Many speculative investments are compared to tulip mania, the craze that supposedly crashed Dutch financial markets in the 1600s. But the current crypto asset boom has a different agricultural analogue: orange groves.
In the 1920s, Florida businessman and orange grower W.J. Howey came up with the idea to sell sections of his groves to tourists. Howey’s companies held thousands of acres, and sold dozens of small tracts to visitors who had little to do with the oranges at all. They hired the Howey companies to take care of the trees and sell the fruit in exchange for part of the profit. But then the Securities and Exchange Commission took notice. The agency argued that Howey wasn’t just selling orange groves and a taste of Florida life: he was selling securities.
In a landmark 1946 case, the Supreme Court agreed. When people buy something expecting to profit because of the work other people are doing to manage it or grow its value, they’re buying an investment contract, or a kind of security.
Since then, the so-called Howey Test has been applied to an odd mix of cases. In certain contexts, “earthworms, chinchillas, beavers, rabbits, cattle embryos, cosmetics, scotch whiskey, vacuum cleaners, fishing boats and cemetery lots” have all been considered securities under Howey, according to one legal treatise.
Top SEC officials have said many digital assets may fall into the same bucket. Under Howey, any “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others” may be a security, according to the agency.
A normal consumer good can be transformed into a security depending on how it’s sold and used. Howey’s investors weren’t simply buying agricultural land; they couldn’t wander into the groves and pick their own oranges. Investors had to hire someone to do that, and most hired a Howey company.
In the 1960s, salesmen from Weaver’s Beaver Association sold pairs of beaver to buyers who hoped they would breed and later be used for pelts. But the association didn’t expect anyone to raise the beaver themselves. As an official involved in the case later told a historian, “nobody could take care of beaver. You can’t put it in your bathtub.”
“The common theme throughout is that someone is buying something that they have no consumptive interest in,” said Lewis Cohen, a securities lawyer focusing on crypto matters.
Many crypto developers and investors had their first brush with Howey in 2017, when the SEC issued a report on The DAO, an organization whose tokens were deemed securities by the agency. The same year, “initial coin offerings” took off. In a typical ICO, digital tokens would be sold to pay for the creation of a trading venue or an opportunity to spend the coins that would presumably increase their value. Some issuers were sued by the SEC.
“The digital asset itself is simply code,” Bill Hinman, then-head of the SEC’s Division of Corporation Finance, said in a 2018 speech. “But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security.”
The SEC has published a “framework” that describes its approach to determining whether a token is a security. The agency even made a fake ICO website to educate normal investors. For finance professionals, it has also published guidance and sought comments on digital-asset questions of special relevance to broker-dealers and investment managers.
But the digital-asset industry is evolving quickly. Last year, the SEC warned investors about “initial exchange offerings,” or IEOs, which it said had similar risks to the ICOs of 2017 and 2018. Even NFTs—which are supposed to be unique and subjective in value—could be securities, depending on how they’re pitched and sold, attorneys said.
Some regulators, lawmakers, and crypto-industry fans say Howey doesn’t cut it anymore.
Hester Peirce, an SEC commissioner who speaks often about digital assets, has criticized some applications of the Howey test. She called for a distinction between tokens and the broader issuance scheme when it comes to applying the investment-contract label. She also proposed a “safe harbor” from enforcement for certain crypto projects that operate in a gray area.
Former Commodity Futures Trading Commission chairman Chris Giancarlo also recently called for the Howey test to be replaced. “The fact that we’re relying on a legal precedent from 1946 to determine the right course for regulating an entirely new financial architecture — disappointing is too light of a phrase, “Giancarlo said in a recent interview. “It’s almost ridiculous.”
Several bills have been proposed in Congress to change the government’s approach to digital assets. Along with the SEC, the CFTC, FinCEN and the Office of the Comptroller of the Currency, to name a few agencies, have all engaged on crypto issues.
One proposal, the Token Taxonomy Act, would exempt digital assets from the legal definition of securities. It was recently reintroduced after gaining little traction in past lawmaking sessions. Another, the Eliminate Barriers to Innovation Act of 2021, would require the SEC and CFTC create a joint working group to consider new approaches to digital asset regulation.
But until the law changes, the Howey test remains a ready reference for lawyers who deal with the crypto side of fintech.
“The law is actually working pretty well,” said Richard Levin, who leads the fintech group at the law firm Nelson Mullins. But he also compared it to an NFL referee trying to call a football game using a rulebook from the 1930s. The test “appears extremely antiquated,” he said.