Crypto Regulations: Marching Through Ambiguity

The recent developments of a top former executive at the highly valued NFT startup OpenSea getting arrested and charged “with wire fraud and money laundering in connection with a scheme to commit insider trading,” compels us to understand the state of regulation and the purview with which law views crypto and digital assets.

The single biggest bone of contention here is the now infamous 'Howey Test'

What is Howey Test?

The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract.” If a transaction is found to be an investment contract, it’s considered security. It’s then subject to registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.

According to the U.S. Securities and Exchange Commission (SEC), an “‘investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The so-called ‘Howey Test’ applies to any contract, scheme, or transaction, regardless of whether it has specific securities characteristics.”

Howey Test Determination

Under the Howey Test, a transaction is an investment contract if:

• It is an investment of money

• There is an expectation of profits from the investment

• The acquisition of money is in a common enterprise

• Any profit comes from the efforts of a promoter or third party

Although the Howey Test uses the term “money,” later cases have expanded this to include investments of assets other than money. The term “common enterprise” isn’t precisely defined, and courts have used different interpretations. Most federal courts define a common enterprise as horizontal, meaning that investors pool their money or assets together to invest in a project. However, other courts use different definitions.

The final factor of the Howey Test concerns whether any profit that comes from the investment is largely or wholly outside of the investor’s control. If so, then the investment might be a security. However, if the investor’s actions largely dictate whether an investment will be profitable, then that investment is probably not a security.

Howey Test & Crypto

To understand how the Howey Test applies to crypto, it’s essential to understand a crucial term debate surrounding cryptocurrencies and securities: initial coin offering (ICO).

The simplest explanation is that an ICO is like a type of crowdfunding. To raise money for their cryptocurrency projects, companies create tokens, which people can purchase.

Here’s how the ICO process works. First, a company creates a white paper, a document outlining the company’s pitch to potential investors, and a website dedicated to the new token. Then, after piquing people’s interests, the company asks for financial contributions (usually via a well-established cryptocurrency like Bitcoin) in exchange for some of the project’s crypto tokens. These tokens can serve various purposes, ranging from access to future goods or services to entitling the investor to a share of profits generated by the venture.

So who can launch an ICO? Anyone. ICOs are largely unregulated in the U.S., meaning anyone with the tech know-how can create one. But that lack of regulation also makes ICOs extremely high-risk, and investors have no protection if an ICO isn’t successful or turns out to be fraudulent. A 2018 study by the Wall Street Journal of 1,450 ICOs found that one in five showed “red flags” of being a scam.

Speaking about crypto assets during a September 2021 testimony before the Senate Committee on Banking, Housing, and Urban Affairs, Gary Gensler, chair of the SEC, said: “Currently, we don’t have enough investor protection in crypto finance, issuance, trading, or lending. Frankly, at this time, it’s more like the Wild West or the old world of ‘buyer beware’ that existed before the securities laws were enacted. This asset class is rife with fraud, scams, and abuse in certain applications.”

SEC & DeFi

The SEC also has asserted to regulate decentralised finance (DeFi), a subsector of crypto that offers financial services through self-executing smart contracts. It might be the agency that ends up reining in stablecoins, privately issued cryptocurrencies with a price pegged to the U.S. dollar (or other currency). The agency is also pushing for greater oversight on crypto exchanges, claiming the platforms offer tokens that might be securities.

So, what happens if it is security? The issuer of the cryptocurrency must register the security with the SEC or receive an explicit exemption from the registration requirement. If exempt, the cryptocurrency will only be available for “accredited investors.” Accredited investors are a limited group of individuals who satisfy any of the following requirements:

• A director or executive officer at a company that issues securities.

• An individual or married couple with over $1 million net worth.

• An individual with a salary above $200,000 or a married couple with a combined income of over $300,000 for the past two years.

Being an accredited investor is not for everyone and significantly reduces the number of people accessing a cryptocurrency. While options such as the use of Simple Agreement of Future Tokens (SAFT) have been considered an alternative way for crypto startups to raise funds without contravening securities laws, the SEC has yet to decide on their validity.

The Ripple v/s SEC Sage

Ripple was founded in 2012 under the name NewCoin - It later Became OpenCoin, and then Ripple.

Offer a leading-edge alternative to the big-bank-owned SWIFT cross-border money-transfer network. Clearing funds on SWIFT can take as long as days, thanks in part to the need to convert among multiple currencies.

Unlike Bitcoin, which is painstakingly “mined” over time by those with high-powered computer equipment, XRP tokens—100 billion of them—were created out of thin air primarily by three developers, one of which is a co-founder of Ripple.

Most of those tokens are either owned by the co-founders or held in escrow by the company. Still, tens of billions of XRP tokens have been sold to the public, constituting what the SEC says is an “initial coin offering,” or ICO, a means for a company to raise money and get its cryptocurrency into circulation.

The SEC filed an action against Ripple Labs and its founders for their unregistered offering of the XRP digital token in alleged violation of the securities laws & this case was being dubbed the “cryptocurrency trial of the century,”

The SEC alleged that XRP is an investment contract due to its centralised nature and the way in which it was offered, sold, and promoted. In order to preserve the sanctity of the Howey test and its application to digital asset cases, the SEC did not allege that XRP (as in the digital token) was security but, instead, the circumstances surrounding XRP’s offering that made it one.

Yet, the SEC felt the need to justify further its position that XRP is an investment contract by explaining why “XRP is not a currency.” This leaves us with one remaining question: if XRP (as in the digital token itself) is not a security, but it’s also not a virtual currency, what exactly is it? According to the SEC, the answer is simple: it’s “software code.”

The XRP digital token represents something beyond software code; it represents a virtual currency. So whether the SEC would care to admit it or not, the Howey orange grove analysis does not apply as neatly to the facts and circumstances surrounding XRP and its offering.

Ripple has now filed a motion to compel the SEC to answer interrogatories identifying the SEC’s theory of how the Howey Test applies to virtually all of Ripple’s transactions in XRP over the last eight years. Even after repeated insistence by Judge Netburn, the SEC has repeatedly refused to provide relevant information on how Howey applies to Ripple’s transactions, calling it “baseless.”

Other frameworks for cryptocurrencies

A digital economy expert, Bronwyn Howell, notes the SEC’s deficiency approach to distributed ledger systems (DLS), which focuses on funding rather than the function. She observes that tokens can exhibit some characteristics of securities, but they perform very different roles and hence need a new regulatory framework that considers applications and users. This has also been described as the token utility approach, developed in statute in Montana and Wyoming.

Mathematician Petrus Potgieter observes that any expectation of profit from ownership is significantly related to the general outlook on cryptocurrencies and not solely to the efforts of Ripple Labs. He cites the evidence that XRP’s fluctuation is highly correlated (around 0.3) with Bitcoin and supports a “Ripple Test”, which would recognise that the asset may have some aspect of a currency, have no explicit claim of profit, and whose value is not solely attributed to the efforts of the promoter or third party.

Taken as a whole, these recent developments should lead cryptocurrency promoters to conclude that they may be subject to securities suits from investors if they indicate their coin may be used as an investment vehicle. However, cryptocurrency promoters should also note that the SEC will be less likely to regulate their coin as a security if it operates off of a distributed ledger.

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