Why fungible crypto assets are not securities

The speakers at our Owl Explains Hootenanny last week are co-authors of the most thorough analysis to date of the burning question of whether fungible crypto assets are - or are not - securities. (Spoiler alert – mostly they are not.) Lewis Cohen, Freeman Lewin and Sarah Chen from DLX law firm have analysed the US Securities Acts, the ‘Howey test’ on investment contracts (more on that below) and 266 pieces of case law where the Howey test was applied to different scenarios. The resulting paper is 180 pages long. But fear not! This owl has served up this pithy appetiser to whet your appetite for the full feast which you can find here

So what’s this all about?

The flurry of Initial Coin Offerings (ICOs) a few years ago has led some regulators to conflate the token sales in an ICO and the crypto assets involved in them and seek to apply US securities laws to both. The authors of this paper do not dispute that the fundraising activity of an ICO – inviting investors to purchase crypto assets in a fledgling project with the hope of making a profit – might indeed involve an investment contract and that securities law would often apply. What they dispute is whether and when the crypto assets themselves qualify as ‘securities’ according to current laws and regulations. Just as oranges, chinchillas, whiskey barrels and stamps can form part of an investment contract but are not themselves securities, the same goes for crypto assets. (This owl particularly enjoyed the bit about how chinchillas are not securities – of course they aren’t – they’re lunch). They also challenge the notion that ‘once a security, always a security’ that continues to classify a crypto asset as a security well beyond the context of an ICO when the crypto asset may be performing all manner of other functions that do not involve an investment contract.

So what should regulators do instead?

The co-authors recommend that the status of a crypto asset can only be determined by first understanding the true nature of the crypto asset – and then by understanding and applying case law and legal scholarship on investment contract transactions. And that is exactly what the article does – exploring first the nature of crypto assets and then delving into case law and legal scholarship to explore when an investment contract does and does not exist.

Why does this matter?

It matters more than ever right now as policy makers and regulators, particularly in the US, are leaning towards deeming many, even all, crypto assets to be securities without going through this exercise of interrogating the nature of the asset and the transaction. And that matters because if all crypto assets are treated as securities even if they represent things that clearly are not – and even when they are clearly not part of an investment contract - regulators risk not only strangling with red tape the innovation and promise of Web3, but also causing confusion for all manner of items like the aforementioned chinchillas.

So when is a crypto asset a security?

A crypto asset is a security either by its very nature (e.g., a stock or bond on blockchain). When it is part of an investment contract according to the Howey Test, well, the crypto asset is not a security but the investment contract is. Clearly crypto assets cannot be assumed to be securities by their very nature – because a crypto asset can represent literally anything at all. They may occasionally be – but equally (and more often) they may not be. So where the asset is not a security by nature, we have to assess whether they might be part of an investment contract as defined by the Howey Test. Still not a security, but the subject of an investment contract.

So what is the Howey Test?

The Howey test says that an investment contract transaction exists when a “contract, transaction or scheme” involves

an investment of money
in a common enterprise
with an expectation of profits to come
solely from the efforts of the promoter or a third party.

So the Howey test defines correctly that fundraising by selling crypto assets as part of an ICO might be an investment contract that the securities laws apply to. And while crypto assets are part of that investment contract, they are not themselves securities. But what happens when the fundraise is complete and the crypto assets are being used for other purposes where Howey tells us clearly there is no investment contract? An example could be when they are merely validated, delegated or staked. Or when they are performing as a utility token intrinsic to the functioning of a blockchain. The article does not shy away from the complexity of all this. In fact it opens with a quote from Homer’s The Odyssey where the old man of the sea changes himself ‘first into a lion with a great mane, then all of a sudden he became a dragon, a leopard, a wild boar; the next moment he was running water and then again directly he was a tree’ Why? Because crypto assets can also shape shift in that different circumstances can affect whether a cryptoasset should be treated as a security or not. With this mercurial nature then, regulators and practitioners need to consider each and every transaction and activity concerning a crypto asset on a case by case basis to determine whether there is a security or not. But this isn’t always possible because the information needed to make that assessment is private.

So what is the solution?

A new law and more engagement from and between the SEC, FTC, CFTC, Department for Justice and state attorneys general.

So you mean regulation?

Yes. Fundamentally the co-authors call for regulation based on the kind of thorough understanding and legal analysis of crypto assets that this paper provides.