Can Cryptocurrencies Pass the “Howey Test”?

Blockchain is enjoying a moment in the spotlight, brought on by the rise of cryptocurrencies like Bitcoin and Ethereum that function as assets on a blockchain protocol. Decentralized applications, or Dapp (pronounced ‘dee-app’), are in early stages of development, but have extraordinary potential to revolutionize the way economic ecosystems grow and function removed from a centralized authority. Cryptocurrency models, which are open-source, peer-to-peer, and encrypted end-to-end, are likely the foundational pieces of the next phases of data storage, social media, and the internet as a whole.

But cryptocurrencies and decentralized ownership are raising difficult legislative and regulatory questions that have roots in an influential court case from the 1940’s, SEC v. Howey Co.

In 1946, a large Florida citrus farm called the Howey Company planned to lease half of its vast acreage “to finance an additional development”. Several local businessmen, anticipating a healthy return, signed the lease contract, establishing a speculative relationship: the Howey Company would work the land, while the investors, with no experience or ability farming citrus, provided the capital and became nominal land owners.

Unfortunately, the Howey Company neglected to notify the Securities Exchange Commission (SEC) of the arrangement, per the requirements of the 1933 Securities Act. Having violated federal law, the SEC issued an injunction, which was rebuffed by a Florida appeals court. A series of back-and-forth legal battles ended with the US Supreme Court ruling that Howey’s contracts were indeed investment contracts, and needed to be regulated as such.

SEC v. Howey Co. birthed the “Howey Test,” which is used to determine whether SEC jurisdiction over securities applies. The test defines the sale of a security as when a transaction’s value hinges on another’s work. This test is being applied to the most-pertinent blockchain questions, primarily because fundamental tenants of decentralized apps and tokens – anonymity, autonomy, decentralization – are rendered useless if crypto owners must register with the SEC.

Naturally, the Howey test has raised questions about coin ownership and initial coin offerings (ICOs). Coinbase, in collaboration with Coin Center, Consensys, and Union Square Ventures, recently issued a paper called “A Securities Law Framework for Blockchain Tokens”, addressing that question by advocating that all decentralized apps be designed in accordance with the Howey test. The paper includes guidelines for developing blockchain tokens within an open-source framework so they will not be regulated as securities.

The idea is that, if designed properly, blockchain tokens are the equivalent of a franchise agreement. Owners gain the right to contribute to a larger system by holding blockchain tokens – by classifying these tokens as a contract, “rather than a passive investment interest”, owners are not subjected to the legal rules that come with holding a security.

The paper’s pragmatic approach stands to pay dividends as Dapp technology evolves. By removing the legal intricacies that come with security ownership, decentralization can continue to grow efficiently and safely.