Crypto Needs Reasonable Rules from SEC
The Securities and Exchange Commission regulates securities. In order to sell securities to the public, you must either register your offering with the SEC or comply with a checklist of requirements for exempt offerings. Either way, developing an asset deemed a security means that developers must hire securities lawyers at costs that can make a new project no longer worthwhile.
But what is a security? Most readers would be surprised by the broad range of business relationships that count as securities under a nearly hundred year-old test used by the SEC. That test is referenced in a case commonly cited as Howey and was based on state law tests used prior to the Securities Act of 1933. That’s right, a test from before widespread adoption of automobiles is still the SEC’s primary tool to regulate 21st century markets.
The basic test has four parts: an investment of money, in a common enterprise, with the expectation of profit, derived solely from the efforts of others. Over time, any logical restrictions on SEC overreach that may have once given the Howey test legitimacy have long since worn away.
The central provisions have each been watered down over many years of interpretation. “Money” no longer means money, “profit” no longer means profit, the qualifier “solely” has all but dissolved. At its most ridiculous the Howey test could lead to a neighbor’s support for a kid’s lemonade stand technically deemed a security (though other exemptions would thankfully protect lemonade stands!).
Enter the exciting world of cryptocurrency (or digital assets), where new stores of value and asset forms innovate at breathtaking speed. Digital assets have characteristics so unlike assets we commonly think of as securities that they demand reasonable amendment to the Howey test. Some digital assets have more in common with arcade tokens or event tickets than with stocks or bonds, they just happen to also have sizeable public demand.
The SEC recently released non-binding guidance on the application of the Howey test to digital assets. Whenever the SEC encountered open questions of legal interpretation regarding the Howey test, it took an aggressive stance in widening the scope of the test as much as it could get away with. The SEC’s obtuse interpretation of this nearly century-old test seeks to capture as many crypto-based products as possible, and will allow the agency to pick winners and losers with no real clarity or consistency. Noted crypto attorney Lewis Cohen has observed that “[i]f the United States truly believes that we need to promote the use of blockchain technology, then we cannot treat tokens in a way that neuters their fundamental and most valuable quality.”
Supporters of the status quo frequently cite instances of fraud in the nascent digital asset space for their refusal to engage in any reform of the Howey test.
Fraud exists in this space, much like the gold rush that created California or the oil boom that fueled the rise of Texas as an economic power. The SEC, state AGs, DOJ, and private litigants already have a wealth of tools to combat fraud without requiring the burdens of SEC registration.
Digital assets will simply migrate to other countries unless the SEC turns from its obtuse approach. Indeed, some have headquartered in Malta or Switzerland. Crypto critics make the exaggerated claim that any amendment to the Howey test will foster a wild west environment.
To the contrary, digital asset entrepreneurs have modest needs. Consider the thoughtful and logical approach taken by Switzerland, where different types of crypto assets are regulated differently. In the U.S. that might mean that primarily utility-based assets are regulated by an appropriate agency like the CFTC, or left to private contract.
Reasonable reform may require the SEC to work with Congress on bills already introduced to create a new regulatory framework for crypto. Let’s agree that the SEC’s decision to draw a line in the sand over a legal test that is nearly a hundred years old serves neither the digital asset industry nor the SEC as an agency.
If SEC remains focused on maximizing the reach of its regulatory power, and protecting turf from other regulators as the digital asset space grows, it will eventually be left out of the conversation altogether — digital asset projects will simply move overseas. Further, if Congress is worried about the prospect of monopolization of crypto-based assets, as many members expressed during the recent Facebook Libra hearings, then removing existing barriers to entry like the Howey test would be a constructive first step to promote competition.
J.W. Verret is Associate Professor of Law at Antonin Scalia Law School at George Mason and a member of the SEC’s Investor Advisory Committee.