ETH Slips Out Of SEC Net, For Now

SEC Chairman Jay Clayton clarifies his view on the Howey Test. Decentralization is a key factor.

  • SEC Chairman Jay Clayton has personally weighed in on the debate over when a digital currency is classified as a security. This is significant for the adoption of cryptocurrency because if/when the security designation is applied to a particular digital asset or an initial coin offering (ICO), the SEC’s registration and disclosure requirements kick in, and the SEC’s Enforcement Division will come down hard on violations.

    Clayton sent a letter outlining his views to US Congressman Ted Budd (R-NC) after Budd, along with the nonprofit advocacy group Coin Center, requested clarification.

    The big news is that Chairman Clayton underscored the validity of the Howey Test and the way in which it can serve as the definitive field trial. As reported by ETHNews last summer, the SEC’s William Hinman, director of the Division of Corporate Finance, pointed to the Howey Test, first developed in 1946, to determine if a project falls under the guidelines of an “investment contract, which is a particular type of security that includes some token offerings.”

    Clayton said he is on board with Howey, which does provide useful guardrails:

    “I agree with certain statements concerning digital tokens in Director Hinman’s June 2018 speech. I agree that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument. A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition.”

    So, it depends on who, when, and how, with decentralization a key factor.

    The SEC applies tests developed through case law, including Howey. Clayton said in his letter:

    “As those cases explain, the ‘touchstone’ of an investment contract ‘is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’ The determination of whether a digital asset is an ‘investment contract’ depends on the application of Howey and its progeny to the particular facts and circumstances of the digital asset transaction.”

    Clayton gave an example: When investors (who have pooled assets to contribute to funding a project) no longer expect a developer (or group of developers) to carry out managerial or entrepreneurial efforts, their investment may no longer be considered a security.

    Think of it this way: If you fund the production of a Broadway show and expect to receive a handful of prime-seat tickets as part of the deal, you are an investor because you expect to profit from your investment if the show is a big hit. The prime seats are just the cherry on top. But if you sell the tickets, those are not securities transactions.

    In a speech earlier this year, crypto-friendly SEC Commissioner Hester Pierce addressed the issue and referred attendees to a report published by Coin Center, which describes its own report as follows:

    “This report, originally published in 2016 and updated in 2018, presents a framework for securities regulation of cryptocurrencies – e.g. Bitcoin and derivative projects or ‘alt-coins.’ The framework is based on the Howey test for an investment contract as well as the underlying policy goals of securities regulation. We find that several key variables within the software of a cryptocurrency and the community that runs and maintains that software are indicative of investor or user risk.”

    Coin Center stated that larger, more decentralized cryptocurrencies (e.g., bitcoin), pegged cryptocurrencies (e.g., stablecoins), as well as distributed computing platforms (e.g. Ethereum) do not easily fit the definition of a security and also do not present the sort of consumer risk best addressed through securities regulation. Coin Center added, “We do find, however, that some smaller, questionably marketed or designed cryptocurrencies may indeed fit that definition.”

    Note that in his letter to Budd, SEC Chairman Clayton made no direct reference to Ethereum. Still, some in the crypto press have jumped on the Budd letter to imply that Ethereum is forever out of the SEC’s registration reach. More will no doubt be reported on this topic in coming months.

    Meanwhile, it’s best to remember that the SEC is not out to get crypto. It is just doing its job: Protect the markets and individual investors. The spirit with which it carries out this mission is deeply rooted in the legacy of the Great Depression of the 1930s, which tore the country apart. Crooks, scoundrels, and grifters had gone to town, and the result was a travesty that took a world war to change.

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