There has been much speculation regarding the regulation and future of digital assets, such as bitcoin, the blockchain, and other cryptocurrencies and crypto-commodities. The emergence of these digital assets has exposed not only the need for more advanced asset classes, but also the deficiencies in current regulations when applied to these new assets.
The Securities and Exchange Commission (SEC), responsible for enforcing federal securities laws, is one of the agencies that could regulate digital assets. As the name suggests, the SEC regulates “securities,” which is defined by the Securities Act of 1933 and includes over thirty specified financial assets. Of the financial assets included in the definition of securities, “investment contract” is the financial asset most often used to classify a digital asset as a security and be placed under the authority of the SEC.
Understanding digital assets as investment contract securities is not as simple as it may seem. The 1946 Supreme Court decision in SEC v. W.J. Howey Co. established the seminal definition of the term “investment contract.” The court held an investment contract is 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.” Since its ruling, many courts have referred to this determination as the Howey test. Composed of four prongs, the Howey test requires a determination of (i) whether there exists an investment of money, (ii) whether there exists a common enterprise, (iii) whether there exists an expectation of profits, and (iv) whether the expectation of profits is solely from the profits of others. If all four-prongs are satisfied, the arrangement passes the Howey tests and constitutes a security. However, should one of the prongs fail, then there is no security. To better understand the application of the Howey test, each prong should be further explored.
Investment of Money
To own digital assets, purchasers typically render a government currency or another digital asset, such as bitcoin or Ethereum, in the transaction. Though the Howey test clearly identifies “money” in its analysis, later court cases have expanded the scope of this prong. Transactions that include bitcoin or even an investment of labor, as decided in SEC v. Shavers and SEC v. Glenn W. Turner Enters., respectively, will satisfy as “money.” When making their determination, courts look to the economic realities of the arrangement, and not make their rulings on the mere labels applied to the elements of any particular transaction.
A common enterprise refers to the collection of individuals organized to engage in a specific endeavor or task, generally. However, courts are split in determining what organizational structures constitute a common enterprise. The majority of courts apply the horizontal commonality test. Under this test, a collection of individuals will be recognized as a common enterprise when the individuals pool their assets together and share in the profits and risks of the enterprise collectively. (see Revak v. SEC Realty Corp.). Alternatively, a minority of courts will apply what is known as the vertical commonality test. Further, the vertical commonality test splits into two additional categories, narrow vertical commonality variation and broad vertical commonality variation. Under the narrow vertical commonality variation, a common enterprise is created when the profits of the investors are connected with the actual profits generated by the security’s promoter or issuer. (see Revak). In contrast, under the broad vertical commonality variation, a common enterprise is created when the profits of the investors are bound to the promoter or issuer’s mere efforts. (see SEC v. Koscot Interplanetary, Inc.).
Expectation of Profits
Generally, an expectation of profits is understood as an expected appreciation in capital that resulted from the development from the initial investment or expected appreciation in earnings that resulted from the use of investor funds. (see United Hous. Found. v. Forman). Furthermore, there is no expectation of profits when a purchaser’s primary motivation is to consume or use the item purchased.
The breadth of the expectation of profits prong is better understood through the case United Housing Foundation v. Forman. In this case, a purchaser bought shares in cooperative housing, which she later expected to sell for more than the purchase price. Here, though the profit motive is present, its influence on the purchase was not substantial. The court reasoned, the purchaser would not have purchased the shares at all if she expected to lose money or to merely break even upon resale. The Forman court helps establish the expectation of profits test by requiring the purchaser’s expectation of profit to predominate the expectation of consuming or using the item purchased.
From the Efforts of Others
The final prong of the Howey test considers the source of the expectation of profits, when the purchaser’s expectation of profit predominates all other consumption or use motivations. This prong explores the question “whether the efforts made by those other than the investor are undeniable significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” (see SEC v. Glenn W. Turner Enters.). Under this prong, a purchaser’s control and influence of the investment is evaluated to determine the degree in which the purchaser relies on the efforts of others.
As digital assets become a more common investment, regulatory agencies such as the SEC, will become more interested and involved in the market. The SEC is burdened with the responsibility of protecting investors without stunting economic opportunity and prosperity. Finding a balance between these objectives is fundamental to the success and livelihood of digital assets and the future of investing.
The information contained in this post is for general information and educational purposes only. The application and impact of laws can vary widely based on the specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions or inaccuracies in information contained in this publication. Accordingly, the information on this post is provided with the understanding that the author and publishers are not herein engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional.