Last Tuesday night, the Securities and Exchange Commission (SEC) ended months of speculation, breaking its silence on blockchain tokens and issuing a landmark report that said a blockchain-based project called The DAO had issued securities under U.S. law.
The report, however, is important beyond its applicability to The DAO: It helps describe how the existing legal and regulatory framework for securities laws apply to crypto tokens more broadly. And, more specifically, it shows how a crucial concept – called the Howey Test – applies to the DAO and other tokens.
For those who aren’t familiar, the Howey Test dates back to a 1946 Supreme Court ruling that established the basis for determining whether or not anything sold in the US, or to US investors, is a security.
The Howey Test is useful because it helps crystalize some of the most important aspects of federal securities laws into a relatively simple formula.
At a prominent meetup last Wednesday night, the story of the Howey Test was broken down into a very straightforward narrative by Cooley LLP partner and fintech practice lead Marco Santori. The text below, paraphrased from Santori, comes from the Cooley event.
Called “The Dean of Digital Currency Lawyers” by American Banker, Santori is considered by many in the space to be one of the leading lights on cryptocurrency legal theory. During his talk at the Cooley-hosted event, he demonstrated why.
Most descriptions of the Howey Test read like legal filings; Santori’s description, on the other hand, sounds like a parable:
A long time ago, someone named Howey owned an orange grove.
Howey said: “I’ve got this orange grove and I’ve got no way to make money out of it – because I need money to make money.”
Tell you what. I’m going to sell you this orange grove and, in exchange, you get whatever profits are made from that little plot.
I’ll work the land. I’m going to pick the oranges. I’m going to squeeze the juice. You just pay me the money.
The plaintiffs said: “That’s a security.”
The SEC said: “That’s a security.”
Howey said: ‘No, no. That’s just selling plots of oranges.”
Ultimately, the Supreme Court said: “That’s a security” – because it passed this test: There was an investment of money. And a common enterprise. With the expectation of profit, primarily from the efforts of others.
‘Solid’ regulation
At this point, you may be tempted to ask some questions.
Isn’t the Howey Test over 70 years old? Yes, it is. And the underlying legal framework that Howey serves as a test for – principally The Securities Act of 1933 and The Securities Exchange Act of 1934 – are even older.
But, this composite regulatory regime has remained remarkably effective and relevant for three-quarters of a century, and it continues to be, as Santori said during the panel discussion, “a testament to solid, principles-based regulation.”
While initial coin offerings, or ICOs, may be a very recent innovation — enabled by the whole complex stack of software technology — the SEC with its new report has reaffirmed that there is nothing new under the sun.
Applying the lessons learned from the SEC’s report on The DAO, we can go one step further to tell a new type of tale.
Here’s how we might adapt this ultra-modern scenario to the decades-old tale:
Not so long ago, a group of developers started a DAO.
The DAO developers said: “There are all these decentralized projects and there’s no way for them to get funding – because they need money to make money.”
Tell you what. We’re going to write code and sell a token and, in exchange, people who buy the token will get whatever profits are made from those projects.
We’ll work the code. They’ll pick the projects. The projects will flourish and everyone will profit.
The SEC said: “That’s a security.”
The DAO developers said: “No, no. That’s just selling tokens.”
Ultimately, the SEC said: “That’s a security” – because of the application of the Howey Test: There was an investment of money. And a common enterprise. With the expectation of profit, primarily from the efforts of others.
Complex concepts
Let’s call it the ‘DAO Test’, perhaps. Tongue-in-cheek statements aside, it’s important for investors to possess a high-level understanding of the legal concepts involved in token investing.
It’s also critical not to lose sight of the dangers and pitfalls of interpreting the complexities of the law too casually.
Or, as Santori framed the issue with specific reference to the SEC report:
“A lot of token sales pass this test. A lot of them don’t. And that’s important to realize. Folks who look at this thing and say. ‘Oh. It looks like a security. It smells like a security. It must be a security … Walk away from them. That’s arm-chairing lawyering at its worst. Some of these things are securities – some of these things are not.”
Oranges image via Shutterstock
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