When Crypto Escapes Howey
The SEC’s March Interpretative Release came as a welcome event, given the commission’s previous crypto stances under perpetually perplexed Jay Clayton and crypto jihadist Gary Gensler. In the my last post, I covered some of the classifications the SEC now uses to distinguish digital assets and keep them out of the often suffocating securities world.
But the commission can only do so much on its own–although its signal that a formal rulemaking is on the way is most welcome.
Nonetheless, the commission is still hamstrung by judicial precedent and in crypto world that means
SEC v. W. J. Howey Co., the famous (or infamous depending on one’s perspective) case about orange grove plots that has defined when an offer to purchase an unconventional financial instrument is an “investment contract.” The Howey test defines an investment contract as a contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits derived from the efforts of others. The test has bedeviled entrepreneurs and lawyers seeking to create and advise Web3 projects for a decade now.
When Crypto Escapes Howey through Managerial Efforts
Until Congress redefines investment contract to exclude crypto or certain types of digital assets from its enumerated list of securities, or the Supreme Court modifies its Howey precedent, the SEC is hamstrung.
With that limitation, the Atkins commission is focusing on managerial efforts to free as many investment contract securities as possible from the SEC’s yolk. Importantly, the Interpretive Release distinguishes the underlying non-crypto asset from the investment contract that subjects to securities regulation:
The issuer’s representations or promises to engage in essential managerial efforts from which a purchaser would reasonably expect to derive profits, when combined with an investment of money in a common enterprise, creates an investment contract under the Howey test. As is the case with other non-security assets, the fact that a non-security crypto asset is subject to an investment contract does not transform the non-security crypto asset itself into a security.
It then provides founders an out, to release the underlying token from the investment contract thereby freeing them from any further securities obligations:
A non-security crypto asset that was offered and sold subject to an investment contract is no longer subject to the associated investment contract once the issuer has fulfilled its representations or promises to engage in essential managerial efforts, even if the issuer continues to provide efforts that are not essential managerial efforts with respect to the non-security crypto asset or an associated crypto system or other software project.
Because the issuer has fulfilled the essential managerial efforts it represented or promised it would undertake, purchasers no longer have any reasonable expectations of profits to be derived from those efforts. Such representations or promises to engage in essential managerial efforts could, for example, relate to developing certain functionalities or features for the non-security crypto asset or the associated crypto system or other software project, achieving certain software development milestones on a roadmap, or open-sourcing related computer code.
Thus the founders can declare their major efforts complete in a widely disseminated way and release the tokens into the wild. Tokens can also escape if the founders quit the project before fulfilling all its promises.
When Crypto Escapes Howey, Implications and Questions
Ceasing further securities obligations matters most for liquidity and tradablity. Freeing tokens from trade restrictions is essential for a functioning crypto system. Forcing tokens through an alternative trading system, or holding periods, or blue-sky laws kills their viability.
But the Interpretative Release leaves questions unanswered. For example, suppose a Layer 1 announces it has sold an allotment of tokens and has now ceased its major efforts to build the system. According the release this makes the tokens freely tradable. But what does this mean in practice? If the founder sells the tokens under Reg CF, does this mean the tokens are not subject to the one-year holding period? If the founder sold under Reg A+, are the tokens covered from blue-sky laws? What role does an ATS play?
Some of these questions could be answered by a rulemaking. The SEC has repeatedly declined to cover Reg A+ securities from blue-sky laws, limiting the exemption’s usefulness. A crypto rulemaking would be the perfect time fix this. Unfortunately, Reg CF‘s one-year holding period is statutory and not so easily dispensed with.
Under the leadership of Chair Paul Atkins the SEC is at least trying. As he stated last year:
[F]or too long the SEC ignored market demands for choice and disincentivized crypto-based capital raising. As a result, crypto markets pivoted away from offering crypto assets and deprived investors of the opportunity to use this technology to contribute to productive economic enterprises. The SEC’s head-in-the-sand posture—as well as its shoot first, ask questions later approach—are days of the past.
But alone the commission can override Congress or the courts. For a truly clean escape from Howey, Atkins needs help.
By Jossey PLLC
