Crypto and securities: New interpretation of US Howey test gaining ground

The crypto community celebrated a victory in court on January 30, when the U.S. Securities and Exchange Commission (SEC) admitted in an LBRY hearing that the secondary sales of its LBC coin were not a sale of securities. John Deaton, a friend of the court, or amicus curiae in this case, was so excited that he created a video for his CryptoLawTV Twitter channel that evening.

Deaton, amicus curiae in the Ripple case, recounted a conversation he had with the judge that day. “Listen, let’s not pretend. Secondhand sales are a problem,” then “I told him about the Lewis Cohen article,” Deaton says. remembered.

Deaton was referring to The Inevitable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities by Lewis Cohen, Gregory Strong, Freeman Levin, and Sarah Chen of the law firm Cohen co-founded DLx. Deaton had praised the document earlier in November 2022 when it was featured in a Ripple case in which Cohen is also amicus curiae.

There is a growing hype around the newspaper. This appeared in the Social Science Research Network Preprint Repository on December 13. When Cryptooshala spoke to Cohen in mid-January, he said the document was the most downloaded in the securities law category on the website, with 353 downloads in about a month. Over the next two weeks, that number more than doubled. The paper has also attracted the attention of mainstream and legal media and cryptocurrency-related podcasts. Its unusual name is a tribute to James Joyce. Ulysses.

Cohen’s paper takes a close look at one of the timeless proverbs of cryptocurrency securities law: securities are not oranges. This refers to the Howey test, established by the US Supreme Court in 1946 for the identification of securities. The paper provides an exhaustive study of the Howey test and proposes an alternative to how the test is currently applied.

When Howie Met Cohen

Not everyone favors the application of the Howey test to cryptoassets, often arguing that the test is better suited for prosecution of fraud cases than for registration assistance. Cohen himself agreed with this position in the podcast of February 3. However, the authors of the article do not dispute the use of the Howey test, which arose as a result of the orange groves case, in relation to crypto assets.

A brief summary cannot come close to reflecting the breadth of the article’s analysis. The authors discuss SEC policy and cases related to cryptocurrencies, relevant precedents, securities and exchange laws, and blockchain technology in just over 100 pages and appendices. They reviewed 266 federal appeals court and Supreme Court decisions — all relevant cases they could find — to reach their conclusions. They invite the public to add any other relevant cases to their LexHub GitHub list.

The Howey test consists of four elements, often referred to as prongs. According to the test, a transaction is a security if it is (1) an investment of money, (2) in a common enterprise, (3) with a view to profit, or (4) must be obtained through the efforts of others. . All four test conditions must be met and the test can only be applied retrospectively.

Cohen and co-authors argue, in the most general terms, that “fungible cryptoassets” do not meet the definition of a security, with the rare exception of those that are inherently securities. This understanding is reflected in the proverb about oranges.

The authors of the article continue that the supply of cryptoassets in the primary market may be Howey’s security. However, they note: “To date, Telegram, Kik, and LBRY are the only well-informed and resolved cases involving the fundraising sale of cryptocurrencies.”

They were referring to the SEC lawsuit against messaging service Telegram, alleging that its initial $1.7 billion coin offering was an unregistered securities offering that was ruled in favor of the SEC in 2020. The SEC case against Kik Interactive also involved a token sale and was decided in favor of the SEC in 2020. The SEC also won a non-registered securities sale case against LBRY in 2022.

LBRY Implications: Implications of the Ongoing Cryptocurrency Regulatory Process

The newspaper’s biggest innovation is its views on crypto asset transactions in the secondary markets. The authors argue that the Howey test should be re-applied to sales of crypto assets on secondary markets such as Coinbase or Uniswap. The authors write:

“Securities regulators in the US have been trying to solve many of the problems that have arisen with the advent of cryptoassets. […] typically by applying the Howey test to transactions in these assets. However, […] Regulators have gone beyond existing jurisprudence by suggesting that most fungible crypto assets are “securities” themselves, giving them jurisdiction over nearly all activities that occur with those assets.”

The authors argue that cryptoassets, for the most part, will not meet Howey’s definition of a secondary market. Mere ownership of an asset does not create “a legal relationship between the owner of the token and the person who deployed the smart contract that creates the token or raised funds from other parties through the sale of tokens.” Thus, secondary transactions do not meet the second aspect of Howey, which requires a third party.

The authors conclude, based on their comprehensive review of Howey-related decisions:

“In the law relating to “investment contracts”, there is no basis for classifying most fungible crypto assets as “securities” when transferred in secondary transactions, since there is usually no investment contract transaction.”

What does all of this mean

The effect of the article’s argument is to separate the issuance of a token from its transaction in the secondary market. The document states that the creation of a token can be a securities transaction, but subsequent transactions will not necessarily be securities transactions.

Sean Coughlin, director of the law firm Bressler, Amery & Ross, told Cryptooshala: “I think he [Cohen’s] taking into account the fact that the releases [of tokens] will be regulated and he is trying to suggest a way how to do it [a token] trade uncontrollably.

Coughlin’s colleague, Christopher Vaughan, had reservations that the paper was “disingenuous” in places.

He said: “This ignores the reality that everyone who has ever traded in cryptocurrencies knows, which is that these liquidity pools and these decentralized exchange transactions do not happen if they are not supported by the token issuer.”

However, Vaughan praised the paper, saying, “I wish this was the cornerstone of cryptocurrency.”

John Montague, an attorney at digital asset Montague Law, told Cryptooshala that custodial issues could complicate Cohen’s argument, especially how self-custody of cryptoassets affects Howey’s investment side.

Montagu acknowledged the high quality of the paper’s scholarship, calling it:

“Perhaps the most monumental thought in the industry regarding securities law, […] definitely since Hester Pierce offered a safe harbor.”

In his final version of the proposal, SEC Commissioner Pierce proposed network developers receive a three-year exemption from the registration provisions of the federal securities law to “promote the participation and development of a functional or decentralized network.”

Recent: Cryptocurrency and Psychedelics: Clarifying Rules Could Help Industries Grow

“What I like about the world of crypto is that it is hostile,” Cohen told Cryptooshala. He said he hoped to “raise the level of discussion” with the newspaper. She did not meet with much resistance in public opinion. Although there were manifestations of cynicism.

“You are a novelist. You have found a character in cryptocurrency that is best explained by law,” said one network developer. commented on Twitter.

“Smart legal opinions rarely change the mind of the SEC or court cases.” – Head of Financial Services said is LinkedIn.

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