Every crypto project must reckon with the SEC’s Howey test

Almost five years ago, SEC official Bill Himan took the stage at a Yahoo Finance crypto summit in San Francisco and gave a prepared speech concluding that Ethereum (ETH) is not a security. A footnote on the SEC’s website clarified that the speech “expresses the views of the author and does not necessarily reflect those of the commission,” but it was still taken that way.

Hinman’s speech came just a week after then-SEC Chairman Jay Clayton said the SEC is not looking at Bitcoin or others cryptocurrencies as securities, as opposed to tokens, Clayton said, “where I give you my money and you go off and make a bet, and in return for giving you my money I say ‘you can get a return’ – that’s a security.”

But Gary Gensler, the current SEC chairman and a scourge of crypto builders, has made it clear that he does not share Hinman’s view. He sees “everything but Bitcoin” as a security. Last fall, just one day after Ethereum completed its merger to become a proof-of-stake network, Gensler said that the native tokens of networks that use stake also look like securities, since “the investment public expects profits based on the stake of others.”

And Gensler uses as his north star the same test that Hinman and Clayton used: a 77-year-old lawsuit involving a citrus grove in Florida.

The “Howey Test” has become a notorious bogeyman for everyone in crypto, and while the industry wants it to go away, it’s clear that it’s not going to happen anytime soon.

Hinman and Clayton are both long gone from the SEC and have moved on to advise crypto firms (naturally). But Howey remains, and Gensler has cited it to prove that all crypto falls under SEC jurisdiction – even though his counterpart at the CFTC said just last month that ETH is a commodity.

(Ironically, Hinman’s June 2018 speech was called “When Gary Met Howey,” but he referenced a 1985 case involving Gary Plastic Packaging that showed that a non-security can become a value depending on how it is marketed; Hinman could not knowing that in a few years another Gary would use Howey as a hammer against an entire trillion-dollar industry.)

The idea of ​​Howey is that an asset becomes an investment contract when it is marketed or sold with the expectation of profit thanks to the work of the seller or a third party. The citrus grove itself was not a security, but shares in the citrus grove were. Hinman argued that, setting aside the first Ethereum fundraising in 2014 that brought in $18 million, the network had since become sufficiently decentralized to preclude the current sale of ETH as a security offering. Gensler doesn’t seem to agree, but more importantly – and more damaging to most new crypto projects – is that all other token sales built on Ethereum look pretty clearly like securities under the Howey definition. Speculators buy them in the hope that the token will go up based on the perceived success of the project.

But wait! What if the token is genuinely used in the project’s ecosystem, and has real utility beyond price speculation? Doesn’t matter, as Hinman said in 2018 before Gensler appeared: “Simply labeling a digital asset a ‘utility token’ does not make the asset something that is not a security.” In other words: call your token whatever you want, the SEC still thinks it’s a security.

People in crypto like to say that the SEC has not provided “clear guidelines” for crypto projects, but the truth is that it has. Its guiding light is the Howey test – the industry just doesn’t like it. Gensler told Congress last week: No new rules are coming, because “the regulations actually already exist.”

Another issue people bring up with Howey is that it’s too old to be used fairly anymore, but even Coinbase Chief Legal Officer Paul Grewal, a former California magistrate, recently said on our gm podcast that the problem with Howey isn’t its age : “I love legal precedents, even if they are decades old. And in some cases, I love them even more if they are a hundred years old. So I have no problem with Howey or any other precedent simply because of its age.”

The real problem with Howey is how it is applied to brand new technology.

“When it comes to the operation of a blockchain-based technology that underpins most digital assets, I think there is often a confusion about the role of the promoter, a confusion about what drives the returns that can accrue to the holder of the tokens, and a confusion about fundamental how these assets work and what real benefit they bring to the networks,” said Grewal. “When it comes to networks that are based on a proof-of-stake consensus mechanism, there is a very important role that these tokens play, which is to make sure that the networks are secure, that the transactions that are confirmed on the network are correct.”

So, is it always fair to count a token’s gains solely to the efforts of the project behind it? What about when the token holders are real participants in the project’s success? That’s the difference many new projects hope excludes their token from the SEC’s clutches, but so far Gensler hasn’t indicated it makes any difference to him.

That approach certainly didn’t work for LBRY, which argued that the token “functioned as an important part of the LBRY blockchain” and still lost its case against the SEC, and lost badly — as University of Kentucky law professor Brian Frye told Decrypt“The district court turned almost entirely to the SEC. . . . He ruled for the SEC on literally everything, without reservation.”

Most people you ask think Gary Gensler wants a bigger job in government. But there’s no guarantee that Gensler’s successor as SEC chairman won’t also happily use Howey for crypto. (Remember: when Gensler first took the job, people in crypto were initially optimistic because he had taught a blockchain course at MIT; don’t assume the next chair will be friendlier.)

The entire crypto industry needs to count on Howey, instead of hoping it just goes away. Some projects do so by calling their coin a governance token, emphasizing participation; others, like Coinbase, are vowing to fight the SEC, which should be applauded by the industry; many others only offer their token outside the US.

For now, it is clear that the current regulatory environment in the US is pushing crypto projects overseas. What happens next with regulation will be the most important determinant of the future of Web3 innovation in America. For now, Howey is alive.