Analysis: Is Ether a security? Will it pass the Howey Test?
Ether might pass the Howey Test, but that doesn’t automatically qualify it as a security in this case.
Ether is going in front of the Securities and Exchange Commission (SEC) on Monday for its judgement day. The commission will decide whether it qualifies as a security. If so, it might be subject to a strict range of controls, such as being barred from trading on most US-based cryptocurrency exchanges, and its “perpetrators” hit with hefty fines or even jail time, depending on how many “investors” were “misled.”
The usual procedure for determining whether something qualifies as a security is to apply the “Howey Test.” If the SEC chooses to push ahead on declaring Ether a security, the argument might hinge on the application of the test.
The Howey Test
The Howey Test emerged from a 1946 court case, where a landowner named Howey sold off parts of his orange groves. The buyers were then encouraged to lease these parcels of land back to Howey, in contracts which granted Howey full access to the land and all its produce and profits.
Howey was then taken to task for selling investment products without a license. The sticking point was that the law Howey was being charged under, the Securities Act of 1933, didn’t tightly define investment products. So in passing judgment, one of the justices had to first argue what exactly constituted a security under US law. The definition he used came to be called the Howey Test. It was first used to define parcels of an orange grove, and now, over 70 years later, it’s being used to define decentralized network tokens.
The Howey Test identifies four characteristics that constitute a security:
- It is offered in exchange for money
- There is an expectation of profits
- The investment is in a common enterprise
- The profits are dependent on the efforts of a promoter or third party
Howey was found guilty, in case you were wondering.
Does Ether pass the Howey Test?
Ether, as initially sold during the ICO, could almost certainly qualify as a security. And being unlicensed and unregistered, the letter is the law clearly suggests that Ethereum’s initial coin offering was an illegal security offering.
- It was offered in exchange for money. Ethereum tokens were initially sold for bitcoin. It’s not money per se, but subsequent cases have laid a precedent for investments of assets other than money qualifying for the Howey test. Ether clearly meets this condition.
- There was an expectation of profits. This could be argued by digging up old buyers’ discussions about the likely future price of Ether. Clearly many people were expecting profits from Ether, and clearly they were right.
- It was a common enterprise. This is a less well-defined area, but in federal courts, it’s typically considered a “horizontal” investment when a bunch of investors pool their funds in a scheme. This is what happened with Ethereum.
- The profits are dependent on the efforts of a promoter or third party. Ethereum probably wouldn’t have gotten very far without the work of its chief “promoter” and developer, Vitalik Buterin, and others.
Will Ether be declared a security?
It seems clear that Ethereum’s initial token sale was an illegal securities sale, and that Ether itself must therefore be a security. But there are also enough arguments against it, that the outcome is uncertain.
First, there are a number of blockchain tech companies and other organizations gearing up for a legal battle to defend Ether being declared a security. It might seem clear, but actually proving that Ether passes the Howey Test could be slow and expensive. This isn’t necessarily a struggle that the SEC wants to have, and it would much rather spend resources going after the actual scams.
Second, the token sale happened in 2014 and Ether has evolved significantly since then. Back when the tokens were being traded purely as a speculative asset, it may have qualified, but now the tokens serve a utility function as “gas” for the Ethereum decentralized network. The initial token sale might have been an illegal securities offering, but the speculative assets that were initially sold are nowhere to be seen. At some point, they were replaced by functional tokens that power a useful decentralized system.
“It’s highly unlikely [the SEC will] go back and impose some onerous burdens. It would be very unusual for a regulator to go back in time and say ‘you should have thought three or four years ago when you started that this was a security’,” said Phil Lookadoo, a commodities lawyer with Haynes and Boone.
“It wouldn’t go back in time and apply the Howey Test to something from 2015 or 2016,” said Blake Estes, financial lawyer with Alston & Bird. “To the extent there were security elements on these platforms, they’ve dissipated over time.”
There are also some questions around who exactly is responsible for Ethereum. It’s not a business, it doesn’t have a street address and the line between developers, sellers and investors has blurred together.
And legally, it’s the SEC’s job to enforce laws, not make or interpret them. If something is arguably a grey area, like Ether certainly is, then the SEC might be overstepping its authority and straying into “interpreting the law” territory. Pro-Ethereum lawyers might argue as such, and the SEC might know it. The SEC probably doesn’t actually want to outlaw Ether trading. It would be messy, and it has better things to do.
Ethereum tokens as first sold in its ICO might pass the Howey Test, but that doesn’t mean Ether is a security.
Disclosure: At the time of writing, the author holds ETH, IOTA, ICX, VEN, XLM, BTC and XRB.
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