Almost five years ago, at a Yahoo Finance crypto event in San Francisco, SEC official Bill Himan presented a prepared speech concluding that Ethereum (ETH) is not a security. The speech was published on the SEC’s website with a footnote stating that it “expresses the author’s views and does not necessarily reflect those of the Commission,” although this was not what was intended.
Former SEC chair Jay Clayton said that the agency does not consider Bitcoin or other cryptocurrencies to be securities a week before Hinman’s speech. Clayton defined a security as “where I give you my money, and you go off and make a venture, and in return for giving you my money, I say ‘you can get a return’—that is a security.”
But current SEC chief and nemesis of crypto architects Gary Gensler has made it quite plain that he disagrees with Hinman. To him, “everything other than Bitcoin” is a form of investment security. Gensler remarked in the autumn that the native tokens of staking networks seem like securities because “the investing public is anticipating profits based on the efforts of others.” This was only one day after Ethereum completed its merging to become a proof-of-stake network.
Gensler, like Hinman and Clayton before him, is navigating by reference to a 77-year-old court case about a Florida orange field.
While the crypto industry would love to see the “Howey Test” go away, it is evident that this is not going to happen anytime soon.
Both Hinman and Clayton have left the SEC and are now advising cryptocurrency companies. But Howey is still around, and Gensler has used it to argue that all crypto is subject to SEC jurisdiction, even though his colleague at the CFTC acknowledged ETH is a commodity only last month.
(Ironically, Hinman’s June 2018 speech was titled “When Gary Met Howey,” but he was referring to a case involving Gary Plastic Packaging from 1985 that demonstrated a non-security can become a security depending on how it is marketed; Hinman couldn’t have known that in a few years, a different Gary would wield Howey as a hammer against an entire trillion-dollar industry.)
Howey’s main argument is that any transaction in which an asset is bought or sold with the intention of making a profit is a form of investment contract. Shares in the citrus grove were considered a security, but the plantation itself was not. Hinman maintained that the Ethereum network has grown sufficiently decentralized to rule out current sales of ETH as securities offerings, notwithstanding the $18 million raised in the original Ethereum crowdfunding in 2014. Despite Gensler’s apparent disagreement, it’s worth noting that all other token sales built on Ethereum do seem quite plainly like securities under the Howey definition. This is especially problematic for most new crypto businesses. Tokens are purchased by speculators who anticipate a price increase due to the project’s popularity.
Not so fast! What if the token is really utilized inside the ecosystem of the project, and its value is not only based on speculation? As Hinman put it in 2018, long before Gensler came along: “Simply labeling a digital asset a ‘utility token’ does not turn the asset into something that is not a security.” In other words, the SEC considers your token to be a security regardless of what you label it.
Hester Peirce, a commissioner at the SEC, discusses the Howey Test and its flaws.
It’s a common misconception in the cryptocurrency community that the SEC hasn’t provided “clear guidelines” for cryptocurrency initiatives. The Howey Test serves as its compass, however it is not well-received by the business community. Last Monday, Gensler testified before Congress and claimed, “the regulations actually already exist.” This means that no new rules will be introduced.
Howey’s antiquity is cited as another complaint, although even Coinbase’s chief legal officer Paul Grewal, a former California magistrate judge, noted on our gm podcast that the problem is not with Howey’s age. Precedents in the law, no matter how ancient they may be, fascinate me. Therefore, the fact that Howey and other precedents are getting on in years doesn’t bother me.
The application of Howey to cutting-edge gadgets is problematic.
There is “often, I think, a confusion about the role of the promoter,” “often, I think, a confusion about what is driving any returns that might accrue to the holder of tokens,” and “often, I think, a confusion about fundamentally how these assets work, and what real utility they bring to the networks,” according to Grewal. “These tokens play a very important role in networks that are based on a proof-of-stake consensus mechanism, ensuring the security of the networks and the integrity of the transactions that are confirmed on the network,” says one expert.
Is it always always correct to attribute a token’s success to the efforts of the project supporting it? But what happens if the token holders actually have a stake in the success of the project? Many new projects are banking on this distinction to keep their token out of the SEC’s reach, but Gensler has not signaled that this is important to him at this time.
Unfortunately for LBRY, this strategy backfired when the company claimed that its token “functioned as an essential part of the LBRY blockchain” but still lost its case against the SEC. As University of Kentucky law professor Brian Frye explained to Decrypt, “The district court almost entirely deferred to the SEC… He ruled for the SEC on literally everything, with no caveats.”
The general public seems to think Gary Gensler wants a higher position in government. However, Gensler’s replacement as SEC head may be just as eager to apply the Howey test to cryptocurrencies. (Remember that the crypto community was hopeful when Gensler was hired because he had taught a blockchain course at MIT; don’t expect the new chair would be much kinder.)
Instead of hoping it would go away, the crypto industry as a whole must face Howey head-on. Others, like Coinbase, are committing to take on the SEC head-on, which is commendable, and many others are only issuing their token outside of the U.S., all in an effort to avoid U.S. regulations.
There is little doubt that the present regulatory climate in the United States is driving crypto initiatives elsewhere. The future of Web3 innovation in the United States will be largely determined by what happens next with legislation. Howey seems to be doing OK for the time being.
