Tag Archives: howey

Decentralized Transactions Challenge Howey Test’s Application to NFTs

Decentralized Transactions Challenge Howey Test’s Application to NFTs
  • The key question is whether NFTs meet the Howey test criteria for classification as securities under federal laws.
  • In the NFT industry, adopting best practices includes transparency, fraud prevention, respecting intellectual property, and ethical conduct.

Non-fungible tokens (NFTs) are unique digital assets that can represent anything from art and music to virtual land and gaming items. They have exploded in popularity and value in recent years, attracting the attention of celebrities, investors, and regulators alike. The legal status of NFTs remains unclear and controversial, especially in the United States, where the Securities and Exchange Commission (SEC) has the authority to regulate securities and protect investors from fraud and manipulation.

One of the key questions that arises is whether NFTs are securities under the federal securities laws, and specifically, whether they meet the criteria of the Howey test, the legal framework established by the Supreme Court in 1946 to determine whether an instrument is an investment contract and thus a security. Howey test has four elements, I will argue that NFTs are not securities. On top of that, I will also address some of the counterarguments and challenges that NFTs may face in the future, and suggest some possible solutions and recommendations for the industry and the regulators.

NFTs are not investments of money, but rather purchases of digital goods

The first element of the Howey test is whether there is an investment of money or something of value in exchange for the instrument. This element is usually easy to satisfy, as most financial transactions involve some form of payment. However, in the case of NFTs, the payment is not an investment, but rather a purchase of a digital good.

They are not shares, bonds, or derivatives that represent a claim or a right to a future cash flow or a share of profits. Rather, they are digital tokens that prove ownership and authenticity of a unique digital asset. In my point of view, they are similar to other digital goods, such as e-books or music downloads, that consumers buy for personal use and enjoyment, not for investment purposes.

NFTs are not common enterprises, but rather individualized and decentralized transactions

The second element of the Howey test assesses the presence of a common enterprise, where investors’ fortunes are tied to the success of an issuer or third party. However, in the case of NFTs, no such common enterprise exists. Transactions are decentralized and individualized, with various artists and creators minting NFTs across different blockchain networks like Ethereum or Solana. NFT buyers rely on blockchain‘s public ledger to verify authenticity, rather than trusting a specific issuer or promoter.

NFTs do not generate profits, but rather subjective value and utility

The third element of the Howey test concerns whether there’s a reasonable expectation of profits. Unlike traditional investments, NFTs don’t generate income or appreciate based on others’ efforts. Instead, their value comes from subjective qualities like rarity, originality, and cultural significance, rather than anticipated financial returns. NFT buyers don’t expect profits but rather value the assets for their intrinsic qualities and utility.

NFTs are not dependent on the efforts of others, but rather on the creativity and innovation of the creators and the community

The fourth element of the Howey test examines whether profits stem from the efforts of others. Unlike traditional securities, NFT profits aren’t reliant on issuer or third-party services. NFT value is driven by the creativity and innovation of artists and developers, not centralized platforms. Buyers assess and appreciate digital assets based on personal judgment, rather than external influences.

Counterarguments and challenges

Despite the arguments in favor of NFTs, potential challenges from regulators and courts may arise in the future. One such challenge is the classification of certain NFTs as securities under regulatory tests like the Howey or Reves tests. Depending on their characteristics, some NFTs could represent real-world assets or rights, potentially falling under the definition of securities, especially if they promise future cash flows or resemble investment instruments.

Moreover, even if NFTs don’t meet all elements of the Howey test, they might still be deemed securities through a flexible analysis. For instance, if they are marketed as investments or show characteristics of speculative opportunities, they could create expectations of profit, thus falling under securities regulations. Additionally, if buyers pool funds or share risks and rewards, or if the NFTs’ value depends on underlying asset performance, regulators might consider them securities.

Furthermore, beyond securities laws, NFTs could be subject to various other regulations based on their nature and function. Anti-money laundering and sanctions regulations might apply if NFTs facilitate illicit transactions. Tax regulations could come into play if NFT transactions generate taxable income or capital gains. Consumer protection laws might be relevant if NFTs involve deceptive practices or breach contracts. Intellectual property regulations could be triggered if NFTs infringe upon original creators’ rights.

My take: Possible solutions and recommendations

Given the uncertainty and complexity of the legal landscape surrounding NFTs, it is important for the industry and the regulators to work together to find possible solutions and recommendations that can balance the interests and needs of all the stakeholders. Here are some suggestions from me that may help to achieve this goal:

  • Industry stakeholders should adhere to best practices and standards to improve transparency, accountability, and compliance in the NFT market. This includes clear disclosure of terms and conditions for NFT transactions, implementing measures to prevent fraud and illegal activities, and respecting intellectual property rights. Additionally, they should engage in responsible and ethical behavior, avoiding harm to the environment, society, or public interest.
  • Regulators should adopt a flexible approach to regulate the diverse NFT market. Avoiding overly restrictive frameworks is crucial to foster innovation and growth. Recognizing nuances among NFT types and consulting with industry and community for feedback is essential. Continuous monitoring and evaluation of market evolution are necessary to update policies accordingly.

Conclusion

NFTs are a new and exciting phenomenon that has revolutionized the digital economy and culture. They offer unprecedented opportunities and challenges for the creators, consumers, and regulators of the digital assets.

The legal status and implications of NFTs are still unclear and uncertain, and may vary depending on the facts and circumstances of each case. Therefore, it is important to understand and address the potential legal issues and risks that may arise from the creation, distribution, and consumption of NFTs, and to seek appropriate solutions and recommendations that can foster a healthy and sustainable NFT market.

 

Source: https://www.financemagnates.com/cryptocurrency/decentralized-transactions-challenge-howey-tests-application-to-nfts/

Anndy Lian is an early blockchain adopter and experienced serial entrepreneur who is known for his work in the government sector. He is a best selling book author- “NFT: From Zero to Hero” and “Blockchain Revolution 2030”.

Currently, he is appointed as the Chief Digital Advisor at Mongolia Productivity Organization, championing national digitization. Prior to his current appointments, he was the Chairman of BigONE Exchange, a global top 30 ranked crypto spot exchange and was also the Advisory Board Member for Hyundai DAC, the blockchain arm of South Korea’s largest car manufacturer Hyundai Motor Group. Lian played a pivotal role as the Blockchain Advisor for Asian Productivity Organisation (APO), an intergovernmental organization committed to improving productivity in the Asia-Pacific region.

An avid supporter of incubating start-ups, Anndy has also been a private investor for the past eight years. With a growth investment mindset, Anndy strategically demonstrates this in the companies he chooses to be involved with. He believes that what he is doing through blockchain technology currently will revolutionise and redefine traditional businesses. He also believes that the blockchain industry has to be “redecentralised”.

www.anndy.com
j j j

Reimagining the Howey Test for the digital age of cryptocurrencies

Reimagining the Howey Test for the digital age of cryptocurrencies

In the case of the stablecoin, BUSD, which is issued by the cryptocurrency exchange, Binance. In February 2021, Binance was reportedly under investigation by the CFTC (Commodity Futures Trading Commission) to determine whether it had violated U.S. rules by allowing Americans to buy and sell derivatives that are linked to digital tokens. Shortly after, it was reported that the SEC was also investigating Binance, specifically with regard to the issuance of the BUSD stablecoin.

This conversation started again this week. According to a press release on Monday, Paxos, the issuer of the stablecoin Binance USD (BUSD), has acknowledged receiving a Wells Notice from the U.S. Securities and Exchange Commission (SEC), indicating a possible enforcement action. The SEC’s charge is that BUSD constitutes an unregistered security, despite Paxos claiming it is not. BUSD is a stablecoin pegged to the U.S. dollar, and Paxos has stated that it is always backed 1:1 with U.S. dollar-denominated reserves, held in segregated accounts, and bankruptcy remote. Paxos also emphasized that the Wells Notice only pertains to BUSD and not any other part of its business. It is mentioned that they are prepared to litigate if necessary. Paxos also announced earlier that it would stop issuing new BUSD tokens at the direction of the New York Department of Financial Services (NYDFS), which CoinDesk reported on. The NYDFS is currently investigating Paxos.

Stablecoins are a type of cryptocurrency that is designed to maintain a stable value relative to another asset, such as the U.S. dollar. They are often used to facilitate transactions on cryptocurrency exchanges or to provide a stable store of value for users of cryptocurrency wallets. In the case of BUSD, the SEC is reportedly investigating whether the stablecoin qualifies as a security under U.S. law. If the SEC determines that BUSD is a security, the issuer could be subject to regulatory requirements under federal securities laws.

The BUSD case highlights U.S. authorities’ continued regulatory scrutiny of the cryptocurrency industry, as well as the potential for stablecoins to be considered securities under the Howey test. I honestly think that BUSD is not a security. This should be a firm stand from all parties as nobody would expect a profit from having BUSD. I will walk you through my thoughts.

Howey Test in 1946

The Howey Test is a legal test used in the United States to determine whether a transaction qualifies as an “investment contract,” which is a type of security that is subject to regulation under federal securities laws. The test is named after the 1946 U.S. Supreme Court case SEC v. W.J. Howey Co., which established the framework for evaluating whether an investment contract exists.

Under the Howey Test, a transaction is considered an investment contract if it involves:

1. An investment of money

2. In a common enterprise

3. With an expectation of profits

4. That are derived solely from the efforts of others

If a transaction satisfies all four prongs of the Howey Test, it is considered an investment contract and subject to federal securities laws, including registration requirements and antifraud provisions.

It’s worth noting that the “common enterprise” prong of the Howey Test has been broadly interpreted by courts to include various arrangements, including cryptocurrency and other digital asset offerings. In recent years, the SEC has applied the Howey Test in several high-profile cases involving digital assets, including initial coin offerings (ICOs) and various types of token sales.

The Howey Test is an important tool for determining whether a transaction qualifies as a security and is used by regulators, investors, and businesses alike to navigate the complex and evolving world of securities laws.

Debate on cryptocurrencies are securities

The question of whether cryptocurrencies are securities under U.S. law has been a topic of much debate and uncertainty. The Securities and Exchange Commission (SEC) has taken the position that some cryptocurrencies may be considered securities if they meet the criteria established by the Howey Test.

In 2017, the SEC issued a report stating that the offering of certain cryptocurrencies and initial coin offerings (ICOs) may be subject to federal securities laws. The report emphasized that whether a particular investment transaction involves the offer or sale of a security depends on the facts and circumstances of that transaction, and the application of the Howey Test.

The SEC has also brought enforcement actions against certain cryptocurrencies and ICOs that it considers to be securities. Another example, in 2018, the SEC charged two cryptocurrency companies with conducting unregistered securities offerings. The companies had offered and sold digital tokens that were deemed to be securities because they met the Howey Test’s criteria.

Despite this, the application of the Howey Test to cryptocurrencies is still a matter of debate, with many in the cryptocurrency industry arguing that it is not applicable to digital assets. Some have argued that cryptocurrencies should be considered a new asset class that does not fit within the traditional definitions of securities, commodities, or currencies.

In response to the uncertainty, some countries have sought to establish clearer regulatory frameworks for cryptocurrencies. In 2019, the Swiss Financial Market Supervisory Authority (FINMA) published guidelines that outlined the regulatory framework for digital assets in Switzerland. The guidelines aimed to provide clarity on the classification and treatment of digital assets for financial institutions and other market participants in the country.

According to the FINMA guidelines, digital assets are divided into three categories: payment tokens, utility tokens, and asset tokens. Payment tokens are defined as digital assets that are primarily used as a means of payment, such as Bitcoin or Litecoin. Utility tokens, on the other hand, are digital assets that provide access to a specific product or service, such as a digital ticket or a token that grants access to a particular platform. Finally, asset tokens are digital assets that represent assets such as real estate, company shares, or other physical or financial assets.

Each of these three categories of digital assets is subject to different regulatory requirements in Switzerland. Payment tokens, for example, are not considered to be securities under Swiss law, and as such, they are not subject to the same regulatory requirements as securities. However, financial institutions that provide payment services with payment tokens must comply with the country’s anti-money laundering regulations.

Utility tokens are not considered to be securities if they meet certain conditions, such as being redeemable for services or products on a platform, but not tradable on secondary markets. If these conditions are not met, utility tokens may be considered securities and subject to Swiss securities regulations.

Asset tokens are generally considered to be securities under Swiss law, and as such, they are subject to the country’s securities regulations. This includes complying with rules around prospectus requirements, disclosure obligations, and registration with the authorities.

The guidelines provided by FINMA have helped to clarify the regulatory treatment of digital assets in Switzerland. By defining clear categories of digital assets and outlining the corresponding regulatory requirements, the guidelines have provided greater certainty and stability for market participants in the country’s digital asset industry.

Such clarify is essential. To me, the application of the Howey Test to cryptocurrencies is still a matter of debate, it is clear that the SEC has taken the position that some cryptocurrencies may be considered securities if they meet the criteria established by the Howey Test. As such, cryptocurrency issuers and investors must be aware of the potential implications of the Howey Test and ensure that their transactions are compliant with applicable securities laws.

Modern-day application of Howey Test on Cryptocurrencies

As the cryptocurrency industry has evolved, questions have arisen as to whether the Howey Test is still applicable in the modern-day context of cryptocurrencies. To address this issue, some experts have proposed a modern-day version of the Howey Test that takes into account the unique characteristics of digital assets.

The proposed modern-day version of the Howey Test for cryptocurrencies would include several factors. The first factor would be whether there is an investment of money. If a digital asset issuer has not sold any assets issued to build its project, it is unlikely to be considered a security.

The second factor would be whether there is an expectation of profits from the investment. If the digital asset is utility-based, such as being used for voting purposes, it is unlikely to be considered a security.

The third factor would be whether the investment of money is in a common enterprise. If the project is decentralized and not controlled and operated by a centralized entity, it is unlikely to be considered a security.

Finally, the fourth factor would be whether any profit comes from the efforts of a promoter or third party. If the profit primarily comes from the community, which has nothing to do with the issuance of the digital asset, it is unlikely to be considered a security.

Adapting Howey Test to better fit Cryptocurrencies

Adapting the Howey Test to fit the unique characteristics of cryptocurrencies better is a complex issue, and there is an ongoing debate among legal experts and regulators on how to do so. However, some potential ways to improve the test’s application to cryptocurrency include:

Examining the underlying technology: One potential approach is to look at the underlying technology of a cryptocurrency and evaluate whether it is sufficiently decentralized and functional to qualify as a utility token rather than a security. For example, suppose a token is used primarily to access a particular blockchain network or platform, and its value is tied to its utility rather than speculation. In that case, it may be less likely to be considered a security.

Considering the role of promoters and third parties: Another potential approach is to examine the extent to which promoters or third parties play a role in the development and promotion of a cryptocurrency. If a token’s value is primarily driven by the efforts of a centralized entity or individual, rather than the broader community of users, it may be more likely to be considered a security.

Focusing on the economic reality of the transaction: Rather than relying on a strict application of the four-pronged Howey Test, some legal experts have suggested that a more flexible approach may be needed to assess whether a particular cryptocurrency is a security. This could involve looking at the economic reality of the transaction and considering a range of factors, including the nature of the token, the purpose of the transaction, and the expectations of the parties involved.

In conclusion, while the Howey Test has been a useful reference point for determining whether an investment qualifies as a security, it is not a perfect fit for the unique characteristics of cryptocurrencies. Cryptocurrencies, especially those that are decentralized, often have features that do not align with traditional securities, and thus may not meet the criteria outlined in the Howey Test. As the cryptocurrency industry continues to evolve, there is a growing need for regulatory frameworks that are tailored specifically to the unique nature of digital assets. While the Howey Test can serve as a starting point, it is important to adapt and refine the rules to better reflect the realities of the cryptocurrency market. It is clear that cryptocurrency is a new and rapidly developing asset class that requires careful consideration when applying traditional securities laws. A more nuanced and flexible approach is needed to ensure that innovation is not stifled while at the same time protecting investors from fraudulent activities.

Coming back to my first point- BUSD is not a security. BUSD is primarily used as a means of payment, rather than as an investment vehicle, and it is not designed to generate profits for investors in the same way that traditional securities do. The price of BUSD is intended to be stable and is tied to the value of the US dollar, rather than being subject to the speculative forces that often drive the prices of other cryptocurrencies. Let’s stick to this.

 

Source: https://www.financialexpress.com/blockchain/reimagining-the-howey-test-for-the-digital-age-of-cryptocurrencies/2992092/

Anndy Lian is an early blockchain adopter and experienced serial entrepreneur who is known for his work in the government sector. He is a best selling book author- “NFT: From Zero to Hero” and “Blockchain Revolution 2030”.

Currently, he is appointed as the Chief Digital Advisor at Mongolia Productivity Organization, championing national digitization. Prior to his current appointments, he was the Chairman of BigONE Exchange, a global top 30 ranked crypto spot exchange and was also the Advisory Board Member for Hyundai DAC, the blockchain arm of South Korea’s largest car manufacturer Hyundai Motor Group. Lian played a pivotal role as the Blockchain Advisor for Asian Productivity Organisation (APO), an intergovernmental organization committed to improving productivity in the Asia-Pacific region.

An avid supporter of incubating start-ups, Anndy has also been a private investor for the past eight years. With a growth investment mindset, Anndy strategically demonstrates this in the companies he chooses to be involved with. He believes that what he is doing through blockchain technology currently will revolutionise and redefine traditional businesses. He also believes that the blockchain industry has to be “redecentralised”.

www.anndy.com
j j j

Modern-Day Version of Howey Test For Cryptocurrencies- How Does It Look Like?

Modern-Day Version of Howey Test For Cryptocurrencies- How Does It Look Like?

Howey test, which the Securities and Exchange Commission uses to decide whether a digital asset should be classed as a security, has certain limitations, according to SEC Commissioner Hester Peirce. I can relate to this statement very much. I felt the same way too, especially when they used the same framework for cryptocurrencies. I will walk you through my thoughts on what should the modern-day version look like.

What is Howey Test?

The Howey test is used by the U.S. Securities and Exchange Commission (SEC) to determine whether a particular financial product or transaction qualifies as an “investment contract.” If a product or transaction is deemed to be an investment contract, it is subject to certain regulatory requirements under federal securities laws.

The test is named after the 1946 Supreme Court case SEC v. W.J. Howey Co., in which the Court established a four-part test to determine whether a transaction qualifies as an investment contract:

1.         It involves an investment of money

2.         There is an expectation of profits from the investment

3.         The investment of money is in a common enterprise

4.         Any profit comes from the efforts of a promoter or third party

If all four of these criteria are met, the transaction is considered an investment contract and is subject to regulation as a security.

What is a Security?

Before we look further, let’s look at what is a security. A security is a financial instrument representing an ownership position in a publicly traded corporation (stock), a creditor relationship with a governmental body or a corporation (bond), or rights to ownership as represented by an option.

There are several types of securities, including:

1.         Stocks: Stocks represent ownership in a company and entitle the holder to a share of the company’s profits.

2.         Bonds: Bonds are a type of debt security that involves borrowing money from an investor for a set period of time at a fixed interest rate.

3.         Options: Options are a type of derivative security that gives the holder the right, but not the obligation, to buy or sell a specific asset at a predetermined price within a specific time frame.

4.         Mutual funds: Mutual funds are investment vehicles that pool money from multiple investors and use that money to buy a diversified portfolio of stocks, bonds, or other securities.

5.         Exchange-traded funds (ETFs): ETFs are investment funds that are traded on stock exchanges, much like stocks. They typically track an index, such as the S&P 500, or a specific sector or theme.

6.         Derivatives: Derivatives are financial instruments that are derived from other assets, such as stocks, bonds, commodities, or currencies. They are used to hedge risk or speculate on the price movements of the underlying asset. Examples of derivatives include futures, options, and swaps.

Howey Test Applied to Cryptocurrencies

The Howey test is a well-established legal test used for decades to determine whether a financial product or transaction qualifies as an investment contract and is subject to regulation as a security. While the test was originally developed in the context of traditional securities, it has also been applied to cryptocurrency and initial coin offerings (ICOs).

The four-part test established by the Howey case has generally been applied to cryptocurrency in the same way as it has been used to traditional securities. However, there may be some nuances or specific considerations that apply specifically to cryptocurrency when applying the Howey test.

For example, the first prong of the test, which requires an investment of money, may be satisfied by the purchase of a cryptocurrency using fiat currency (such as U.S. dollars) or by the exchange of one cryptocurrency for another.

The second prong, which requires an expectation of profits, may be satisfied by the potential appreciation of the cryptocurrency’s value or by the ability to earn returns through the use of the cryptocurrency in a particular platform or network.

The third prong, which requires the investment of money to be in a common enterprise, may be satisfied by the pooling of resources or the use of a shared infrastructure or platform.

The fourth prong, which requires any profits to come from the efforts of a promoter or third party, may be satisfied by the involvement of a central authority or the use of a decentralized autonomous organization (DAO) to manage the cryptocurrency or ICO.

Modern-Day Version of Howey Test for Cryptocurrencies

The above pointers may sound familiar to you. You are a project owner and have spoken to a lawyer before; this is the same advice they gave you. My question now is, since the state of play in cryptocurrencies are changing rapidly, should there be an adapted version for the modern day?

The modern-day version might look something like this:

1.         Is there an investment of money?

If the crypto digital asset issuer has not sold any assets issued to build its project. It is most likely not considered a security.

2.         Is there an expectation of profits from the investment?

If the crypto asset is utility-based, for example, it is used for voting purposes. It is most likely not considered a security.

3.         Is the investment of money in a common enterprise?

If the project is decentralized, it is not controlled and operated by a centralized entity. It is most likely not considered a security.

4.         Are any profit comes from the efforts of a promoter or third party?

If the profit primarily comes from the community which has nothing to do with the issuance of the crypto asset. It is most likely not considered a security.

Reminding all again, when all four criteria are met, the investment is considered a security and is subject to regulatory requirements of the Securities Act of 1933. The application of the Howey test to cryptocurrency may involve considering the specific characteristics and features of the particular cryptocurrency or ICO in question, as well as the broader market and regulatory context in which it operates.

Take some time to do a self-evaluation based on the above thoughts shared. If you have time, you can ask yourself these questions about the tokens you invested. This is a good exercise for self-reference. I am not a lawyer, and none of the written content is formal advice.

“If you are a retail crypto investor- Do your crypto research. Learning about the regulation side of things can help you with your investment decision, avoiding unnecessary issues down the road.

If you are a project and you claim to be decentralized. Please stay decentralized. This will also avoid getting into any regulatory problems.” – Anndy Lian

 

 

Source: https://www.benzinga.com/22/12/30205466/modern-day-version-of-howey-test-for-cryptocurrencies-how-does-it-look-like

Anndy Lian is an early blockchain adopter and experienced serial entrepreneur who is known for his work in the government sector. He is a best selling book author- “NFT: From Zero to Hero” and “Blockchain Revolution 2030”.

Currently, he is appointed as the Chief Digital Advisor at Mongolia Productivity Organization, championing national digitization. Prior to his current appointments, he was the Chairman of BigONE Exchange, a global top 30 ranked crypto spot exchange and was also the Advisory Board Member for Hyundai DAC, the blockchain arm of South Korea’s largest car manufacturer Hyundai Motor Group. Lian played a pivotal role as the Blockchain Advisor for Asian Productivity Organisation (APO), an intergovernmental organization committed to improving productivity in the Asia-Pacific region.

An avid supporter of incubating start-ups, Anndy has also been a private investor for the past eight years. With a growth investment mindset, Anndy strategically demonstrates this in the companies he chooses to be involved with. He believes that what he is doing through blockchain technology currently will revolutionise and redefine traditional businesses. He also believes that the blockchain industry has to be “redecentralised”.

www.anndy.com
j j j