32 - The Howey test
Earlier this month, the Securities and Exchange Commission (SEC) made headlines by charging Kim Kardashian with the unlawful promotion of a crypto security. The move constituted a continuation of a year of regulatory crackdowns. The agency first made headlines in July when it filed an insider trading case against a former Coinbase employee and two related parties. The case alleges that the defendants had insider knowledge of the assets that were going to be listed on Coinbase; and using that knowledge, they pocketed over $1 million in ill-gotten profits. The Coinbase charges were the first time the SEC filed an insider trading case against someone involved in digital asset markets.
The SEC isn't the only federal body beginning to look more closely at regulating the digital asset space. The US Attorney for the Southern District of New York (SDNY) also made headlines in June for filing insider trading charges against Nathaniel Chastain, the former head of product at Open Sea, the NFT marketplace juggernaut. In the Chastain matter, the government alleges that the defendant profited by buying NFTs prior to their being listed on Open Sea’s main homepage. All three cases bring into focus two important questions: 1) what type of financial instrument is a digital asset: and 2) who should regulate them?
The players
In the United States, there are several financial industry regulators all of which want oversight of the nascent digital asset industry. Some, such as the Office of the Comptroller of the Currency (OCC), believe they have regulatory rights within a specific area of the industry. Others, like the Department of Justice (DOJ), see their role as enforcing federal law in whatever form that takes. Then there are those such as the SEC and Commodities and Futures Trading Commission (CFTC), that see themselves as having direct and total authority over the industry. Understanding each of their perspectives requires us to first understand why these agencies were created in the first place.
The OCC is a bureau within the Department of Treasury responsible for federal banking regulation. It has attempted to find a seat at the table by focusing on the regulation of stablecoins. Brian Brooks, who led the OCC as the comptroller of the currency under President Trump, issued four interpretive letters prior to leaving office. These letters essentially gave banks the green light to become more involved in stablecoin activity such as holding the funds that back fiat collateralized coins. Your author happens to be cited on page six of the Letter 1174. Michael Hsu, the current comptroller, has not gone so far as to resend the letters, nor has he expressed support for them either.
Although the OCC and Treasury Department would like to control some corner of the digital asset industry, the true oversight battle is being waged between SEC and CFTC, two independent federal agencies. The SEC is responsible for “protecting investors, maintaining a fair and orderly functioning securities market, and facilitating capital formation.” The CFTC, on the other hand, has a mandate to “promote the integrity, resilience, and vibrancy of the U.S. derivatives markets.” These agencies have similar responsibilities; but the line defining where one agency's influence begins and the other ends can be drawn using a simple question: Is the financial instrument being regulated a “security”? If the instrument is a security, then it falls under the SEC’s responsibility to regulate; and if it is not, then the CFTC most likely has oversight duties.
Howey and his oranges
Since the early days of crypto, entrepreneurs and investors alike have been concerned about the intervention of the SEC in the industry. Specifically, they have been worried that the notoriously harsh SEC will crack down on digital assets by classifying them as securities. The SEC has historically employed a test known as the “Howey test” to determine if a financial instrument should be categorized as an “investment contract.” The Howey test was created and gets its name from a 1940’s Supreme Court case that the SEC brought against a Florida citrus farmer named W.J. Howey.
In 1946, Howey was charged with securities fraud from his sale of orange groves. Howey’s defense team argued that the citrus grove sales constituted a sale of property and thus were not ”securities”. The SEC argued that the details underlying the transactions made those sales an offering of securities. Eventually, The Supreme court sided with the SEC because Howey marketed the orange groves as an investment opportunity from which the purchaser could profit greatly not as the purchase of land.
Buyers, most of whom were out of state financiers and not farms, could buy the grove and lease them back to Howey, who would then farm the land for a fee. At the end of each harvest, Howey would send the buyer any income the land generated above that fee. Howey’s orange groves were not what his customers wanted, but rather the cash flow those groves generated. A combination of how the investment was being marketed, the reason most buyers were investing, and the identify of the investors all mattered in the eventual decision.
Interestingly, the Securities Act of 1933 never defined the characteristics of an investment contract. Instead the definition was penned by Supreme Court Justice Frank Murphy in writing for the Howey majority. In the decision, Justice Murphy defined four characteristics necessary to establish that a financial instrument was in fact an investment contract subject to SEC regulation. Those characteristics or prongs are:
An investment of value by the purchaser
In a common enterprise
With the expectation of profit
From the effort of others
Since that decision, the SEC has cited the Howey test in many cases and opinions in determining if a financial instrument is in fact a security.
Regulation by enforcement
What makes the actions of the SEC in recent months so interesting is that they are attempting to establish many digital assets as securities without having to directly say why some digital assets are not. For example, take the case against the former Coinbase employee. In its official statement, the SEC alleges that the defendants “.... purchased at least 25 crypto assets, at least nine of which were securities….” Diving a little deeper into the actual complaint, we can see that the nine digital assets identified as securities are AMP, RLY, DDX, XYO, RGT, LCX, POWR, DFX and KROM. The complaint outlines, in detail, how each of these assets meet all four prongs of the Howey test.
In particular, the SEC’s discussion of AMP is illustrative of its approach (beginning on pg. 23 of the complaint):
An investment of capital
Between February 2018 and April 2019, Flexa sold 12 billion Flexacoins [eventually becoming AMP] in private sales to groups of accredited investors, token funds, and other strategic partners, with over $14 million raised in April 2019 alone.
10% to a Network Development Fund; 20% to token sales; 20% to a Founding Team and Employee Pool; 25% to a Merchant Development Fund; and 25% to Developer Grants. The Flexa network launched in May 2019.
In a common enterprise
Amp investors also share a common interest with Flexa’s management team. Flexa explained in an April 2019 Medium post that 20% of the total percentage of Flexacoin was reserved for the Founding Team and Employee Pool to “incentiviz[e] current and future Flexa team members. All supply from this allocation will be distributed on a four-year vesting schedule.
With the expectation of profit
In the Amp white paper, Flexa explained that Amp “serves as a medium for accruing value” and “continuously appreciates in value as a direct result of its utility” within the Flexa network.
Flexa’s August 2019 description of Flexacoin, Amp’s predecessor, also reinforced the potential rewards for investors: “Stakers don’t collateralize Flexa payments purely out of the goodness of their hearts. Rather, as an incentive for deploying Flexacoin as collateral – and to compensate for the risk they incur when collateralizing unproven apps on the network – stakers earn the network reward generated after every successful payment confirmation.
By the efforts of others
The May 2019 Flexacoin white paper devoted an entire section to “Our team,” making clear that the co-founders and a small number of employees were responsible for Flexa’s administrative, marketing, and technical development. Further, as noted above, Flexa’s founders and management team held 20 billion of the total 100 billion Flexacoin (and therefore hold the same number of Amp tokens) to “incentiviz[e] current and future Flexa team members.”
The issue here is that the SEC is making these claims indirectly and not against the projects themselves. If the defendants are found liable for insider trading, then there is an implicit finding that the defendants were trading securities. It allows the SEC to have on record the federal court’s finding that these nine assets constitute securities without having to explain why the other sixteen other assets are not. The SEC’s lack of clarity around how they came to define one token as a security and the other not has frustrated the industry for years. The current dichotomy only works to perpetuate that problem.
The facts outlined above not only angered the digital asset space as a whole but also angered Coinbase, the supposed victim in the case. In a blog post, Coinbase condemns the actions of the SEC in asserting that the assets being traded on Coinbase were not in fact securities. Coinbase explained that they have an extensive listing policy specifically designed to prevent assets that fail the Howey test from being listed. With a favorable ruling in this matter, SEC will have the ammunition it wants to go after these projects for being unregulated securities and Coinbase for being an unregistered broker dealer.
Takeaways
Most people in the industry would agree that the defendants in the Coinbase case are in the wrong. Front running the market using insider information is at the very least scummy. It also does nothing to endear our young industry to regulators. Unfortunately, the SEC decided to take the opportunity to go one step too far by attempting to “regulate by enforcement” rather than through public discourse or any formal regulatory process. Hopefully as the SEC oversteps its bounds, the industry can rally together to fight back against such egregious overreach.