The Fate of Crypto Rises and Falls on One Legal Question

The entire crypto space hangs in the balance of one decisive legal issue. The answer could mean the difference between widespread adoption and crippling regulation.

The world of cryptocurrency has been on edge as the SEC’s lawsuit against Ripple Labs, Inc. continues to play out. At the heart of the matter is a crucial legal question that has implications not just for Ripple, but for the entire crypto space: whether XRP, the digital asset sold by Ripple to facilitate cross-border payments, should be considered a security under the Howey Test. A ruling in favor of the SEC could have far-reaching adverse consequences for the crypto industry, while a ruling in favor of Ripple could provide much-needed clarity and legitimacy to the space. The fate of crypto, it seems, rises and falls on this one legal question, and the outcome of this case is eagerly anticipated by investors, regulators, and enthusiasts alike.

In 2017, a US-based company called Munchee launched an initial coin offering (ICO) to fund its new restaurant review app. The company raised $15 million in just two weeks, but the SEC stepped in and shut down the ICO, stating that Munchee’s tokens were unregistered securities. This case set a precedent for the crypto industry, and the question of whether a cryptocurrency is a security has been at the forefront of legal discussions ever since.

A security is a financial instrument that represents ownership in a company or entity, or represents a debt owed by the entity. In simpler terms, it’s like a piece of paper that you own that represents a certain amount of value and that gives you passive income. This can include stocks, bonds, or other types of investments.

If a cryptocurrency is deemed to be a security, it is subject to a range of regulations under securities law. This can include registering with the SEC, providing financial disclosures to investors, and complying with trading restrictions. While this may sound like a burden, being classified as a security can offer some benefits, such as increased investor protections and more legitimacy in the eyes of the public.

The most widely used test for determining whether a financial instrument is a security is the “Howey Test”. This test comes from a 1946 Supreme Court case involving a company that sold fractional interests over an orange grove to investors. The Howey Test asks whether a transaction involves an investment of money in a common enterprise with an expectation of profits derived solely from the efforts of others. If the answer to this question is yes, then the transaction is likely a security.

It may seem strange that an orange grove could be in the same category as stocks and bonds, but the concept of securities is intentionally broad. In fact, any contractual arrangement that meets the Howey Test can be considered a security. This broad definition has allowed the SEC to regulate a wide range of investment products, including many types of cryptocurrencies.

Since the landmark Supreme Court case of SEC vs Howey, there have been numerous surprising cases where unconventional contractual arrangements have been deemed to be investment contracts and classified as securities by the SEC. Here are some examples:

• Timeshares

• Racehorse partnerships

• Whiskey casks

• Life settlements

• Virtual real estate

• Art investment funds

• Carbon credits

• Parking lot investments

• Gold mining ventures

Many token projects choose not to register their tokens as securities because it can be a lengthy and expensive process. In addition, registering as a security can subject the project to more scrutiny and restrictions than they may want. Instead, some projects may choose to structure their tokens in a way that avoids being classified as a security, such as by emphasizing their utility rather than their investment potential.

For example, MakerDAO is a decentralized lending platform that allows users to borrow cryptocurrency using other cryptocurrency as collateral. Rather than selling tokens that represent ownership in the platform, MakerDAO has created a stablecoin (DAI) that is pegged to the US dollar. By emphasizing the stablecoin’s utility as a means of payment rather than its investment potential, MakerDAO expected to avoid the DAI from being classified as a security (whether the SEC agreed with MakerDAO is a different matter).

Consider also Telegram, a messaging app that attempted to launch its own cryptocurrency, called “Grams”, through an ICO in 2018. The SEC filed a lawsuit against Telegram, alleging that the sale of Grams was an unregistered securities offering. In March 2020, a federal judge ruled in favor of the SEC, stating that Grams were indeed securities and could not be sold in the US.

Below is a sampling of token projects that were either held to be securities or are currently at risk of being characterized as securities:

• EOS: a cryptocurrency designed to support decentralized applications (dApps)

• Filecoin: a decentralized storage network that allows users to buy and sell unused storage space

• The DAO governance token: a token issued by a decentralized autonomous organization designed to function as a venture capital fund for cryptocurrency projects

• Augur (REP): a decentralized prediction market platform

• Blockstack (STX): a decentralized computing platform that allows users to create and run dApps

• Tether (USDT): a stablecoin that is pegged to the US dollar

• Polymath (POLY): a platform for creating and managing security tokens

• Kik (Kin): a cryptocurrency that is designed to be used within the Kik messaging app

Being labeled an unregistered security in the crypto industry can lead to disgorgement of profits, damages, and fines, as well as damage to a company’s reputation and credibility.

While the Howey Test has been the standard for determining whether an investment is a security for decades, it has certain flaws. One of the biggest criticisms of the test is that it is somewhat vague and open to interpretation. This can lead to uncertainty and confusion for companies that are trying to determine whether their tokens qualify as securities. Additionally, the test can be overreaching in some cases, capturing commercial arrangements that may not necessarily be securities under a more nuanced analysis. As the crypto industry continues to evolve, there may be a need for a more specific and tailored test to determine whether a particular investment is a security.

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