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US Securities and Exchange Commission

Testing Howey: With Congress Stalled, the SEC Stakes its Expanding Crypto Enforcement on a Nearly Eight-Decade-Old Test

Bill Flook  Editor, Accounting and Compliance Alert

· 14 minute read

Bill Flook  Editor, Accounting and Compliance Alert

· 14 minute read

The SEC under Chair Gary Gensler is ramping up its enforcement campaign against the cryptocurrency industry, making good on his threats that the bulk of what the industry is offering fits the definition of a security.

Central to that push is Gensler’s confidence in the commission’s ability to stretch the so-called Howey Test over the digital asset space – a still unanswered question that could ultimately shape the crypto regulatory landscape. That test, created under a 1946 Supreme Court decision concerning Florida citrus grove transactions, is the foundation of the SEC’s authority to police securities deemed to be “investment contracts” that fall outside of tidy categories such as stocks and bonds.

In past decades, the Howey Test has formed the basis of SEC enforcement actions involving subjects as diverse as condominium developments and warehouse receipts for collectible bottles of scotch. Those past cases have raised questions around the sort of activity the commission can regulate under Howey, “but never where the business was as large and the implications so broad as it is in the cryptocurrency industry,” said Ari Gabinet, a senior fellow at Brown University’s Watson Institute for International and Public Affairs and a former director of the SEC’s Philadelphia office.

Following the collapse of the FTX cryptocurrency exchange in late 2022, the SEC is expected to continue accelerating its digital asset enforcement efforts this year with a wider array of products in its sights, including potentially stablecoins. And with major crypto legislation bogged down on Capitol Hill that could more clearly define the commission’s authority, Gensler’s success will ultimately hinge on convincing courts that a broader range of disparate tokens and other crypto-based products and services satisfy all four necessary elements under Howey. Key cases such as SEC v. Wahi et. al. and SEC v. Ripple Labs Inc. et al. could bring clarity on that question.

SEC v. W.J. Howey Co.

The Securities Act of 1933 lists what financial instruments fall under the definition of security, and therefore under the SEC’s regulatory purview. Those include stocks, bonds, notes, security-based swaps, and more than a dozen other instruments. Of note here, it also lists the undefined term “investment contract.”

The SEC had sued W. J. Howey Company and Howey-in-the-Hills Service for selling tracts of a citrus grove to the public alongside a service contract giving Howey-in-the-Hills a leasehold interest and possession of the acreage. Howey, which had the necessary expertise and equipment, remained in charge of cultivation, harvesting and marketing. Purchasers received a share of the profits.

Based on that arrangement, the commission accused Howey of the offer and sale of unregistered securities in violation of the Securities Act.

The case eventually founds its way to the Supreme Court. Writing for the Court, Justice Frank Murphy concluded that the transactions clearly involved investment contracts under the law and established what would become known as the Howey Test. That test is determined by “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

Teresa Goody Guillén, a partner at Baker & Hostetler LLP who co-leads the firm’s Blockchain Technologies and Digital Assets group, said the Howey Test “was designed to capture novel financial transactions that don’t fit neatly into any of the defined terms and the definition of a security.”

“So by design, it’s broad and able to be applied to all sorts of novel financial transactions,” she said.

Guillén, a former litigation counsel in the SEC’s Office of the General Counsel, said much of the SEC’s approach to enforcement depends on the agency’s leadership, pointing to the aggressive enforcement and broad application of the Howey Test by Chair Gensler and Enforcement Director Gurbir Grewal. She also noted that the SEC is not unanimous in this posture, with dissents coming from Commissioner Hester Peirce.

Many crypto defendants have chosen to settle with the SEC rather than commit the time and expense of picking a fight with the commission in a deeply uncertain and unpredictable area of law. The SEC’s efforts have recently have yielded a number of high-profile settlements, including the $100 million settlement alongside state regulators with BlockFi Lending LLC over its crypto lending product in February 2022; the $45 million settlement in January with Nexo Capital Inc. over its crypto lending product, also split between the commission and state regulators; and the $30 million February settlement with Kraken over is staking-as-a-service program. In each case, the SEC made the case for why the products in question were investment contracts, and therefore securities, under Howey..

“It is so expensive to litigate, and to fight the government to actually get to the point where you can have something like a Supreme Court ruling, or even a Circuit Court ruling,” Guillén said. “And so it’s difficult for litigants to get to that point, but it’s really helpful when they do, because then we can get more clarity.”

That’s one of the reasons why Ripple Labs “seems to have a lot of support in the community, not only for people who believe in those arguments, but also for the fact that it is being fully litigated so far,” she said.

Among those supporters is the Blockchain Association, which has filed amicus briefs on behalf of both Ripple and Wahi. In its most recent amicus filing on behalf of the latter, it defended tokens in question as “merely software.” The group argued it is “devastating to the industry at large for the SEC to be able to proclaim, at will, and without meaningful review or challenge, that certain software packages are securities.”

“It gives the SEC the ability to cause great damage to the industry, merely by making adverse allegations that may be proven untrue if contested in a court of law, but which the SEC knows will not be meaningfully contested,” the Blockchain Association wrote.

The brief repeats long-standing criticism by the industry over the lack of clearer rules or guidance from the SEC beyond its nearly four-year-old staff interpretive guidance in Framework for “Investment Contract” Analysis of Digital Assets. Chair Gary Gensler has so far refused calls for new rules, asserting that the vast majority of tokens on the market are securities, and that the commission has all the authority it needs to regulate them. And any legislation that might impose a more restrictive framework on the commission remains stalled in a Congress that has yet to reach any major agreements on crypto, least of all on which regulator should take the lead.

For Gabinet, most of the crypto activity he sees the SEC go after “doesn’t seem to be very different from garden-variety securities law issues.”

“And most of what I see seems to me to look an awful lot like a traditional security,” he said.

Gabinet predicted there may be room for the Supreme Court to provide additional guidance on how the Howey Test is applied, given the subtle differences among tokens.

“Like what is the fundamental difference between Bitcoin or Kin, and does it matter whether there’s not more entrepreneurial activity to be done when the token is issued,” he said. “Those are fundamental questions that relate to how the Howey Test is applied.”

Kin is the token of Kik Interactive, which the SEC charged in 2019 with conducting an unregistered securities offering surrounding its $100 million sale of the tokens. Kik had attacked the lack of crypto guidance from the SEC, and also argued the term “investment contract” was unconstitutionally vague as applied to the company’s sale of Kin tokens, but lost in SDNY in 2020 and was ordered to pay a $5 million penalty.

SEC v. Wahi et. al. (Western District of Washington)

The SEC in July 2022 charged Ishan Wahi, his brother Nikhil Wahi and friend Sameer Ramani in what might otherwise be a vanilla case of alleged insider trading, were it not surrounding digital assets.

Ishan Wahi was a manager at Coinbase’s Assets and Investing Products Group from October 2020 to May 2022, a position that provided him with insider knowledge of upcoming listing announcements at the crypto exchange. The SEC alleges that he repeatedly tipped off his brother and Ramani with what the complaint frames as material nonpublic information about the timing and content of those listings. The alleged tippees then traded ahead of more than 10 announcements in at least 25 crypto assets, according to the commission. Importantly, the SEC asserts the two traded in at least nine “crypto asset securities,” seven of which were the subject of listing announcements. At the same time, the U.S. Attorneys Office for the Southern District of New York (SDNY) announced parallel charges of wire fraud and wire fraud conspiracy against the three.

The case was notable as a first for crypto insider trading charges. But perhaps more important were SEC’s assertions within the complaint, which critics on Capitol Hill and in the crypto industry casts as a land grab of digital asset authority.

The SEC dedicated a large part of the 62-page complaint to providing a token-by-token justification for why the nine crypto assets – POWR, AMP, DDX, DFX, KROM, RLY, XYO, RGT, and LCX – qualified as investment contracts under Howey. The commission is not alleging any wrongdoing on the part of the token issuers themselves as part of the Wahi complaint.

Take POWR, a token announced in 2017 by the Australia-based Power Ledger Pty. Ltd. The company’s stated goal was “to allow participants in energy grids to track, trace, and trade energy in real-time through a decentralized protocol,” with POWR tokens needed to participate on the platform, according to the SEC’s description. The token was initially offered through two phases, according to the SEC, with a sale of 90 million tokens around August 2017 raising $17 million Australian dollars, and another “public sale” later that year raising the same amount.

To meet the “common enterprise” prong of Howey, the SEC points to Power’s representations in a Medium post, interview, white paper, and secondary market listing application around the use of the funds to pay for platform development or other growth. To meet the “reasonable expectation of profits based off the efforts of others” requirement, the SEC pointed to Power’s alleged assertions around the opportunities for buyers to benefit in various ways, including by receiving a portion of revenue.

The commission’s designation of the crypto assets as securities drew significant blowback. Former Senator Pat Toomey of Pennsylvania, then the ranking member of the Senate Banking Committee, said he was “very skeptical” of the SEC’s arguments and criticized the agency for failing to disclose its rationale before launching the investigation. Commodity Futures Trading Commission (CFTC) Commissioner Caroline Pham in a statement called the action a striking example of regulation-by-enforcement that addressed questions better suited for a formal notice-and-comment rulemaking process.

The Wahi brothers have both pleaded guilty to the criminal charges, with Nikhil Wahi sentenced in January to 10 months in prison and Ishan Wahi awaiting sentencing in May.

They continue to fight to the SEC, however. Their Feb. 6, 2023, motion to dismiss accused the SEC of “trying to seize broad regulatory jurisdiction over a massive new industry via an enforcement action against a 32-year old former Coinbase employee and his kid brother.”

“An enforcement action against individual people—particularly ones who are already occupied with federal criminal proceedings at the other end of the country—is not how major questions of law that loom over entire industries should be resolved,” the two stated in the filing. “Yet that is how the SEC has chosen to proceed.”

In the motion, the Wahi brothers seek to repudiate the SEC’s use of Howey. They reject that the tokens are investment contracts, pointing to the absence of any contract between buyer and seller. Their sale imposes no ongoing legal obligations on developers, and do not entitle buyers to profit sharing.

“A pie may have any number of fillings,” the defendants argued. “A term paper may cover any number of subjects. But a pie needs a pastry, and a term paper needs a paper. So too here. There is no question an ‘investment contract’ may include ‘countless and variable schemes’—from orange production to muskrat rearing to real estate. But for those schemes to become federal securities, the prerequisites of an ‘investment contract’ still must be present.”

SEC v. Ripple Labs Inc. et al. (SDNY)

The SEC in December 2020 charged Ripple Labs and two executives with conducting an unregistered securities offering through the sale of the XRP token starting in 2013, which raised more than $1.38 billion, according to the complaint. The two executives, former Chief Executive Officer Christian Larsen and current CEO Brad Garlinghouse, profited by about $600 million from the sale of XRP, according to the complaint.

The SEC, in its complaint, points to Justice Murphy’s observation in the Howey opinion that the definition of whether an instrument is an investment contract embodies “a flexible, rather than a static, principle, 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.” The complaint leans heavily on e-mails, promotional statements and other representations to argue that XRP was an investment contract at all relevant times during the offering. And the defendants “understood and acknowledged in non-public communications that the principal reason for anyone to buy XRP was to speculate on it as an investment.” XRP, SEC argued, has no significant non-investment use.

Ripple, represented by team that includes former SEC Chair Mary Jo White and former Enforcement Director Andrew Ceresney, has drawn a raft of industry support that underscores the stakes to the broader crypto market in the outcome of the case.

Ripple, in its own filings, argued the SEC has failed to meet its burdens on each of the elements of Howey. The SEC, it argued, “is asking the Court to rewrite the statutes that define its authority.”

“For the SEC to prevail in its opposition, the Court would have to endorse the SEC’s theory that there can be an ‘investment contract’ without any contract, without any investor rights, and without any issuer obligations,” Ripple wrote in a December 2022 reply in support of summary judgment. “It would have to endorse the SEC’s theory that there can be a ‘common enterprise’ even if the SEC cannot say what the enterprise is or prove any of the elements that define such enterprises. And it would have to endorse the SEC’s theory that purchasers could reasonably have expected profits from Ripple’s efforts even though Ripple never promised to make any efforts, even though it expressly disavowed any obligation to do so, and even though profits were overwhelmingly due not to Ripple’s efforts, but to market forces.”

The SEC’s position, Ripple wrote, “boils down to a view that any time someone buys an asset hoping to make money, and the seller’s interests are even partly aligned with the buyer’s, it is a security subject to registration.”

“That is not the law, even if the seller uses the sales proceeds to run its business,” Ripple stated in the filing. “If Congress wants to expand the securities laws that way, it can do so; but this Court should not.”


This article originally appeared in the Feb. 17, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.

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