In 1946, the US Supreme Court passed a ruling on Securities and Exchange Commission v. W. J. Howey Co that would set a precedent for how the term “security” would be defined for all future assets.
Quite simply, a security is an investment in an enterprise with the expectation of future profits. But determining whether an investment was made with the intention of raking in future profits isn’t always clear cut. The legal uncertainty surrounding the nascent cryptocurrency industry makes things even murkier.
In 1946, the US Supreme Court Case was presented with the case of William John Howey. Howey, who owned vast tracts of citrus groves in Florida, decided to be smart about his agricultural enterprise. He kept half of the land for himself and sold the other half to outside investors under the auspices of the W.J. Howey Company. The catch was that investors would immediately sell the land back to Howey – or more precisely, “Howey-in-the-Hills” – via a service contract which gave Howey the right to work the land and market the produce. In other words, the W.J Howey Company and the service provider “Howey-in-the-Hills” existed in name only.
The reality is that the contracts Howey was selling were essentially leaseback agreements, a type of investment contract. Howey was smart because he realized he could finance future developments of his agricultural enterprise by accepting funds from people who were neither farmers themselves nor had any particular interest in the cultivation of citrus fruit. The man was a self-made venture capitalist.
Justice Frank Murphy made a ruling that later became known as the Howey Test. "An investment contract,” he said, “means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise."
That’s quite a mouthful. So how does the Howey Test apply to cryptocurrencies? It turns out selling leaseback agreements for an orange farm isn’t very different from selling cryptographic tokens on the blockchain.
Let’s distil what the Howey Test actually means. In order for an investment to be dubbed a “security”, it must fulfil all of these four criteria:
It must be an investment of money
With an expectation of profit
‘In a common enterprise
With the profit generated by a third party
It’s clear to see why stocks, for example, are considered securities.
What’s in a name?
The answer: a lot. Being classified as a security puts an investment contract under the burden of numerous regulations and requirements. This includes registration with the SEC and timely financial reporting. When cryptocurrencies came along, there was little consensus over how they should be classified. But things changed with the DAO hack.
In 2016, a few members of the Ethereum community announced the inception of The DAO, a “Decentralized Autonomous Organization”. For a brief period, anyone was able to buy DAO tokens with Etherum. During the initial sale, The DAO team managed to gather 12.7M Ether (around USD 150 million at the time).
And then they got hacked. On June 17, 2016, a hacker found a loophole in the code of The DAO blockchain that allowed them to siphon off 3.6 million ETH (USD 70 million at the time) in just a matter of hours. The bug that allowed the hack did not come from Ethereum itself, but from an application built on The DAO. Thanks to a 28-day-holding account, the hacker couldn’t actually remove the funds from the Ethereum blockchain. In July 2016, a majority vote decided that in order to return the funds, the Etherum code would have to undergo a hard fork, resulting in the split between Ethereum and Etherum Classic. A hard fork is a radical change to a network's protocol that makes previously invalid transactions valid, or vice-versa. Members of The DAO and Ethereum community hotly contested the situation. A blockchain is meant to be immutable – which means it shouldn’t be able to be altered, even in ugly situations like the DAO hack where money has been stolen.
One year later, the SEC ruled that The DAO had been offering unlawful securities contracts to its investors. They believed that had The DAO been subject to the same regulatory scrutiny as initial public offerings (IPOs), the DAO hack may never have happened. They had a point – for example, it’s known that the hack exploited a vulnerability that had been raised by the community just months before. Might the DAO founders have been more careful had they felt some kind of legal obligation?
An ongoing quest to clear the grey area
The DAO case certainly set a precedent for how ICOs and cryptocurrencies are viewed. In February 2018, SEC chairman Jay Clayton made a series of comments suggesting ICOs were almost definitely securities. “Every ICO I’ve seen is a security,” he said. Today, the SEC stipulates that “ICOs can be securities”.
As digital assets continue to be defined and refined, we’ll likely see more cases like The DAO. Cryptocurrencies currently suffer from a lack of legal certainty, and it’s evident in projects like Facebook’s Libra, where no one really knows what the nature and consequences are of the technology. The question is, do the legal definitions of the 20th century still apply to the technology of the 21st?