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The application of traditional federal securities laws to crypto assets continues to evolve. In some cases, the Securities and Exchange Commission (SEC) considers tokens and other digital assets to be securities. This makes them subject to federal securities law, including the Securities Act of 1933 and the Securities Exchange Act of 1934. This classification has significant implications for businesses engaging in token offerings. Understanding crypto securities law and keeping close tabs on new legal developments is critical.
Understanding the Howey Test Crypto Framework
Crypto assets may be considered securities if they are offered or sold as investment contracts. The Howey test is one of the most widely used tests for determining what qualifies as a security. The decision is decades old and has been further fine-tuned over the years. It has proven applicable to a wide range of instruments, including tokens.
In SEC v. W.J. Howey Co, the U.S. Supreme Court addressed when investment schemes should be considered "investment contracts." These would therefore be "securities" under the Securities Act. The Court defined "investment contract" as one involving:
- An investment of money,
- In a common enterprise,
- With an expectation of profit,
- Derived primarily from the efforts of others.
As explained by the Court, this definition embodies a "flexible rather than a static principle." It is "one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits."
How the SEC Applies the Howey Test to Digital Assets
The SEC and the courts routinely apply the Howey test to determine whether tokens qualify as securities. The third and fourth prongs often play a central role in the analysis. These focus on whether profits are expected from the efforts of others.
For example, the rights and expectations of token holders are carefully analyzed, as demonstrated in recent SEC enforcement actions involving digital assets, to determine whether a digital asset is a security.
SEC guidance has also emphasized factors such as whether a promoter or sponsor plays a central role. This includes their involvement in the development or management of the asset or its underlying network. The analysis is always very fact dependent. If a digital asset is marketed with an expectation of returns based on the issuer's or a third party's managerial efforts, the SEC will likely find it is subject to federal securities laws.
Requirements If a Token Is a Security
SEC oversight over initial coin offerings (ICOs) and token sales is strict. This is particularly true if they are classified as securities under the Howey test crypto standards. To avoid compliance headaches, companies pursuing token offerings must:
- Evaluate Securities Classification: Determine whether the token qualifies as a security, thereby requiring SEC registration or an exemption.
- Satisfy Registration Requirements: If classified as a security, the offering must be registered or rely on exemptions.
- Disclose Investor Risks: Companies must provide transparency regarding token utility, governance structures, and financial backing to avoid misleading investors.
Companies that fail to meet these requirements face serious consequences, as crypto enforcement actions can result in substantial penalties and legal complications.
Crypto Securities Law Under the Trump Administration
Under the Trump Administration, the SEC has adopted a more lenient approach toward cryptocurrency regulation and enforcement.
The agency has dropped several high-profile enforcement actions and lawsuits against crypto firms. This signals a willingness to work with the industry rather than impede it.
In September, the SEC also issued a no-action letter. The letter confirms that it won't pursue enforcement action against a token launch by blockchain-based Decentralized Physical Infrastructure Networks (DePIN). The DePIN projects enlist participants to provide real-world capabilities through open and distributed peer-to-peer networks. These capabilities include storage, telecommunications bandwidth, mapping, or energy. The projects use tokens to incentivize participation. The SEC determined that the DePIN tokens did not meet the criteria for securities under federal securities laws. The agency cited that the token distribution is not designed to raise capital or profit from managerial efforts. Rather, it rewards labor or services.
The SEC has also signaled that it plans to propose a more comprehensive regulatory scheme for cryptocurrency. This is extremely encouraging. However, until this occurs, courts will continue to apply prior interpretations of securities law. This includes the Howey test and related doctrines as they have over the past several years.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
