Misconception #2: my token didn’t meet the definition of a security under the howey test. therefore, it can’t be a security!
Reality: The threshold question is whether a particular token would be considered a security under the 1933 Act and the 1934 Act. If the answer is yes, the token may be subject to various SEC registration, exemption, sale, transference, and reporting requirements.
Section 2(a)(1) of the 1933 Act and Section 3(a)(1) of the 1934 Act enumerate multiple instruments that are considered securities. The definition of security includes notes, stock, security futures, swaps, bonds, debentures, options, investment contracts, and more. The “investment contract” phrase has acted as a catch-all phrase to encompass innovative financial arrangements that have the spirit of a security, but may not meet the description of the enumerated instruments.
Applying Howey’s 4-Factor Test
In SEC v. W. J. Howey Co. (1946), the U.S. Supreme Court provided a four-part test for whether an arrangement constitutes an “investment contract”. The test checks whether there is (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) which are derived solely from the efforts of the promoters or third parties.
The idea that utility tokens may not be considered securities arises from the thought that if a token has a utility, then any expectation of profit would derive mainly from the token’s consumptive value, not on the efforts of third parties. Therefore, the fourth factor would fail, making the arrangement not an investment contract. Marco Santori from Cooley provides a more in-depth analysis of Howey for tokens here. Coinbase, Coin Center, Union Square Ventures, and Consensys have also built-out a thoughtful securities law framework to test whether a token may be considered a security.
While the Howey test is relied upon to judge whether an arrangement is an investment contract, Howey is not the end-all-be-all test to check whether a token is a security. A court may choose a different test.
Applying Reves’s Family Resemblance Test
A separate securities test is the Reves “family resemblance” test from the 1990 U.S. Supreme Court decision in Reves v. Ernst and Young. The Reves test articulates four factors to determine when a note, one of the enumerated categories of securities in the 1933 and 1934 Act, should be classified as a security.
In Reves, the default presumption is that a note is a security, but this presumption could be rebutted if it bears a “family resemblance” to one of the enumerated categories on a judicially developed list of exceptions. The Reves test considers: (1) the parties’ motivation for entering into the transaction, (2) whether there was a trading market for investment in the instrument, (3) the expectation of the investing public, and (4) whether there are other regulatory schemes applicable to the instrument that could reduce risk to the buyer. Based on this test, the court determines whether a note resembles an excepted non-security note and is therefore not a security.
While Reves applies to notes, the same judicial rationale could be extended to other enumerated categories of securities. The Howey and Reves tests could both be applied -- for example, even if a token is not an investment contract under Howey jurisprudence, it could be considered a security under Reves. A token issuer should be mindful of how Howey and Reves may apply to its token.
Applying the Risk Capital Test
Token issuers also have to consider securities regulation beyond the SEC. Issuers who distribute their tokens all across the U.S. may have to comply with each state’s securities regime (i.e. “Blue Sky” laws). This means a token that is beyond the jurisdiction of the SEC may still be subject to securities regulation by one or more of the states.
States may use different frameworks to judge what constitutes a security. For example, courts in California, Arkansas, Michigan, Washington, Oregon, and other states have instituted a “risk capital” test. In California, the risk capital test considers whether there is attempt by an issuer to (1) raise funds for a business venture or enterprise (2) through an indiscriminate offering to the public at large, (3) where the investor is in a passive position to affect the success of the enterprise, and (4) the investor’s money is substantially at risk because it is inadequately secured.
Using this test, the California Supreme Court found that country club memberships were securities in a landmark case called Silver Hills Country Club v. Sobieski (1961). In this case, an organization attempted to finance improvements on a country club by selling club memberships. The membership did not entitle the holder to any share of profits -- it only enabled the holder to use club facilities. The court held that courts have to look through form to substance to protect the public from schemes to attract "risk capital” with which a company can develop a business for profit. The purchaser has to contribute capital in a high risk project for there to be any chance that the benefits of club membership will materialize.
A state that uses the risk capital test may apply it in conjunction with Howey. A transaction is considered a security if it satisfies either test. Given that many token issuers are raising funds from the general public for business ventures in which passive investors contribute capital to help materialize a risky product, the risk capital test may be applicable in many circumstances.