Congress can do better than the Howey test for crypto regulation
Cryptocurrencies are generally not subject to federal regulation unless they are deemed to be “securities,” in which case the Securities Act of 1933 requires them to abide by disclosure requirements and antifraud regulation by the Securities and Exchange Commission (SEC) if they are offered to the public.
The test the SEC uses to determine whether a cryptocurrency is a security was laid out by the Supreme Court in Securities and Exchange Commission v W. J. Howey Co. If the SEC asserts that a cryptocurrency is a security, an alleged issuer seeking to challenge that contention must litigate. The criteria contained in the so-called Howey test are irrelevant to any rational public policy reason to regulate cryptocurrency. Yet, cryptocurrency companies are forced to spend millions in legal fees to seek to demonstrate that their products do not meet these criteria.
Howey, of course, did not deal with cryptocurrency or any other form of modern technology. Rather it dealt with a 1940’s era scheme to market units of a citrus grove in Florida coupled with a contract for cultivating and marketing the grove’s fruit and paying the profits to investors. The court held that an investment is an “investment contract,” and thus, a security as defined in the Securities Act, if it is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
With respect to cryptocurrency, the crucial prong of this test is usually whether profits result solely from the efforts of a promoter or third party. Using this test, the SEC determined that Bitcoin, which is a decentralized network with no promoter, is not a security. A number of forms of cryptocurrency follow the decentralized finance, or “defi,” model that relies on peer-to-peer payments with no promoter or financial intermediary. It is unlikely that these forms of cryptocurrency would be deemed securities under Howey. Other forms of cryptocurrency, such as interest-bearing stablecoins, would meet the Howey test because a promoter is paying interest. Does this distinction make any sense?
In determining whether a financial product should be regulated, governments generally look at the following factors: Do the people who are being offered the product require protection from fraud or dishonesty? Do the markets in which the product is sold require regulation to preserve their integrity? Are there broader governmental interests at stake?
In the case of cryptocurrency, regardless of whether profits result from the efforts of a promoter, purchasers have been defrauded of billions of dollars, resulting from cyber hacks and failures to disclose risks or the actual assets and liabilities of cryptocurrency entities. Cryptocurrency is increasingly being marketed through the same vehicles as more conventional financial products, including broker-dealers, mutual funds and securities exchanges and the integrity of these markets must be protected. Finally, important governmental interests mandate regulation. For example, since cryptocurrencies are often used by criminals, law enforcement and anti-money laundering regimes are implicated. In addition, the government’s strong interest in preserving the primacy of the U.S. dollar gives it an interest in overseeing potential competitors to the dollar. All of these factors are present for all cryptocurrencies regardless of whether or not they meet the Howey test.
Unfortunately, in the absence of congressional action to regulate cryptocurrency, the SEC is left with only the Howey test and its resulting illogic. In designing a regulatory scheme, Congress has the luxury of directly considering the technologies involved, rather than applying a test that originated in the Florida citrus industry.
A number of schemes for regulation have already been floated, particularly for stablecoins, a form of cryptocurrency backed by financial assets. The President’s Working Group on Financial Markets has proposed that all stablecoin issuers be regulated as federally insured banks. The cost of this regulation may make this nascent industry unprofitable.
A more prudent regulatory approach was recently proposed by Sen. Pat Toomey (R-Pa.). It involves some form of state or federal license for stablecoin issuers, appropriate financial disclosure about the assets backing the product, and most importantly, a requirement that stablecoin issuers obtain audited financial statements so that purchasers can see their assets and liabilities. A regime of this sort, broadly applicable to cryptocurrency, would protect consumers, financial markets, and governmental interests while allowing the marketplace to ultimately determine whether the cryptocurrency experiment will be successful.
Howard B. Adler, a retired corporate and securities law partner at Gibson, Dunn & Crutcher, LLP, served as deputy assistant secretary of the Treasury for the Financial Stability Oversight Council from 2019-2021. He is the coauthor of the forthcoming book, “Surprised Again! The COVID Crisis and the New Market Bubble.”
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