SEC Crypto Proposal Wouldn’t Clear Up Howey Ruling’s Uncertainty
The Securities and Exchange Commission’s proposed “Regulation Crypto Assets,” announced on Aug. 18, seeks to create a workable federal framework for crypto offerings. It would establish tailored exemptions, require token-specific disclosures, and provide a mechanism whereby trading in tokens can eventually stop being treated as securities transactions.
The proposal shows the SEC can define the asset class with precision, but it retains the source of uncertainty it aims to clear up. That’s because the proposal builds atop the US Supreme Court’s 1946 opinion in SEC v. W.J. Howey Co., a case involving orange groves and “investment contracts,” the catchall category of securities.
Building a permanent regime for continuously traded fungible assets on investment contracts is a choice Howey’s own facts undercut. To see why, suppose the Howey investment contracts were subjected to Regulation Crypto Assets. What would happen to the oranges?
In Howey, purchasers acquired interests in citrus acreage and entered service contracts under which Howey-in-the-Hills cultivated, harvested, and marketed the fruit. The purchasers sought profits from Howey’s work, not the opportunity to farm their own parcels.
The Supreme Court held that the arrangements were investment contracts and therefore securities. It didn’t hold that the land, trees, or oranges were securities. Those assets were the subject of the investment contract but existed independently of it. Once an orange entered commerce, a produce dealer didn’t need to determine whether it came from a Howey grove before reselling it.
The SEC’s proposal takes a different approach. It applies where a crypto asset isn’t itself a security but is subject to an investment contract. Under the agency’s interpretation, secondary-market sales of the crypto asset remain securities transactions until the asset separates from the issuer’s promises to undertake “essential managerial efforts.” The issuer can establish that separation under the proposal by completing or permanently ceasing those efforts and filing a certification to that effect.
Applied to Howey, the cultivation and marketing arrangement would be the investment contract, and the oranges would be the subject assets. Although the oranges wouldn’t themselves be securities, they would remain subject to the investment contract while Howey performed the promised managerial efforts. A secondary sale during that period would consequently be treated as a securities transaction. And a produce wholesaler might himself have to register with the SEC as a securities dealer.
To avoid that, the wholesaler would need to ask unfamiliar questions: Did this orange originate in a Howey grove? Was it distributed pursuant to the investment contract? Which services did Howey promise? Have those services been completed or abandoned? Has Howey filed the required certification, and was it accurate?
The problem becomes clearer when Howey’s oranges are stored with identical oranges grown by independent farmers. Nothing about the fruit reveals its legal provenance. If securities-law treatment follows the original transaction, physically identical and economically interchangeable oranges may have different legal statuses. Once commingled, purchasers can’t determine which is which.
All this resembles the problem facing a trading venue handling fungible tokens. Units of the same crypto asset may have been mined, distributed in airdrops, issued offshore, earned as rewards, or acquired in other transactions that never involved an investment contract. But the blockchain doesn’t encode the legal theory governing each unit’s original distribution. If legal status follows provenance, and provenance can’t be observed at the point of trade, the asset’s status can’t reliably be determined either.
The SEC would reasonably respond that crypto assets differ from oranges. An orange has an obvious use and value independent of its grower. A token’s functionality, adoption, and value may continue to depend on a developer’s work. A secondary purchaser may therefore rely on the developer’s promises despite having no contractual relationship with it.
That distinction doesn’t resolve the issue. Many non-security assets derive value from an identifiable person’s continuing activities. Art depends partly on the artist’s reputation and future work. Franchised products depend on brand management. Mobile phones are more valuable because of the manufacturer’s ongoing bug fixes and regularly restocked app store. Economic reliance on someone else’s efforts doesn’t by itself establish that a purchaser entered a securities transaction.
Howey aimed to prevent promoters from evading securities laws through novel arrangements, and so the case sensibly defined “investment contract” as a flexible tool. That flexibility is needed when regulators confront unusual schemes. It is less suitable as the organizing principle for a permanent framework governing fungible assets traded continuously on organized markets.
The new proposal demonstrates that crypto assets are no longer indescribable novelties. The SEC defines crypto assets, networks, and applications; addresses airdrops, governance, and token economics; and prescribes tailored disclosures. Having shown that the asset class can be described, the commission could regulate it by description rather than build a new system on an 80-year-old catchall.
A better framework would establish objective conditions under which specified crypto assets and transactions are subject to the federal securities laws. Relevant conditions might include the purchasers’ enforceable rights, the developer’s continuing financial interest and control, and the asset’s economic function. Sales that benefit the developer could trigger ongoing information filing obligations for some period without subjecting transactions in the asset itself to securities regulation. And intermediaries should be entitled to rely on public filings unless they know those filings are materially false.
This wouldn’t abandon investor protection or permit promoters to avoid liability by calling securities “utility tokens.” Howey should remain available to identify schemes that function as securities offerings despite their unconventional forms. It shouldn’t determine the status of every later transfer of a separate fungible asset.
The thought experiment reveals the category error. Securities regulation should follow the investment arrangement, not the orange indefinitely through the produce market. The SEC should define the asset and regulate the developer’s capital raise, but allow the orange to remain an orange.
This article does not necessarily reflect the opinion of Bloomberg Industry Group Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.
Author Information
Joseph A. Hall is a partner at Davis Polk & Wardwell, where he advises numerous companies in the digital asset space.
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