Is Crypto Security? The Howey Test and More
By: Mel Zhou
Tags: Securities Law, Cryptocurrency, Blockchain, Token Sale, ICO

This article is for those who are doing blockchain startups and preparing ICOs, or for those prudent crypto investors who worry about regulatory compliance. If an ICO constitutes security offering, one must file with the SEC. However, the cost of producing the prospectus, registration materials, plus the cost of ongoing reporting obligations are so expensive that most startups may not be able to afford such expenses. If a cryptocurrency isn’t security, it could avoid the foregoing filing requirements.

So when is a cryptocurrency security? The answer has been vague, but the SEC has been working on applying the legal regime to crypto and has given us some guidelines. In here I’ll discuss the Howey Test (SEC applies it to determine whether a digital asset constitutes security) and related securities regulation, try to shed some light on in what circumstances a token would be considered as security.

This article will cover:

How the SEC applies the Howey Test (for securities) & prior cases How to structure your ICO so it’s not security What you should do if your ICO constitutes security offering

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How the SEC applies the Howey Test (for securities) & prior cases

In Sep. 2017, the Commission issued a Report of Investigation concerning the application of the U.S. federal securities law to the offer and sale of DAO Tokens, which were deemed as securities by the SEC. In the report, the Commission warned that ICOs can be securities offerings.

Recently, there are a number of actions enforced by SEC, concluding certain tokens as securities and disqualifying the offering from any registration exemptions. Those being charged against include but not limited to Paragon Coin, Inc, CarrierEQ, Inc., d/b/a Airfox, BlockVest LLC (the Court found the SEC failed to demonstrate a previous violation because of a disputed issue of fact).

SEC applied the Howey Test in the prior reports to determine whether a cryptocurrency is security.

The Howey Test

The Howey Test is created by the Supreme Court in SEC v. W. J. Howey Co. for determining whether a contract, transaction or scheme qualify as security.

This test has 4 factors (which we’ll further discuss), all of them must be met for an instrument to be considered as security. The SEC has appeared to emphasize the third and fourth factor in their reports. When applying the test, the Court or the SEC emphasizes the economic realities underlying a transaction, disregarding the form of the offerings.

1. A person invests his money

Given the broad definition of money investment, and non-security tokens are usually be distributed through a sale with the price set per token, almost all ICOs would satisfy this factor.

2. In a common enterprise

Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: 1) horizontal; 2) narrow vertical and 3) broad vertical. In the prior reports and complaints, the SEC did not focus on this factor.

3. Is led to expect profits

Regardless of whether a token is labeled as a utility token or a security token, The SEC scrutinizes, among others, the promotional materials, merchandising approaches, oral assurances and prospects of the project.

There are a slew of similarities in prior cases, which the Commission found to strengthen their conclusion that the investors are led to expect profits.

First, the issuer plans to increase the value of the Token, probably by creating some sort of ecosystem or developing the Apps.

Example of two prior cases:

In Airfox, the SEC finds the investors were led to expect profits, partly due to the fact that the proceeds were to be used to build an ecosystem, improve the App and add new functionality that would increase the value of AirTokens.

In Paragon, a similar accusation appears as Paragon stated repeatedly in the White Paper, marketing materials, internet forums and elsewhere, that it was planning to use the proceeds to build an “entire ecosystem” around the PRG tokens that would increase the token value. Paragon also highlighted that it’ll increase the value of PRG tokens through its deflation algorithm, controlled reserve fund, and token “burning”, among other things. A principal at the company stated, “ A product that we’re expecting to appreciate in value due to its limited supply and the ecosystem we’re building around to build a strong demand.” Prospect(oral or written) of higher token value would be deemed as solicitation and leading to investor’s expectation of profits.

Second, no matter what they claim how the tokens would be used, the functionality does not exist during the offering.

At the time of the AirToken ICO, the AirFox App was a prototype that only enabled users to earn and redeem loyalty points. The company claimed that the prototype was “really just for the ICO and just for investment purposes” and “did not have any real users”.

Third, the company promises that they’ll ensure a secondary trading market for the token would be available shortly after the completion of the offering.

Airfox and Paragon both highlighted that they’ll ensure secondary trading market shortly after the completion of the offering, prior to the creation of the ecosystem.

Fourth, the project is mainly marketed to speculative investors instead of real users.

In Airfox, the SEC finds that the promotion directed mostly at digital token enthusiast rather than customers who would ultimately use AirTokens to purchase data from prepaid wireless carriers in developing countries. They promoted the offering in forums including BitcoinTalk.org and marketed the ICO to investors who reasonably viewed the tokens as a speculative, tradeable investment vehicle.

Fifth, an explicit expression of potential profit.

In the DAO report, the SEC finds that the investors of the DAO tokens have a reasonable expectation of profits because the ETHs received from the token holders were pooled and available to the DAO to fund projects. The DAO token holders share in potential profits from the contracts.

In Blockvest, the SEC pointed out that BLV holder will share in the profits of the Blockvest30 and other ventures in their complaints. These profits are stated in the Blockvest’s whitepaper, “as a Blockvest token holder, your Blockvest will generate a pro-rated share of 50% of the profit generated quarterly as well as fees for processing transactions.”

4. From the efforts of the promoter or a third party

This factor is most frequently asked by the SEC. It inquires whether investor’s profits were to be derived from the significant entrepreneurial and managerial efforts of others.

Blockchain projects are oftentimes run by a decentralized autonymous organization (DAO), which is controlled by shareholders and not influenced by a central government. A DAO is legally arguable when it comes to the relationship between investors and the issuer/promoter. The SEC would scrutinize the structure, rules, distribution of rights, and actual operation of a DAO. Among others, the shareholders’ sophistication, ability to obtain sufficient information, and relationship with the control person(if any) have a great impact on the answer to this question.

In the DAO report, the SEC finds that the investors reasonably believe that they can rely on the Slock.it, its co-founders and curator’s expertise, because Slock.it created the website, online forums and closely monitored them; the creator held themselves as experts in Ethereum, and told investors that they had selected people to serve as curators based on their expertise and credentials. The SEC concluded that the managerial efforts of the above entities and individuals were essential to the enterprise, and investors had little choice but to rely on their expertise, as the ability to vote for contracts was largely perfunctory one (votes are limited to proposal whitelisted/cleared by the curators; no sufficient information to permit them to make informed voting decisions), and DAO Token holders were widely dispersed and had limited communication.

Simply labeling a digital asset a utility token does not turn the asset into something that is not a security. The main reason why DAO Tokens are securities is that the network and structure in which DAO Tokens are based on is not sufficiently decentralized. The investors are given insufficient rights and information to influence the enterprise, and the issuer/curator remains to hold significant power and control in the ecosystem.

In Airfox, besides the efforts the issuer put in building the system and facilitating secondary trading market, the fact that it highlighted its founder’s background(worked at prominent tech companies and attended prestigious universities) strengthens SEC’s view that investor would reasonably expect that Airfox and its agent would expend efforts to develop the Airfox App and the Airtoken ecosystem.

If the issuer/promoter retains a stake or other interest in the tokens such that it would be motivated to expend efforts to cause an increase in value in the token, or makes certain statements that lead the investors reasonably believe the issuer/promoter would undertake reasonable efforts for profits or return on their investment, there will be a red flag.

How to structure the ICO so it’s not security

The idea behind this is if the ICO no longer represents a fraction of the enterprise’s interests, the ICO would probably not seem as security offering. Also always remember the SEC usually step in when they find it necessary to protect investor interests and capital markets. If the ecosystem is sufficiently decentralized or the investor is accredited or sophisticated (in private offering), then the offering would not likely violate the securities regulation.

For an ICO to fail the Howey test, we should focus on whether the marketing materials, statements and etc. would lead investor to expect profits, and they’ll reasonably believe that they could rely on the issuer/promoter’s managerial expertise.

If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract and thus not constitutes securities. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.

— William Hinman, Director, Division of Corporate Finance in SEC

Bitcoin is not deemed as security by the SEC mainly because there’s no central party whose efforts are a key determining factor in the enterprise. Applying securities law to the offer and sale of Bitcoin would seem to be unnecessary as the Bitcoin network is operational and decentralized for a long period of time. Also, based on the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions, and applying the disclosure regime of federal securities law to it would seem to add little value. In cases that there are sufficiently decentralized networks and system, regulating the tokens or coins as securities may not be required.

What if your ICO constitutes security offering?

First thing first, if the ICO constitutes security offering, the issuer is obliged to register the offer and sales of securities to avoid violation of Section 5 of the Securities Act. The issuer should file a Form 10 to register under Section 12(g) of the Securities Exchange Act of 1934 the tokens as a class of securities.

To be exempted from the registration requirement, one might try to be subject to a valid exemption. These exemptions include a private offering under Section 4(a)(2), a Reg D offering (Rule 506 of Reg D is the most commonly used exemption by startup companies to sell equity to accredited angel investors and venture capital funds. Required to file a Form D), crowdfunding (Form C), a Reg A offering(Form 1-A) and intrastate offering. Find more information in the chart below: