The rapid development of blockchain technologies has brought many use cases in the train and consequently required scrutiny of governmental bodies. Even though most countries (including the United States) have not enacted comprehensive legislation on blockchain and digital assets, general rules remain applicable while determining that blockchain-related activities are legitimate. At the moment, various digital assets have been competing with traditional financial instruments, so the future of digital assets is strongly dependent on how regulatory authorities will take a stance in evaluating whether a digital asset is a security. Such an analysis may be challenging but essential to ascertain the legislation applicable to the specific asset. In this article, we will focus on the practice in the United States, analyze reference methods to differentiate cryptocurrencies and securities, and lastly, provide some takeaways from the practice.

What is security, and what happens if a digital asset is considered a security?

In the United States, the Securities Act of 1933 and the Securities Exchange Act of 1934 are the two main pieces of legislation defining securities and providing a general set of rules to which securities are subject. These laws define security very broadly and cover all financial instruments that hold any kind of value, such as stocks, bonds, transferable shares, and investment contracts. Securities are under the province of the Securities and Exchange Commission (the “SEC”) in the United States. Any offer or sale of a security, including the digital assets, must either be registered with the SEC or qualified for an exemption from the registration (such as private sales to accredited investors or crowdfunding). Furthermore, the SEC enforces specific disclosure and filing requirements to protect the investors from market manipulation and help them make informed investment decisions.¹

Classifying a digital asset as security is usually scary for the sector participants, especially for issuers of such assets, since this will result in registration and broader disclosure requirements before the SEC. At this point, it is significant to emphasize that the SEC considers most of the digital assets as securities, which fall within the scope of the investment contracts since they meet all prongs of the Howey Test, that will be discussed in greater detail below. ²

How to determine whether a digital asset is a security or not?
a.Howey Test

In 1946, the United States Supreme Court developed a standard, namely the "Howey Test", in order to determine whether a financial instrument is an investment contract, and falls within the scope of the SEC's province. ³ Over the years, this standard has been accepted and adopted internationally and has become a well-established precedent in U.S. courts.

The U.S. Supreme Court’s Howey case and subsequent case law ruled that an “investment contract” exists when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.⁴ Therefore, the Howey Test provides a litmus test with four criteria to consider if a particular financial instrument (including a digital asset) should be regarded as security on a case-by-case basis. Here is the summary of what these four criteria represent:

1.      Investment of Money

Even the Howey Case required investment of "money" to create an investment contract; subsequent court decisions and the SEC interpret this term broadly and do not require making payments in cash. Any form of contribution, including fiat currency or digital assets, will suffice to meet this requirement.

The SEC emphasizes that this criterion is always satisfied in offering and selling a digital asset since such purchase or acquisition happens in exchange for a value.⁵

2.      Investment in a Common Enterprise

Since “common enterprise” is not defined in any pieces of legislation, the courts adopted different interpretations for this term, either as horizontal or vertical commonality. In general terms, horizontal commonality requires investors to pool their money or assets to a project in return for distributing shares pro-rata to their contribution. On the other hand, vertical commonality focuses on the relationship between the investor and the promoter of the project. If the investor and the promoter share a common interest and the investor's success depends on the promoter's expertise, then vertical commonality exists.⁶

Even the courts consider a “common enterprise” as a distinct element of an investment contract; the SEC believes that "common enterprise" typically exists in digital assets and does not require vertical or horizontal commonality per se. ⁷

Lastly, the SEC made an open statement in the DAO Report⁸ that token purchasers are investing in a common enterprise and meet this criterion in any way.

3.       Investment with Reasonable Expectation of Profit

The SEC also interprets the term "profit" broadly in the Framework for “Investment Contract” Analysis of Digital Assets (the “Framework”), which covers any kind of profit, including but not limited to capital appreciation arising from the development of the project following first investment, or contribution to the enterprise’s earnings through dividends. On the other hand, it is worth mentioning that price appreciation resulting solely from external circumstances (such as inflation) is not considered "profit" under the Howey Test.⁹

With the Framework, the SEC also provides various characteristics that may inherently indicate the reasonable expectation of profits. In this regard, if the following elements are present for a particular digital asset, it will be more likely that a reasonable expectation of profit exists:

• The digital asset grants the investor right to contribute to the enterprise's income (such as dividend) or realize earnings from capital appreciation as a result of sale on the secondary market (available now or in the future);
• The digital asset is offered for all potential purchasers in public, rather than targeting  users of  goods/services or who will benefit from the functionality of the network;
• The promoter of the project has raised funds for the project, in excess of the amount needed to establish and maintain a functional network;
• The digital asset is marketed with the promise (implied or explicit) to build a business or operation instead of delivering currently available goods or services for the existing network.
• The digital asset is marketed using the expertise of a promoter or third party, based on the enterprise's future (and not present) functionality.

Please note that the foregoing explanations are the summary of the list the SEC has provided. A complete list of the characteristics can be accessed here.

4.      Reliance on the Efforts of Others

This criterion mainly protects the passive investors, who have no control over the enterprise and only rely on the promoters' or sponsors’ efforts to make the enterprise a success.¹⁰ If the promoter, sponsor, or any other third party (collectively, the “Active Participants") is essentially responsible for the network's development, operation, or promotion to achieve or retain the enterprise's intended purpose or functionality, then this criterion will be met. In such a case, rather than an unaffiliated community of users (i.e., decentralized network), the Active Participants perform or are expected to perform essential managerial tasks, such as creating, controlling (e.g., by limiting supply), and supporting a market for the digital asset. On the other hand, if the Active Participants merely perform ministerial or routine tasks rather than playing a vital role in the project or the project is sufficiently decentralized, this criterion will not be met.¹¹

The SEC has also provided a non-exhaustive list of the circumstances that strengthen the possibility of reliance on the Active Participants' efforts, which is accessible here.

b. Other Considerations outlined in the Framework

Together with the Howey Test, both federal courts and the SEC take the investment's economic reality into account to determine whether a specific digital asset is a security or not. In this context, the SEC provided another illustrative list of characteristics that may lower the risk of meeting the requirements of the Howey Test.¹² The SEC’s stance proves that the Howey Test may be avoided when a digital asset has a specific use case and limited prospects for appreciation-characteristics.¹³ To sum up, if the following characteristics exist, it will be less likely that the digital asset is regarded as securities:

• The distributed ledger network and digital assets are fully developed and operational;
• Investors (holders) may always use the digital assets for their intended functionality on the network;
• The digital asset is created as much as users need, and structured to meet such needs, rather than feeding speculation to increase its value.
• Appreciation of the digital asset’s value is limited; therefore, the holders do not consider that asset as an "investment". Any economic benefit derived from appreciation in the digital asset’s value is incidental.
• If the Active Participants encourage the secondary market, transfers may only be made by and among users of the platform (which is applicable for game tokens and loyalty points in many cases).
• If the digital asset is a virtual currency, then it can always be used as a substitute for a fiat currency in a wide variety of contexts. 
• If the digital asset represents rights over a good or service, there should be a correlation between the value of the digital asset and the market price of the underlying goods or services.

c. Further Takeaways from Hinman’s Speech

In his speech dated 2018, Hinman provided various insights on how digital assets should be handled while considering their nature (i.e., security or not)¹⁴. Some of the key takeaways from his speech may be summarized as follows:

• Evaluation of whether a digital asset is a security or not, requires a careful and fact-sensitive legal analysis.
• Naming a digital asset as a "virtual currency", "cryptocurrency", "coin", "token", or calling the transaction as an "initial coin offering (ICO)" will not affect the security nature of a digital asset and the applicability of the federal securities law. What matters is the substance and economic reality, not the form. Therefore, understanding how a digital asset is offered or sold should be examined in detail¹⁵. It is worth noting that the former SEC Chairman Jay Clayton has also touched on this issue in one of his speeches.¹⁶
• Whether a particular digital asset satisfies the Howey Test at the time of its offer or sale, depends on the specific facts and circumstances. For instance, a digital asset previously sold as a security, may get sufficiently decentralized afterward. In such a case, the Active Participant's efforts will no longer affect the enterprise's success, and purchasers would not reasonably expect an Active Participant to conduct essential management of the enterprise. In this regard, each digital asset should be re-evaluated at the time of later offers or sales.

What is the Current Situation in the Marketplace?

As noted previously, the SEC considers most of the existing digital assets as security, so they should be either registered with the SEC or qualified for an exemption from the registration. On the other hand, some high-ranking SEC officials confirmed that neither Bitcoin nor Ether is considered a security in the eyes of the authority.¹⁷ This is because both are sufficiently decentralized, and there is no central third party whose efforts are a key determining factor in the enterprise. With respect to remaining digital assets, the SEC leaves the market participants to decide whether a specific crypto asset is a “security”.¹⁸

For reference, we would like to briefly touch on the present status of the most-debated digital assets as follows:

a. Bitcoin

The position of Bitcoin is very straightforward. Since investors act on their own accord but do not pool their funds, the “investment of money” criterion is not met. Similarly, the success of an investor is dependent on the market price of Bitcoin, not the efforts of the others. Therefore, it is unanimously accepted by the sector participants that Bitcoin does not meet the requirements of the Howey Test and cannot be considered a security. ¹⁹

b. Ethereum

Classification of Ether remains highly debated, especially following the introduction of Etherium 2.0.²⁰When it was first launched, Ether could satisfy all four criteria of the Howey Test. Over time, it has morphed over and acquired by mining as Bitcoin works, rather than being sold by a common enterprise. Considering this change, Hinman also emphasized in his speech dated 2018 that current offers and sales of Ether are not security transactions due to the decentralized structure.²¹ However, Ethereum 2.0. has been introduced at the very end of 2020 and changed the mining system to the staking, so weakened the decentralization. Nevertheless, one of the commissioners of the Commodity Futures Trading Commission clarified that ETH is still a non-security commodity.²² Even though this is the case, we believe many issues are still open to discussion before reaching a conclusion.

Last but not least, ERC-20 is one of the frequently used tokens, which may run on the Ethereum blockchain and is subject to the SEC's province as considered among the security tokens.²³Therefore, companies should be cautious while selecting the correct token before proceeding.

c. XRP

At the very end of 2020, the SEC filed a lawsuit against Ripple Labs, Inc., alleging that the company did not fulfill the registration and disclosure requirements, even though XRP is considered a security, not a commodity.

While Bitcoin and Etherium are created gradually through the mining process, Ripple created 100 billion units of XRP directly for itself and started to sell it through scheduled allotments. Therefore, the SEC intervened and filed a lawsuit consequently.²⁴

The lawsuit is still ongoing; however, it is expected that the court will examine the difference between Bitcoin, Ethereum, and XRP and provide insight into how the courts will take a stance in this regard. No doubt that the ruling will affect the future of all digital assets in the United States, and so the rest of the world. 

d. Recent Class Action Against CoinBase

Last month, a class-action lawsuit was filed against Coinbase, a Nasdaq-listed cryptocurrency exchange platform, alleging the platform permits customers to buy and sell 79 different cryptocurrencies (including XRP, DOGE, SHIB) that are considered securities without disclosing this fact. The digital assets subject to the lawsuit are not registered with the SEC, as well as Coinbase. The aggregate claims exceed $5,000,000, and plaintiffs would like to recover all damages, considerations paid for such tokens, and trading fees, together with relevant costs and interests.

Conclusion

Since the federal securities laws provide various requirements for the assets considered securities, the correct classification of a digital asset from the very beginning, plays a crucial role in the future and success of the project. We know this may be very challenging for the startups, especially before the project is structured well; however, you may benefit from litmus tests such as the well-regarded Howey Test or further considerations of the SEC officers. If this stage is skipped without due care, the damages can be enormous and irreversible for the promoters, the project, and the exchange platforms.

---

1. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
2. https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03 (Last Access Date: 04/04/2022).
3. The United States Supreme Court, SEC v. W.J. Howey Co., 328 U.S. 293 (1946). In brief, Howey was the owner of a land with orange groves and created a financial model by selling the sections of the land to different purchasers and then leasing back in order to cultivate and share the profit with such purchasers in the end. The court ruled that such a financial model constitutes an investment contract under the federal securities laws, and therefore is subject to the supervision of the SEC.
4. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
5. https://www.sec.gov/files/dlt-framework.pdf; https://www.sec.gov/litigation/investreport/34-81207.pdf (Last Access Date: 04/04/2022).
6. https://www.jdsupra.com/legalnews/cryptocurrencies-and-the-securities-and-6989064/ (Last Access Date: 04/04/2022).
7. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
8. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, https://www.sec.gov/litigation/investreport/34-81207.pdf (Last Access Date: 04/04/2022).
9. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
10. https://www.sec.gov/news/speech/speech-hinman-061418 (Last Access Date: 04/04/2022).
11. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
12. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
13. https://www.mondaq.com/unitedstates/fin-tech/1129220/is-crypto-a-currency-or-security-litigation-involving-the-sec-may-provide-guidance (Last Access Date: 04/04/2022).
14. https://www.sec.gov/news/speech/speech-hinman-061418 (Last Access Date: 04/04/2022).
15. https://www.sec.gov/files/dlt-framework.pdf (Last Access Date: 04/04/2022).
16. https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11 (Last Access Date: 04/04/2022).
17. https://www.sec.gov/news/speech/speech-hinman-061418 (Last Access Date: 04/04/2022).
18. https://www.winston.com/en/crypto-law-corner/when-is-a-crypto-asset-a-security-and-why-does-that-matter-part-i.html (Last Access Date: 04/04/2022).
19. https://www.sec.gov/news/speech/speech-hinman-061418; https://www.jdsupra.com/legalnews/cryptocurrencies-and-the-securities-and-6989064/ (Last Access Date: 04/04/2022).
20. https://www.jdsupra.com/legalnews/cryptocurrencies-and-the-securities-and-6989064/ (Last Access Date: 04/04/2022).
21. https://www.sec.gov/news/speech/speech-hinman-061418 (Last Access Date: 04/04/2022).
22. https://www.fxstreet.com/cryptocurrencies/news/cftc-commissioner-clarifies-ethereum-is-non-security-commodity-ending-sec-ambiguity-202108160433 (Last Access Date: 04/04/2022).
23. https://www.sec.gov/litigation/admin/2019/33-10714.pdf (Last Access Date: 04/04/2022).
24. https://news.bitcoin.com/coinbase-sued-for-allegedly-selling-79-unregistered-crypto-securities-xrp-dogecoin-shiba-inu/;https://www.mondaq.com/unitedstates/fin-tech/1129220/is-crypto-a-currency-or-security-litigation-involving-the-sec-may-provide-guidance (Last Access Date: 04/04/2022).