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 ruled a blockchain-based project called The DAO had illegally issued securities under U.S. law.
However, the report is important beyond its applicability to The DAO: it helps to describe how existing the legal and regulatory framework for securities laws applies to crypto tokens more broadly. And, more specifically, it shows how a crucial concept – called the Howey Test – applies.
For those unfamiliar, 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.
While entrepreneurs have doubtless been told to keep the law in mind, the best thing about the Howey Test is how easily it conveys what was otherwise a complex ruling from the federal agency.
And at a prominent meetup last Wednesday night, one of the clearest and simplest stories was made all the clearer by Cooley LLP partner and fintech practice lead Marco Santori.
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, and in his talk at the Cooley-hosted event he showed why.
The text below, paraphrased from Santori, comes from a Cooley discussion in which Santori featured.
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.
Here, you may be tempted to ask questions.
After all, isn’t the Howey Test over 70 years old? Yes, that’s true. The underlying legal frameworks 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 ruling 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.
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 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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