New interpretation of the US Howey test is gaining ground

The crypto community celebrated a victory in court on January 30 when the United States Securities and Exchange Commission (SEC) admitted at the hearing in the LBRY case that secondary sales of the LBC coin were not securities sales. John Deaton, who represents Ripple in court in the SEC’s case against it, was so excited that he made a video for his Twitter-hosted CryptoLawTV channel that night.

Deaton, a friend of the court, or amicus curiae, in the case, recounted a conversation he had with the judge that day. “Look, let’s not pretend. Secondary market sales are a problem,” so “I brought up to him that Lewis Cohen article,” Deaton recalled.

Deaton referenced the paper “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities” by Lewis Cohen, Gregory Strong, Freeman Lewin and Sarah Chen of the DLx Law Firm, which Cohen co-founded. Deaton had praised the paper before, in November 2022, when it was filed in the Ripple case, in which Cohen is also an amicus curiae.

There is a growing buzz around the paper. It appeared on the Social Science Research Network preprint repository on December 13. When Cointelegraph spoke to Cohen in mid-January, he said the paper was the most downloaded in the site’s securities law category, with 353 downloads after about a month. This number more than doubled in the following two weeks. The paper has also received attention in mainstream and legal media and crypto-related podcasts. The unusual title is a nod to James Joyce’s Ulysses.

The Cohen paper takes a close look at one of the timeless adages of crypto-securities law: Securities are not oranges. This refers to the Howey test, established by the US Supreme Court in 1946 to identify a security. The paper takes an exhaustive examination of the Howey test and proposes an alternative to how the test is used today.

When Howey met Cohen

Not everyone likes applying the Howey test to cryptoassets, often arguing that the test works better for prosecuting fraud than as a registration aid. Cohen himself agreed with this position in a podcast on February 3. Nevertheless, the paper’s authors do not challenge the application of the Howey test – which arose from a case about orange groves – to cryptoassets.

A short summary cannot come close to capturing the breadth of the thesis’ analyses. The authors discuss SEC policy and cases involving crypto, relevant precedents, the Securities and Exchange Acts, and blockchain technology in just over 100 pages, plus appendices. They reviewed 266 federal appellate and Supreme Court decisions — every relevant case they could find — to reach their conclusions. They invite the public to add other relevant cases to their list on the LexHub GitHub.

The Howey test consists of four items often referred to as outliers. Under the test, a transaction is a security if it is (1) an investment of money, (2) in a joint enterprise, (3) with the expectation of profit, or (4) being derived from the efforts of others. All four test conditions must be met, and the test can only be used afterwards.

Cohen and co-authors argue, in extremely basic outline, that “fungible cryptoassets” do not meet the definition of a security, with the rare exception of those that are securities by design. This is the insight captured in the proverb about oranges.

The paper’s authors continue that an offering of cryptoassets on the primary market could be a security under Howey. However, they note, “To date, Telegram, Kik and LBRY are the only thoroughly briefed and settled cases related to crypto fundraising sales.”

They referenced the SEC lawsuit against messaging service Telegram, claiming its $1.7 billion initial coin offering was an unregistered securities offering, which was settled in favor of the SEC in 2020. The SEC case against Kik Interactive also involved token sales and was ruled in favor by the SEC in 2020. The SEC also won its unregistered securities sales case against LBRY in 2022.

Related: The aftermath of LBRY: Consequences of crypto’s ongoing regulatory process

The newspaper’s biggest innovation is the view on transactions with crypto assets on secondary markets. The authors argue that the Howey test should be re-applied for the sale of crypto-assets on secondary markets, such as Coinbase or Uniswap. The authors write:

“Securities regulators in the United States have attempted to address the many issues raised by the emergence of cryptoassets […] generally through an application of the Howey test to transactions in these assets. On the other hand, […] regulators have gone beyond current case law to suggest that most tradable cryptoassets are themselves “securities,” a position that would give them jurisdiction over almost all activity that takes place with those assets.”

The authors argue that, for the most part, cryptoassets will not meet the Howey definition in the secondary market. The mere ownership of an asset does not create a “legal relationship between the token owner and the entity that implemented the smart contract that created the token or that raised money from other parties through the sale of tokens.” Thus, secondary transactions do not satisfy the second Howey prong, which requires a third party.

The authors conclude, based on their extensive examination of Howey-related decisions:

“There is no applicable basis in the law relating to ‘investment contracts’ to classify most fungible cryptoassets as ‘securities’ when transferred in secondary transactions because an investment contract transaction is usually not present.”

What it all means

The effect of the paper’s argument is to separate the issuance of a token from a transaction with it on the secondary market. The paper says the creation of a token may be a securities transaction, but subsequent trades will not necessarily be securities trades.

Sean Coughlin, a principal at law firm Bressler, Amery & Ross, told Cointelegraph: “I think he is [Cohen’s] takes ownership of the fact that the issues [of tokens] is going to be regulated and he is trying to suggest a way to get it [a token] trade in an unregulated manner.”

Coughlin’s colleague, Christopher Vaughn, had reservations that the paper was “disingenuous” in places.

He said: “It ignores the realities anyone who has ever traded crypto knows, which is that these liquidity pools and these decentralized exchange transactions don’t happen unless the issuer of the token facilitates them.”

Nonetheless, Vaugh praised the paper, saying, “I would love for this to be the be-all and end-all of crypto.”

John Montague, an attorney at Digital Asset-focused Montague Law, told Cointelegraph that custody issues could complicate Cohen’s argument, particularly how self-custody of crypto assets affects Howey’s investment edge.

Montague recognized the high quality of the paper’s scholarship, calling it:

“The most monumental thought in the industry with respect to securities law perhaps ever, […] definitely since Hester Peirce’s safe harbor proposal.”

In his final version of the proposal, SEC Commissioner Peirce proposed that network developers be granted a three-year exemption from federal securities law registration provisions to “facilitate participation in and development of a functional or decentralized network.”

Recent: Crypto and Psychedelics: Regulatory Clarification Can Help Industries Grow

“One thing I like about the crypto world is that it’s adversarial,” Cohen told Cointelegraph. He said he hoped to “raise the level of discussion” with the paper. It did not find much opposition in public responses. However, there have been expressions of cynicism.

“You are a novelist. You found in crypto a character that is best explained by the law,” a network developer commented on Twitter.

“Smart legal opinions rarely move the needle on SEC rulings or enforcement cases,” said one LinkedIn CFO.