The advent of cryptocurrency has brought both technological excitement and legal/regulatory conundrum. In the context of a startup company, an innovative use of cryptocurrency is the Initial Coin Offering (“ICO”), where entities create and offer new cryptocurrencies in exchange for an influx of cash. Beloved for its decentralized and deregulatory nature, cryptocurrency has posed complicated legal puzzles for multiple regimes of law, one of which is the US securities law. More specifically, the fundamental question is whether cryptocurrency should be subject to US securities law, thus to the purview of the US Securities and Exchange Commission (“SEC”). Ever since SEC v. W.J. Howey Co. (1946), case law has traditionally used the “Howey Test” to determine whether something is an “investment contract,” which in turn would make it a “security” according to the definition in US securities law.[1] It is likely that the agency and courts will apply the same test to ICOs, and, to avoid potential legal liabilities, an entrepreneur should grasp these legal concepts before rushing to do an ICO.

The Howey Test

The Securities Act of 1933 (“Act”) regulates “securities”, which is a term of art. Although the Act technically provides a definition,[2] its unwieldy length makes it less definitive, but more of a suggestion that almost everything can be securities. The underlying items or business in most transactions in the commercial world do not carry the label “securities” with them – indeed, most people do not want to be regulated by the strict and technical rules of SEC – while the SEC is quite aggressive in sweeping financing activities within its ambit. Investors who are disappointed with the performance of an investment also would want to argue that the items sold/purchased are “securities” subject to SEC regulation, because the Act will then provide them with certain remedies that may not otherwise be available in state contract law.

In addition to the Act’s broad definition of security, the term “investment contract” has typically been used as a catch-all for what is a security. To provide more guidance and certainty, the Supreme Court of the United States posited the famous “Howey Test” to determine whether an item sold in a transaction was an investment contract. In Howey, the court is concerned about an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. It was an adventure that went south (all the way to Florida!).[3] The units and contract were determined an investment contract and therefore a security. For our present purpose, it suffices to understand the Howey Test established in the opinion has become the go-to test to determine if something is an investment contract, and therefore, a security. The test has four prongs, which look at whether:

  1. It is an investment of money;
  2. There is an expectation of profits from the investment;
  3. The investment of money is in a common enterprise; and
  4. Any profit comes from the efforts of a promoter or third party.[4]

The term “money” in the first prong was later expanded to include assets more than hard cash. The term “common enterprise” in the third prong was not precisely defined and courts allow different interpretations. Most federal courts define common enterprise as one that is “horizontal”, meaning investors pool their money or assets together to invest in a project. The fourth prong mainly concerns with investor’s control: if the investors’ actions largely dictate the investment, then it probably is not a security.

Applying Howey Test to Cryptocurrency

Investment of Money

Now, let’s apply the Howey test to cryptocurrency. The first thing we should keep in mind is that there are a variety of different cryptocurrencies issued and used for a variety of different purposes. Not all ICOs are proceeded with the goal of funding for a business venture. For example, if the coin is created for building up a decentralized open source ecosystem then the money you put in should probably be characterized as a “donation”, rather than an “investment”, which already flunks the first prong of the Howey test. An example of such an open source ecosystem is the project Ethereum, with its coin “ether”.[5] It essentially provides a programming language for people to implement their ideas via the so-called “smart-contract”. In contrast, if the coin is offered as a token that afford the holder a claim to an asset, then it probably is an investment

Expectation of Profit

One thing in law that can be counterintuitive is that your subjective expectation may not matter from the legal perspective when the law only looks at the objective standard, which in turn can also be different from the stated objective of the ICO. For example, in the case Warfield v. Alaniz (2009), “charitable annuities” were offered as the underlying item of the transaction, which on paper stated that the item was mainly for charity purposes. But the Court argued that, this transaction is still an investment contract because an investor can reasonably be led to expect profit from this transaction.[6] Accordingly, suppose the offering document is likely to lead a reasonable investor to believe that buying the coin can award a good return in the future, then even if the coin claims to be “utility token” that merely grants the coin holder the access to certain network, platform or services, the court may still consider the coin passes this prong.

Common Enterprise

Most ICOs currently offer coins to pool funds together to propel the development of their projects. The offering documents usually are clear about this point as well.

Efforts of a Promoter

This prong is certainly trickier, as the decentralized nature of cryptocurrency means a substantial holder of the coins can be actively involved in the project and aims to accumulate their tokens (you can think of the “mining” activity to create more coins for yourself), thereby creating a greater impact on the value and profit than the original development group of the project can have. If that is the case, the ICO will be fundamentally different from you relying on the orange grower far away in Florida to make your investment valuable. However, many subsequent new projects are run by a team of sophisticated programmers who use platforms like Ethereum as programming language to implement their ideas, and then offer new coins in exchange for existing coins that will fund their projects. For example, Storj, a cloud storage network, was based on Ethereum blockchain and offered its coin in exchange for existing cryptocurrency such as Bitcoin. The Bitcoin raised by the team was then sold for cash that can be used for funding the project further.[7] In cases like these, not only the projects are actively promoted, but initial coin purchasers will also rely on the efforts of the people running the projects. If so, it will likely meet the fourth prong of Howey Test.

What did the SEC Say?

The SEC has kept an eye on ICOs, largely because the increasing popularity of using ICOs to raise money: as of June 2018, ICOs have raised more than 9 billion dollars.[8] In general, SEC has made it clear that it will not bend the traditional regulatory regime to cater to the cryptocurrency, and if the ICOs constitute securities, the SEC will regulate them.[9] Meanwhile, the SEC also exempted bitcoins and ethers from SEC regulations,[10] probably because these two cryptocurrencies fail the Howey Test, especially the fourth prong. However, in a recent case, a federal judge has made it clear that the exemption does not give a green light to all cryptocurrencies. SEC rules, especially the Howey Test, still apply.[11]

Conclusion

So what is the takeaway? I think it is safe to conclude that an entrepreneur who is in dire need of cash to build up her for-profit company offering coins to get funding probably sits squarely within the definition of “securities” under Howey Test. As such, she will probably be subject to SEC regulation, such as the requirement for securities registration, violation of which can lead to legal liabilities. We should not get too excited about the fact bitcoins and ether are explicitly exempted from SEC regulation, for these projects are highly technical decentralized networks where “transactions” or “smart contracts” take place between users. This is vastly different from most ICOs, which more closely resemble the traditional IPOs for funding purposes.


[1] 15 U.S.C. 77b(a)(1), https://www.law.cornell.edu/uscode/text/15/77b

[2] Id.

[3] The facts of the case, though fascinating, are less relevant for the purpose of this blog. For more information, see https://en.wikipedia.org/wiki/SEC_v._W._J._Howey_Co.#Facts.

[4] https://caselaw.findlaw.com/us-supreme-court/328/293.html

[5] Ethereum/Ether is not securities primarily because it fails the last prong of Howey test. More information will follow in the article.

[6] Warfield v. Alaniz, 569 F.3d 1015 (2009).

[7] For more information, see https://www.coindesk.com/cloud-storage-startup-storj-raises-910-btc-crowdsale

[8] https://www.cnbc.com/2018/06/06/sec-chairman-clayton-says-agency-wont-change-definition-of-a-security.html

[9] Id.

[10] https://www.reuters.com/article/us-cryptocurrencies-ether/u-s-sec-official-says-ether-not-a-security-price-surges-idUSKBN1JA30Q

[11] https://www.cnbc.com/2018/09/11/federal-judge-says-sec-rules-apply-to-initial-coin-offering.html