoin, Ethereum, and a few other blockchain projects, it has been almost impossible to apply the SEC staff guidance in a way that provides agreed-on and repeatable answers. Market participants are expected to analyze a cryptoasset and its underlying project under many vague factors, some of which are based upon information not publicly available. The analysis is unwieldy at best and impossible at worst, particularly without guidance on which factors might outweigh others and with little clarification through rules or substantive litigation. Adding further complexity, market participants are expected to evaluate the relevant facts and circumstances about a cryptoassets on an ongoing basis, as a cryptoasset that achieved non-security status at one point could, nevertheless, revert to security status if the project’s ecosystem becomes less decentralized.
We agree that it is not practical for market participants to assess the level of decentralization. The solution we propose is much more elegant, one we will lay out in the next couple of posts.
For blockchain project sponsors, the expectations created by the SEC staff’s guidance have distorted economic incentives in unhelpful ways. Blockchain projects often plan on token issuances in early stages of their development, both to jumpstart network effects and to meet investor expectations. Project sponsors then quickly find themselves in a race to decentralize—not based on the economic or practical characteristics of the project or its underlying technology, but instead based on the presumed need to address some number of the SEC’s decentralization factors. The decentralization of a blockchain project often is a critically important goal. But the imperative to decentralize to achieve a particular regulatory outcome is a distraction that promotes short-term tactics—sometimes disparagingly been referred to as “decentralization theater”—at the expense of longer-term strategy. Ultimately, this incentive is detrimental to value creation and innovation in the crypto industry.
The decentralize-and-morph theory seems to confound even the regulator who coined it. The SEC has deployed the theory inconsistently and sometimes confusingly in the enforcement context. In some instances, the SEC describes the cryptoasset as a security.[8] In others, the SEC describes the cryptoasset as embodying or representing a security.[9] And in yet others, the cryptoasset is described as being part of a securities transaction, whether or not the cryptoasset is itself a security.[10] This inconsistency suggests the need for a better approach.
We are not believers in the decentralize-and-morph theory; that is just a byproduct of the SEC’s insistence on Howey. In our view, the answer is much more simple. If there are sufficient people out there who purchase crypto with an expectation of profit, and risk money along the way, the token is, de facto, a security.
One may object on the grounds that this is not workable either. What constitutes sufficient? Is it 50%? 75%? To be clear, other laws face similar spectrum issues like these. A game is generally characterized as gambling when chance predominates skill and not gambling when skill predominates chance. Hence the never-ending argument about whether poker is gambling or not. Sometimes, the reality is that a binary decision needs to be made even when what we are measuring lies on a spectrum. Naturally, it becomes even more difficult when the measurement is close to the middle. Chess is not gambling (easy), and roulette is (also easy). Poker? We will have that debate forever.
Luckily, in this case the decision is not whether to allow crypto trading or not. The decision is to protect investors and, at the same time, allow the subset of buyers that care about utility to be able to buy the tokens. We are convinced that our solution, again, please bear with us until the end of the series, accomplishes both. It minimizes the regulator’s burden, while at the same time transferring full accountability to the buyer.
Separating the Investment Contract from the Cryptoasset
With the benefit of a few years of experience, it is clear that SEC’s decentralize-and-morph theory is flawed. But then how should we think about the fundamental question of whether fungible cryptoassets are securities?
The Ineluctable Modality paper shows us how, by starting with the basics and discussing key federal appellate decisions applying the Howey test. The paper persuasively shows why ICOs and other capital raising transactions—which may well involve securities offerings—are distinct from the subject cryptoassets themselves. This intuitive step makes room for an analytical approach grounded in existing law that yields better incentives for crypto market participants and a path to better investor protection.
A capital-raising transaction where a blockchain project sponsor (or other insider) sells a cryptoasset to finance development of the project likely involves an investment contract and thus a security. Investors purchasing from the project sponsor would be participating in an “investment scheme” with an understanding of how sale proceeds were going to be used by the sponsor to increase the value of the cryptoassets sold. This would be the case whether or not the project is decentralized at the time of the transaction. But the cryptoasset sold under the investment contract is never a security—no more than were the citrus groves in Howey. Instead, the contract or arrangement under which the project sponsor or insider sold the cryptoasset, whether or not its terms are written in a single document, is the investment contract.
We categorically disagree that the “cryptoasset” sold under the investment contract is never a security. Why would that be the case? Sure, there are scenarios in which it wouldn’t be and we covered them in detail in our previous post. That said, it’s not a given that it is never the case. This alleged equivalence between orange groves and cryptoassets is simply not there. The former is a cash-flow-generating asset, the latter is not. That means Howey, in its original form is not applicable.
Of course, even after the initial sale, a cryptoasset can again be sold in an investment contract transaction—for example, as part of a distribution by an insider or large holder who received tokens under the initial investment contract. And other types of arrangements involving promises and commitments by a project sponsor or insider and token purchasers can constitute investment contracts under a traditional Howey analysis. But that does not mean the cryptoasset itself ever is, becomes, or later stops being a security, as “morphing” would imply. Accordingly, absent the promises, claims and inducements made by a project sponsor to a buyer that are the hallmark of an investment contract, third-party trading of cryptoassets anonymously on crypto exchanges would not be securities transactions.
This again goes to the heart of the issue. The world in which the Howey decision was rendered was one where all we had examined was cash-flow-generating assets. “Promises, claims and inducements” are hallmarks of investment contracts when we have cash-flow-generating assets. There can still be investment contracts outside that zone.
Applying this approach to the ether ICO yields the correct result. A court would likely have found the initial sale of ether by project sponsors to the public in 2014 to be a securities transaction and subject to the registration and disclosure requirements of the Securities Act of 1933. But subsequent anonymous trading of ether, which is not a security, on cryptocurrency exchanges or in peer-to-peer transfers among third parties should not involve securities transactions. This is similar to the end result contemplated by Mr. Hinman in his 2018 speech, but without the need for market participants to constantly assess whether, when and how the Ethereum Network later became decentralized enough for ether to morph into a non-security.
Again, why would Ether not be a security? That it isn’t a security is an opinion and we vehemently disagree unless the facts show enough people are buying it for a utility basis. We are not convinced that is the case, at least not as of today. What is actually happening is closer to Jim Cramer’s characterization, namely, most people are buying Ether so they can sell it to a greater fool.
We agree that the constant assessment of decentralization is not workable, but resolving that problem by concluding Ether is not a security defeats the whole purpose of the Securities Act: protecting investors. Speculators are free to make choices (assuming the totality of speculative activity is considered beneficial for society as a whole) but they have to make informed choices. The disclosure missing is that they are speculating, not investing.
The paper’s approach does not require new and confusing legal theories. It avoids the impracticalities of an asset changing its status as a security over time based upon extrinsic or nonpublic events, which would require market participants to constantly reassess the regulatory status of a cryptoasset based upon factors they may not be able to ascertain. It would appropriately capture capital-raising activities by blockchain project insiders, even where a blockchain is arguably decentralized. It also appropriately allocates regulatory responsibility for those capital raising activities to the SEC while avoiding subjecting all dealings in cryptoassets to laws that were not designed to regulate commercial activities not involving securities.
This does not mean that marketplace transactions in cryptoassets cannot or should not be regulated. FTX’s demise is yet another demonstration of why they should be. Instead, it means only that secondary market trading in cryptoassets should not be regulated by existing securities laws. Instead, regulatory gaps should be closed by new law. The authors of the paper call for Congress to address these gaps through legislation to give the Commodity Futures Trading Commission with authority to regulate crypto markets and intermediaries operating in them. Indeed, several bills contemplating this type of regulation have been introduced in Congress this past year.
Well, this whole concept of an asset changing its status over time is not something we agree with. If we start with the wrong problem, we’ll get the wrong answer.
The premise that the SEC’s only regulatory responsibility is capital raising transactions is one we are having a hard time taking seriously, especially given the fact that the SEC clearly has regulatory responsibility, one that is mandated by Congress, over secondary stock transactions.
As far as the argument that the secondary market trading in crypto should not be regulated by existing securities laws… Why not? Imagine a scenario where crypto is regulated by new laws and assume that the word investing remains undefined - people can go to regulated crypto exchanges and speculate at will. Some of them get rich because one of the 10,000 or so coins gains widespread acceptance - perhaps that is Bitcoin - and maybe a few other tokens show some staying power because they provide utility to certain market segments. Let’s say the total number of such projects is 1,000 (a generous number we feel). The prices of the remaining 9,000 coins go to zero and “investors” are wiped out. Who, exactly, will be responsible for that outcome? Who is supposed to protect all these people? Can we say, with a straight face, these new laws and regulations were helpful from an investor protection perspective?
Let’s remember the backdrop against which the securities laws were enacted, and that Congress discussed how 50% of the securities were deemed worthless. That was before the securities laws! That was the reason why Congress passed those laws. Does it strike any of us as sensible that such an outcome (maybe even a worse one) might be a real possibility after we pass laws to prevent that very outcome? The focus on the CFTC as a potential regulator is also misplaced in our opinion, but that’s for another day (or month).
If you say, well, people should be responsible for their actions, we agree with you, but only after we give them full information. We can’t just allow the constant selling of speculation as investing to continue.
In the meanwhile, courts and litigants working through the fundamental question of a cryptoasset’s status under the securities laws should take note of this paper and the briefs arguing to apply the approach.[11] The appeal of demystifying the legal classification of cryptoassets without new and muddled theories is clear. It provides a more elegant outcome for many of the pending cases that hinge on whether a cryptoasset transaction involved an investment contract by treating fundraising activities appropriately—as being subject to federal securities laws—without harming cryptoasset markets and investor value.
The problem is this: There is no investor value, there is only price. Even personal finance experts that are pro-Bitcoin are, reluctantly, admitting that fact.
The bottom line is this: The finance question “What Is Investing?” should guide how we resolve the legal question “What Is An Investment Contract?” Where various opinions fall within that 2x2 matrix is key to understanding what truly is at issue.
