Law and Ledger: Are Digital Currencies Classified as Securities?
Law and Ledger, a crypto legal news segment by Kelman Law, a firm specializing in digital assets, presents the first installment of a series that addresses a pressing question: Are digital currencies classified as securities? The current U.S. legal framework does not provide a specific law addressing cryptocurrencies; instead, the SEC and judiciary continually interpret the investment contract doctrine established in the Supreme Court case SEC v. W.J. Howey Co., dating back to 1946 and originally centered around agriculture rather than blockchain technology.
Understanding the Howey Test
In this series, we aim to dissect how the Howey definition functions within the realm of crypto assets and its implications for token issuance and distribution. Despite technological advancements, tokens can still fall under SEC regulations, particularly when they exhibit characteristics of securities, which include tokenized bonds or stocks. Simply placing an asset on a blockchain does not alter its inherent nature. The focus here will be on the four critical criteria of the Howey test and the SEC’s adaptation of these components to the unique context of cryptocurrency.
Four Essential Elements of the Howey Test
The SEC laid out guidelines in August 2019 for evaluating digital assets using the Howey test. To determine if an asset qualifies as an investment contract, four essential elements must be satisfied:
- Investment of Money: This element requires the presence of an investment of money, which encompasses not only traditional currency but also other forms of assets that hold value. Notably, this component is frequently met, as courts consider efforts, labor, and other contributions valuable.
- Common Enterprise: Legal interpretations of this principle have evolved, with horizontal commonality focusing on the mutual fortunes of investors, while vertical commonality emphasizes the issuer’s endeavors to grow the network. Although the SEC has generally deemed this element satisfied, actual court rulings often reveal complexities, especially during secondary market transactions. The legal case against Ripple exemplifies this issue, showing a distinction between the initial institutional sales and subsequent buyers in the secondary market.
- Expectation of Profit: This element examines whether investors have a reasonable expectation of profit. Here, the assessment pivots to the typical buyer’s perspective, analyzing if they could reasonably anticipate value appreciation from the token. This measurement is considered objective; promotional tactics that highlight price potential, scarcity, or future partnerships contribute evidence of profit motives.
- Managerial Efforts: The last element scrutinizes whether purchasers rely on significant input from a core development team to realize promised growth. If a token’s success is closely linked to the team’s future actions—like software updates or partnerships—the courts view that reliance as meeting this critical prong. Projects that begin with centralized control may later transition towards a decentralized model, but without clear guidelines for this shift, early buyers may still be held in reliance on the foundational team.
Economic Context Over Technical Structure
Importantly, courts prioritize the actual economic context of these transactions rather than solely their technical structures. Thus, possessing a label such as “utility token” or features like governance rights does not necessarily exempt a token from classification as part of an investment contract. All aspects of the value proposition—including marketing strategies and the issuer’s conduct—are taken into account.
Recent Judicial Precedents
Recent judicial precedents, including the SEC’s case against Ripple Labs, have clarified that the XRP token is not inherently a security; rather, securities status can emerge from specific methods of offering and selling tokens. This distinction implies that secondary market transactions may not be deemed securities sales if they occur in a decentralized context devoid of issuer influence.
Conclusion
As regulation surrounding cryptocurrencies evolves, understanding and navigating the complexities of the Howey test remain crucial for participants in the market. Kelman Law is poised to support clients as they engage with these intricate legal frameworks, ensuring informed decision-making amid ongoing developments in the cryptocurrency regulatory landscape.
