SEC Scrutiny of Cryptocurrencies and Classification as Securities

The best way to navigate a new cryptocurrency ICO is to see whether or not it passes the Howey Test as stipulated by the Supreme Court in Securities and Exchange Commission v. W. J. Howey Co. 328 U.S. 293 (1946). A transaction will be considered an investment contract (and therefore subject to securities registration requirements) if it is (1) an investment of money in (2) a common enterprise with (3) an expectation of profits from the investment (4) due to the efforts of a promoter or a third party. Three relevant quotes from SEC v. Howey:

For purposes of the Securities Act, an investment contract (undefined by the Act) 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…

This definition was uniformly applied by state courts to a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one other than themselves.

The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.

            If a cryptocurrency is indeed classified as a security according to the Howey Test, then it can expect to garner attention from the SEC and it will be required to register as a security with the SEC in accordance with the Securities Act of 1933 and the Securities Exchange Act of 1934.

            A press release from the SEC sheds some additional light on the issue. In the press release dated July 25, 2017, the SEC “found that tokens offered and sold by a ‘virtual’ organization known as ‘The DAO’ were securities and therefore subject to the federal securities laws”. This ruling shows that cryptocurrencies are not immune to investigation and review by the SEC. Furthermore, the SEC stated that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology”.

            The SEC Report of Investigation provides an in-depth analysis of why DAO Tokens are securities. The Report states that under “Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, a security includes ‘an investment contract’”. The analysis used by the SEC is similar to the one used in the Howey Test in that the SEC defines an investment contract as “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”. In the case of The DAO, an important caveat is that in “determining whether an investment contract exists, the investment of ‘money’ need not take the form of cash”. ETH was exchanged for DAO Tokens and “[s]uch investment is the type of contribution of value that can create an investment contract under Howey”. Secondly, it was determined that purchasers of DAO Tokens “were investing in a common enterprise and reasonably expected to earn profits through that enterprise”. The SEC stated that profits include “dividends, other periodic payments, or the increased value of the investment”. Lastly, the investor’s profits “were to be derived from the managerial efforts of others”. The SEC noted that the limited voting rights of DAO Token holders spoke to how DAO Token holders lacked “significant managerial efforts or control over the enterprise”. This analysis can be applied to any new token or coin and yields similar results. Regardless of whether cash or cryptocurrencies are exchanged for a new token or coin, it will be an investment of money according to the SEC. Additionally, the term “profits” is broadly interpreted and can simply mean an increase in value of the investment. If a new token or coin is indeed a security according to the Howey Test, then the safest course of action is to register it as a security with the SEC.

The SEC press release can be viewed in full here.

The SEC Report of Investigation on “The DAO” can be viewed here.