American justice recognizes not all tokens on the blockchain as securities

Over the past year, we have repeatedly witnessed how the SEC, in its characteristic manner, harshly and uncompromisingly waged war on the entire Blockchain industry. Today’s article is from the category “Don’t let your children go for a walk in Africa or which ICOs in the USA will be within the law.” To do this, let’s figure out what the Howey test is and why it is remarkable.

If you are young and talented, bursting with ideas, and suddenly decided to launch your own Blockchain startup, attracting investment from abroad, then be prepared for the fact that in many countries there have been fundamental changes in the legal sphere. And the United States, in this case, is the most intransigent from the point of view of the law, especially when it comes to protecting the investment rights of its own citizens.

It is the Howey Test that is the criterion in the process of preparing an ICO, which could hypothetically enter the American market.

We repeat that this test cannot be avoided in cases where, within the framework of the declared project, it is planned to attract funds from investors from the United States (citizens/residents), or conduct advertising and other commercial activities in the United States.

Before moving on to the description of the Howey Test, let's first remember what a Blockchain Token is. 

Blockchain Token is a certain digital asset that has its own value (material or intangible) expression and which can be obtained in exchange for fiat or digital money, for a certain activity, or free of charge according to the purpose of the token and the conditions of its distribution. 

Conventionally, tokens can be divided according to their functionality and features into the following:

- a product token (utility token), provided with a certain service or product from the issuer itself;

- a cryptocurrency token (coin token), which performs the function of a means of payment;

- a token-share and a token-bond (security token), which in their characteristics are as close as possible to valuable ones securities, since most often they give the right to a part of the profit of the company that issued them, less often - the right to vote in the company itself.

The latter will be discussed, since their issue, circulation and use for attracting investment funds, from the point of view of legislation, is considered the most scrupulous.

The legalization of such tokens requires a special approach, since they are subject to regulation of securities law, and their sale, for example, to US citizens requires mandatory registration with the Securities and Exchange Commission US exchanges (SEC). Moreover, either at the federal level or individually in each individual state, which has its own rules for registering securities, often called “blue sky laws”.. Some states, such as California, use a venture capital test, which primarily checks the reasons that motivate investors to invest their money and the risks associated with them.

Thus, the key question before starting an ICO in the event of entering the US market is to decide what exactly the token to be issued will be. And if in the future it can be classified as securities, as a subtype of an investment contract, then the lack of proper execution and permission from the SEC is considered a gross violation of local law and can lead to serious fines, including criminal liability.

As a general rule, all securities distributed in the United States must be registered with the Securities and Exchange Commission (SEC), unless an exception is provided. A company offering securities that are not exempt must register them. This process involves disclosing to the SEC such data as:

- a list of the company's property assets;

- a detailed description of the security proposed for issue and sale;

- information about the management and management of the company;

- the conclusion of independent and certified auditors on the financial position of the company.

In 2016, the cryptocurrency exchange Coinbase presented to the public on its official website a document entitled "Securities Law Relating to Blockchain Tokens", compiled in collaboration with Coin Center, Union Square Ventures and Consensys. In it, companies apply securities litigation and, above all, the so-called “Howey Test” to the new technology.

Since the United States has an Anglo-Saxon system of law based on judicial precedents, it becomes clear that such a term appeared much earlier, namely as a result of the SEC vs Howey trial in 1946.  In June 1945, Howey Company, a Florida citrus farm in Lake County, decided to sell half of its holdings to obtain additional financing... But since the buyers of these plots had neither experience nor knowledge in such a specific business as growing citrus fruits, they were offered to enter into a 10-year leaseback contract with the right to subsequently collect and sell part of the crop, which was later converted into a specific profit for the landowners.

The fact that Howey Co. failed to register these contracts with the US Securities and Exchange Commission (SEC), was found to be in gross violation of the Federal Securities Act of 1933, and the company was subject to an injunction preventing further sales of the sites. However, the company decided not to give up immediately and filed an appeal with the District Court for the Southern District of Florida, which overturned the previously imposed ban. However, in May 1946, the case went to the US Supreme Court, which upheld the SEC's decision, ruling that Howey's leaseback agreements were investments and therefore subject to securities law regulation. SEC vs Howey Co. Case formed the basis for further securities regulation by the SEC. The court decision introduced the term "Howey Test", which involves simple criteria for determining whether a transaction contains an investment agreement and, accordingly, whether such a transaction falls under the jurisdiction of the SEC with subsequent mandatory registration. With the growing "tokenization" of the IT society, the Howey Test was adapted by the head of Coin Center Peter van Valkenburg and resulted in an analytical product called "Fundamentals of Legal regulation of cryptocurrencies." In his work, Peter gave a detailed breakdown of exactly which cryptotokens fall under the concept of so-called book-entry securities within the meaning of Section 2(a)(1) of the US Securities Act as amended in 1933 (SECURITIES ACT OF 1933) and Section 3(a)(10) of the US Securities and Exchange Act as amended in 1934..

Unfortunately, the US Securities Act as amended in 1933 gave a rather vague concept of securities (security) for the ICO world: any bills, shares, own shares, stock futures, swaps with securities, debentures, bonds, debt documents, certificates of equity participation under any agreement on participation in the profits of an investment contract

However, with the beginning of the use of the Howey Test in relation to tokens, a special Coinbase questionnaire is gaining incredible popularity in 2016. When you pass it, points are awarded, and the fewer points you have, the less your token meets the definition of a security. This questionnaire collected a set of characteristics divided into three groups. Each of the groups is essentially the same three basic criteria of the Howey Test, which make it possible to evaluate tokens for correlation with securities:

— the fact of investing funds (both fiat and cryptocurrency, both real money and “dubious”);

— the fact of using investments in a “joint venture,” that is, for a common business with someone (the term “joint venture” in this case does not have a clear definition, therefore courts use different interpretations, most federal courts understand joint ventures as so-called horizontal enterprises, that is, enterprises in which a certain pool of investors invests their money);

— the fact of expecting or receiving profit from the actions of third parties (the final factor determining the result of the Howey Test is the extraction of profit, independent of the actions of the investor. If such profit is made, this may be the basis for recognizing the investment as a security. If the final result largely depends on the actions of the investor himself, such the investment is likely not a security).

In addition to the criteria for evaluating crypto tokens for attribution to securities, Coinbase also developed guidelines for creating tokens that would not be securities and could be considered like a license agreement or franchise agreement.. The holder of such a token would have the right to “contribute to the project”, and not just have a “passive investment interest”.

Here are examples of rights that can be assigned to a token outside the definition of securities:

- the right to program, develop or create sets of functions for the system;

- the right to connect to the system or license the system;

- the right to use the system or the results of its work;

- the right to sell products, created by the system;

- the right to vote on issues of expanding or reducing the characteristics and functionality of the system.

Summarizing all that has been said, we can confidently say that an investment that, even if not directly called a security (bond), can still be recognized by law as such. This in turn means that such an investment will be subject to appropriate registration and disclosure requirements. 

Since the creation of the Howey Test, some issuers have attempted to manipulate their tokens in an attempt to hide the true status of their securities in order to avoid registration requirements. However, both the courts and the SEC pay attention not to form, but to substance, and the key factor here has always been and remains the factor of extracting profit from an investment with the participation of third parties. If an investment generates profit solely through the actions of the investor himself, if such an investment is controlled by the investor, then it is more likely that you will not have problems with either the SEC or the law in the United States.