In the past few months, federal courts have shown more of their cards on how they will apply The Howey Test when determining what cryptocurrencies will be considered securities.
Civil suits have worked their way through federal courts to an extent where a few decisions now serve as guidance on when a cryptocurrency may qualify as a security under federal law.
To determine if a cryptocurrency meets the legal definition of a security, federal and state courts use a well established legal analysis known as The Howey Test.
The U.S. Supreme Court adopted the Howey Test in 1946 in order to provide a uniform analysis for lower courts and litigants to apply when determining if an investment qualified as a security.
A recent federal court decision has given coin proprietors and regulators a framework in understanding how some federal judges may apply The Howey Test to cryptocurrencies.
In Balestra v. ATBCOIN LLC, a federal court in the Southern District of New York held that the cryptocurrency ATB Coin could be considered a security because its investors expected a profit from their investment and relied upon the coins promoters for guidance.
The Balestra Court held that ATB Coin met the second element of the Howey Test, common enterprise, could be met because Plaintiffs had plausibly alleged that “potential profits stemming from the future valuation of the ATB Coins were entirely reliant on the success of Defendants’ new blockchain.”
“Defendants encouraged investors to purchase ATB Coins based on the claim that the speed and efficiency of the ATB Blockchain would result in an increase in the coins’ value.” Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340, 354 (S.D.N.Y. 2019).
The Balestra Court also held that ATB Coin met third prong of The Howey Test, the expectation of profits, was met because “purchasers of ATB Coins reasonably believed that those coins would increase in value based primarily on Defendants’ entrepreneurial and managerial efforts.” Id.
Critically, however, the Court found that ATB coin did not operate on a decentralized system, such as Ethereum or Bitcoin, but instead resembled a more centralized investment fund.
Although this decision should put coin proprietors on notice that they may be exposed to civil suits from investors, the SEC has also consistently hinted that it does not consider decentralized cryptocurrencies to be securities.
The SEC has taken the position that a very important distinction between “a replacement currency” and “tokens”. As SEC Chairman Jay Clayton stated last year:
” … there are different types of crypto assets. Let me try and divide them into two areas. A pure medium of exchange, the one that’s most often cited, is Bitcoin. As a replacement for currency, that has been determined by most people to not be a security.
Then there are tokens, which are used to finance projects. I’ve been on the record saying there are very few, there’s none that I’ve seen, tokens that aren’t securities. To the extent something is a security, we should regulate it as a security, and our securities regulations are disclosure-based, and people should follow those and provide the information that we require. “
The SEC has recently released an extensive guidance on the difference between mediums of exchange and tokens entitled “Framework of ‘Investment Contract’ Analysis of Digital Assets” (available here: https://www.sec.gov/files/dlt-framework.pdf).
In thiswhitepaper, the SEC takes the position that the first two elements of the Howey Test, Investment of Money and Common Enterprise, “typically exists” in digital assets.
In its analysis of the third element, Reasonable Expectation of Profits Derived from Efforts of Others, the SEC focuses its inquiry on active participation or promotion by a cryptocurrency proprietor.
“When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.”
Conversely though, the SEC also heavily relies upon the nature of the cryptocurrency to determine whether the Howey Test is met. If a fully operational decentralized network exists, the SEC states “the less likely the Howey test is met.”
Taken as a whole, these recent developments should lead cryptocurrency promoters to conclude that they may be subject to securities suits from investors if they indicate their coin may be used as an investment vehicle. However, cryptocurrency promoters should also note that the SEC will be less likely to regulate their coin as a security if it operates off of a distributed ledger.