The Howey test involves an analysis of a given token offering to assess whether or not it should be treated as a ‘security’ under US securities laws and sold only to a certain pool of high net worth investors, or whether it is a ‘utility’ token, which would not be a security and may be sold to any retail investor. Generally speaking utility tokens are digital assets that are used or consumed to obtain goods or services. Otherwise, utility tokens may also be tokens that act as securities but are used on a platform that is basically more or less self-governing and automated.
The SEC has clarified that Bitcoin and Ethereum are not ‘securities’ at this point, although they may have been securities in the past, due to the fact that these platforms are currently decentralized and more or less on autopilot. This analysis implies that these two tokens fail the Howey test, and that other tokens with a similar automated platform functionality will also fail the test. SEC has indicated that no additional regulations or reinterpretations of current securities laws will be issued, and all future crypto-related regulatory actions will be based on the existing legal framework. In spite of this very significant clarification from the regulators, questions nonetheless linger.
With respect to third-party management of a business venture, what is the threshold before oversight, maintenance, and general directional control of an enterprise or platform, crosses through the threshold of essential control of an enterprise necessary to deem a given issuance a sale of ‘securities’? This question generally requires substantial subjectivity. If we draw an imaginary scale with ‘total control’ on one end to ‘total automation’ on the other, then each platform will fall somewhere on that scale with respect to the management and control necessary to maintain its functionality, profitability, and stability. At this time we have little clarification as to that middle area where some definite oversight is required but the platform more or less functions and governs itself on a day to day basis.
For example, there is certainly the question of technical supervision and stability of a platform, and if it is being actively managed on a daily basis then certainly this would be deemed to be reliance on a 3rd party and the test would be passed. However, what if there is a moderate amount of management, say once or twice per week the developers repair errors and make adjustments, but management still retains control of the direction or significant changes to a given platform? Would this situation pass or fail the Howey test? What if platform developers make upgrades to the platform every month or quarterly? Would this situation be deemed to be reliance on a 3rd party? How significant would such upgrades need to be before the Howey test is passed? Such major changes to the platform may greatly affect its adoption and therefore profitability, but if only made quarterly or bi-annually, how could this be deemed to be ‘essential managerial efforts’ on the part of the issuer?
The ‘common enterprise’ question is currently incredibly vague, ambiguous, and lacks consensus among various court approaches. The analysis may include a ‘horizontal’ or ‘vertical’ analysis, which may look at pooling of funds and sharing of profits among investors for the former, or reliance on the promoter’s expertise or the linkage of fortunes among the investors and the promoter for the latter. This analysis is fraught with uncertainty and begs for additional clarification that would not be subject to the whims of a given court. Best case scenario would be a clear SCOTUS ruling as to which approach should be used by all federal courts, and a clarification of the particular analysis to be implemented. For example, the vertical approach is redundant of the ‘reliance on others’ analysis and the horizontal approach is far more useful, along with a possible simple two-step process for the analysis:
- Is there pooling of investors’ funds or does each investor otherwise retain its own separate identity in the venture as well as in the profit/reward structure?
- Are investors’ profits and losses correlated? Meaning does each investor earn a proportional amount of the venture’s profits to the amount of equity which that investor owns in the venture?
An affirmative response to each question (‘yes’ to pooling of funds) should be necessary to pass the Howey test. Something simple and easily applicable by not only lower courts, but by entrepreneurs and their respective legal counsel would go a long way to providing certainty and predictability to a market currently mired in fog. This would obviously also save the SEC a great deal of time, effort, and expense in investigations and other enforcement actions so that they might focus on truly fraudulent activity, which occurs mostly on Wall Street.