Clarity from the SEC — Bitcoin and Ether Likely Fail the Howey Test
By Daniel G. Viola, Partner of Sadis & Goldberg, LLP, a New York based law firm. Daniel is the Head of the Digital Asset and Compliance Groups at his firm and is also the founder of the Crypto Asset Webinars and the Blockchain Shift Conferences.
On May 1, 2018, the Wall Street Journal reported that while Bitcoin escaped government oversight as a security, regulators were examining whether other widely traded cryptocurrencies should be regulated as securities. In particular, Ether, the world’s second most valuable cryptocurrency after Bitcoin. This analysis typically turns on whether the founders of the virtual currency exert significant influence over their value, similar to the way a company’s stock price is dependent on its management team. Critics to this position argue that the analysis depends on how decentralized the organization is. For example, with Ether, since it has become highly decentralized, it should not be deemed a security because an owner of Ether is not relying on the efforts of the founders of Ether to experience a profit from their purchase of Ether.
On June 14, 2018, Mr. William Hinman, the Director of the Division of Corporation Finance at the U.S. Securities and Exchange Commission (the “SEC”) seemed to agree with the critics and concluded that Ether , the cryptocurrency of the Ethereum network, is likely not a security and is therefore likely not subject to the requirements of U.S. securities laws. Of course, a non-security can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, when a Bank Certificate of Deposit, which is generally exempt from being treated as a security under Section 3 of the U.S. Securities Act of 1933 (the “Securities Act”), is sold as a part of a program organized by a broker who offers retail investors promises of liquidity and the potential to profit from changes in interest rates, then this instrument can be part of an investment contract and defined as a security, as set forth in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985).
Under Section 2(a)(1) of the Securities Act, a security includes “an investment contract.” See, 15 U.S.C. § 77b. An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others, such as a founder or promoter of a company. See, SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also, United Housing Found., Inc. v. Forman, 421 U.S. 837, 852–53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”). This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299. The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Id. In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” Forman, 421 U.S. at 849.
In order for an arrangement to be deemed an investment contract, it must qualify under all three (3) prongs of the Howey Test. See also, SEC v. SG Ltd., 265 F.3d 42, 48 (1st Cir. 2001), holding that all the factors must be present in order for an investment contract to meet the statutory definition of a “security.”