This is Howey Do it — Rethinking the Security

Malt Liquidity 123

Beyond hunting and gathering to collect food to eat or finding shelter to safely rest, speculation has been as innate to the human experience as just about anything else historically. From a simple transaction where one might lend to someone based on a recommendation of a friend to meticulous record keeping of weather patterns to predict when the next rainy season will come, speculation comes as a derivative of human curiosity. It logically follows that a simple question we might ask our parents endlessly as a child — “why” — leads to a similar question — “what happens? — that can be answered much more deeply with much more than words. In preparation for a long winter season, a farmer might stockpile grain for their family. Or, if one had a more profit-oriented motive in mind, as the famous Homer Simpson quote goes, one might invest in pumpkins: “They’ve been going up the whole month of October. And I got a feeling they’re going to peak right around January and that’s when I’ll cash in.”

As societies scaled and became more interconnected, the need for more formal market mechanisms arose. An obvious consideration was location, as a centralized place for every party that wanted to transact made more sense than arranging separate meetings with each interested party in case a deal fell through. Another obvious consideration was having some sort of neutral third party present to make sure that each person got what they paid for. By 1730, purportedly the concept of “futures markets” had been developed in Osaka, Japan, with rice sold in advance of subsequent harvests through “tickets” to guarantee a price against wild fluctuations between them. Beyond origin stories, this style of market definitively existed in the United States in Chicago during the 1850s, with the first corn future being sold at the Board of Trade in March 1851. However, speculation in Chicago wasn’t limited to just harvesters, merchants, or consumers. Anyone with money in their pocket who wanted to buy and sell contracts could do so, and thus arose the concept of a speculator in commodities as purely a trader who bought and sold contracts with no intention of taking delivery of the underlying rather than a merchant acquiring inventory or a farmer planning on offloading future harvests. In fact, this was necessary for a functioning market — the trader was a critical intermediary that provided liquidity for the producer and the acquirer to transact at their convenience.

Stocks and bonds predate the futures contract, perhaps because it’s what we colloquially think about as an “investment” as they’re much more straightforward. Stocks give you a stake in something (a.k.a. equity), while a bond is effectively a loan that you own the repayment rights to (a.k.a. debt). If you were alive in 1648, you could have bought a Dutch perpetual bond that still pays 5% to this day, a version of an issue that originated out of Venice in the 1100s. While these bonds were directly issued from the borrowers themselves, of course, the same concepts of centralization and transaction verification played a role in formal exchanges opening up, such as the New York Stock Exchange. The traders played the exact same role here as in the commodities market — the existence of their activity allowed investors to gain or reduce exposure in a more liquid fashion. Of course, the practice of trading stocks to make money off the short term movement rather than investing for the long-term was extremely popular, as highlighted in 1923 by “Reminiscences of a Stock Operator”, the definitive account of the infamous boom-and-bust trading career of Jesse Livermore.

In the aftermath of the Great Depression, there was a large push to regulate and monitor speculation more closely, as many powerful individuals naturally felt that manic speculation had accentuated the market collapse. This led to the creation of the Securities Act of 1933 (“1933 Act”), the Securities Exchange Act of 1934 (“1934 Act”), and the Securities and Exchange Commission (“SEC”) to enforce the Acts. While additional financial regulations have been codified over the years, these Acts, the SEC, and the associated caselaw remain largely influential on how securities are monitored. Of course, any “securities regulation” cannot be enforced without first answering a question: what exactly is a security?

There are definitions in the acts themselves. In the 1933 Act, a security is defined as

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing

which is largely replicated in the 1934 Act. The comprehensive definition covers stocks, bonds, and any related derivatives, but most notably, the term “investment contract” and the phrase “any interest or instrument commonly known as a security” are used as sort of a catch-all to allow regulation of any products deemed securities that weren’t originally defined. The landmark Supreme Court case SEC v. W.J. Howey Co. from 1946 created the aptly named Howey test that is still used to determine whether a transaction constitutes an investment contract and would thereby be subject to securities regulation. The Howey test states that a security exists if a person (1) invests his money (2) in a common enterprise (3) with the expectation of profit (4) solely from the efforts of the promoter or a third party.

It’s worth taking a glance at some rulings that are relevant to how we should think about the Howey elements to get a grasp on why we would bother with the “security” designation. When a transaction is being assessed under the Howey test, the court assesses the “economic reality” of the transaction rather than strictly adhering to elements. Different circuits have used varying interpretations of “common enterprise” by looking at how the risk is shared between investors and promoters. Sometimes courts have looked for investors to share risk with other investors, while others have assessed whether the promoter has skin in the game as well. Additionally, “Expectation of profit” can be combined with “solely from the efforts of others” although they are technically separated in the test from Howey itself. “Profit” could be anything from a direct payment of dividends to an increased value of the investment overall — essentially, it’s referring to an expectation of return on the investment. The “solely” language from the original Howey case has generally been interpreted as “primarily”, “substantially”, or “predominantly” from the efforts of others going forward, as otherwise a thorny situation might arise if investors participated in any way and exempted themselves from securities law protections.

Over the course of time after its creation, the Howey test has become the de facto method for assessing whether or not an offering qualifies as a security. It has held up when assessing sale-and-leaseback transactions with regards to payphones and private share sales of lumber businesses. Even when Initial Coin Offerings (ICOs) roared into vogue in the 21^st century as an investment opportunity structured well beyond anything dreamed up in 1946, Howey held up as recently as 2022 in SEC v. LBRY. In LBRY, the three-part Howey test was used to assess whether the LBC tokens LBRY sold to fund their ecosystem constituted a security. The token, beyond being mineable, was supposed to be utilized to “publish content”, create “channel[s]” for single users, pay tips, and more on the LBRY network. The SEC won summary judgment in New Hampshire District Court due to promotional statements made accompanying the sale of tokens and others made later referring to the market capitalization of the token ecosystem that obviously indicated an expectation of a return through LBC as the LBRY ecosystem continued to grow.

Think back to the original motivation for why the Securities Acts and the SEC were created in the first place: first, the government wants to prevent false, unrealistic promises that don’t quite amount to fraud (or other criminal conduct) from being marketed to investors without giving them some amount of protection, and second, they want to know what exactly is being offered as an investment and monitor it. The broadness of Howey and the discretion with which the SEC can use it should remain attached to those principles. Certainly, the ICO market was rife with sketchy activity, with an estimated ~$10 billion lost out of ~$15 billion raised according to one analysis. But many of the non-LBRY ICOs were prosecuted as fraud charges first and foremost by the SEC. The LBRY case indicated something different, in that the SEC was now motioning for and winning summary judgment against companies who were cognizant of the market capitalization attached to their tokens and made public statements referring to it in any way. In a weird way, it might have been worse if management had not commented on it at all from a business development standpoint as it could have signaled a lack of enthusiasm or awareness regarding the sentiment surrounding the company. Should company insiders be totally precluded from commenting on the fluctuating value of an attached token lest it be deemed a security?

Another concern about the LBRY ruling is that many things trade like a quasi-security but aren’t treated as such, especially in a high-tech age where designer shoes, luxury goods, and trading cards all have internet-based real-time candlestick charts and bid-ask platforms that enable their trading. A speculative purchase of a pair of limited edition Nike shoes could reasonably be thought of as a bet on the employees’ efforts to increase the brand’s reputation and appeal and be electronically traded in a similar manner to a token, yet the shoe will obviously never be treated as a security by the SEC even though counterfeit designer shoes and trading cards are regularly produced in quantities worth well above 8 figures to scam speculators. In fact, SEC Chair Gary Gensler himself struggles to distinguish between the purchase of a trading card and a tokenized trading card. If the tokenization aspect itself is treated differently and made to fall under Howey, it’s hard to see how any token with utility created by a company that fluctuates in value can avoid being categorized as a security by this interpretation if any comment is made by employees regarding the market capitalization of the coin or the future productivity of the ecosystem. Currently, this is how Gensler seems to be treating every cryptocurrency other than Bitcoin.

A few months after LBRY, a much bigger crack in Howey analysis was exposed in SEC v. Ripple. The SEC motioned for summary judgment once again by claiming that three types of XRP token sales — Institutional, Programmatic, and Other Distributions (e.g., employee sales or private transactions) — were unregistered securities offerings, while Ripple claimed the opposite. Interestingly, the SEC won on Institutional sales, but Ripple won on the others at the trial court level (and the decision is now under appeal to the Second Circuit). Certainly, the Howey elements were trivial to clear on the Institutional sales (which were to high-value, accredited investors) due to marketing materials Ripple used to tout XRP and how it would appreciate in value from the planned expansion of the Ripple ecosystem, thereby creating a common enterprise and an expectation of profit. However, the Programmatic sales (defined as trades made by Ripple into a market through blind auto-liquidation) are much more interesting, as the various buyers could not have known whether this money was flowing to Ripple directly due to the method of the transaction, so the Court could not determine the buyers’ intentions. After all, the Court cannot baselessly speculate on what the buyers were thinking. Many Programmatic buyers were not even aware of Ripple’s existence as a company and could not have known if Ripple was on the other side of the XRP transactions in question.

Intuitively, this is confusing, as how can something concurrently be a security and not a security? And, keeping in mind the original idea behind securities regulation, why would the wealthy, sophisticated institutional purchasers of XRP be protected by securities regulation but not the ordinary people buying it programmatically on the electronically traded, publicly available market? Think back to Jesse Livermore and the development and prominence of the market-agnostic day trader — does trading in and out of a market to make money imply an expectation of profits from the efforts of others or in the fact that other potential speculators (with indeterminable intentions) might reprice the market in one’s favor in the future? The point the Judge clearly made by distinguishing the types of sales is that the accredited investors that treated XRP like a security didn’t automatically make it a security for everyone transacting in XRP. Rather, each type of sale would need to be assessed “on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme”.

Note that this is not a situation that is specific to XRP transactions; this logic applies to the buyers of most “meme” cryptos that trade on electronic markets where the identity of the matched seller is not known (as is the case in a vast majority of traditional and cryptocurrency markets.) Take HarryPotterObamaSonic10Inu (“HPOS10i”) coin, for example, which, at the time of writing, has a market cap of over $100 million, or DogeCoin, which holds a market cap above $10 billion and a daily trading volume in the high 9 figures. These coins trade like stocks in the sense that they have elaborate charts, indicators, order books, and market makers, but what exactly are they? If we try to apply the Howey test to HPOS10i, it doesn’t really make sense:

1. Did investors invest money? Yes, HPOS10i was created by its founders and sold for money.

2. Was there a common enterprise? Possibly? HPOS10i operates as a satire of meme coins and could gain value through the virality of the memes created by the general community (who may or may not hold the coin themselves.) In no way are the community or the memes attached to the value of the coin itself — they just make memes and share them online and the coin does what it will.

3. Is there an expectation of profits? Probably? A lot of the memes touch upon the coin going “to the moon” (i.e., rapidly appreciate in price), but that has been a long-running meme in all sorts of communities, including ones entirely unrelated to investing. It is not a realistic assumption upon investment that a buyer has a quantified expectation of HPOS10i “going to the moon” as there is no explicit reason as to why one would purchase it in the first place. Frankly, there might not be any reason at all, as a common phrase bandied about is “It’s funnier if you don’t sell.”

4. Do the profits come primarily from the efforts of others? Not really? Supposedly HPOS10i can go up in value because of the virality of the memes made in its community extending awareness of the coin, but it is impossible to tell if this counts as “efforts of others” or if it even has any relation whatsoever to potential profits.

In essence — people buy it because it is fun to play along, and hey, it might go up in the meantime. People trade it because there is enough volatility in the price action to potentially buy low and sell high. The market capitalization itself is a meme (as in “hey, this Sonic coin has reached $150mm, maybe it can do a billion”) so it could hardly be thought of as promotion from someone touting benefits of an attached, extended ecosystem. Also, the ticker is $BITCOIN.

Notably, albeit without anywhere near the same levels of ironic meme generation (though there are plenty of meme communities surrounding Bitcoin), all of these non-answers pretty much apply to Bitcoin, which the SEC uniquely treats as a commodity amongst cryptocurrencies (though it’s up in the air what they plan to treat Ethereum as.) It’s not really clear what the common enterprise is behind Bitcoin, why it even goes up beyond people with unknowable expectations bidding it up, or whose primary efforts would cause price appreciation (the miners? ETF issuers? etc.) But due to Bitcoin’s enormous market capitalization, which has ranged from trillions to its current level of $680 billion, it seems to get a pass.

The core issue with Howey and what the meme coins (and Bitcoin) reveal is that the manner in which humans speculate has fundamentally transformed both in the rate at which an individual can do it and in the philosophy of how it is thought about. Howey outlines a framework that assumes that the investor wants to make a legitimate investment that creates profit through someone’s effort and thus determines whether that investment deserves legal protection. However, in the modern age, people increasingly just want to speculate for the sake of speculation and the potential of profit regardless of whether an expectation of profit is rational or even exists. Placing a sports bet or trading crypto can be done within seconds at any time of day by picking up your phone — in fact, you can get even faster access to some cryptocurrencies than the markets by using telegram bots. Prices move 24 hours a day and 7 days a week in crypto markets but “reasons” why the prices move rarely appear day to day beyond the essential mechanics of supply and demand. Even good or bad news that moves traditional stock markets might come as infrequently as once a week — meanwhile, Dogecoin has done billions of dollars in volume by that point. Bitcoin and Dogecoin have fundamentally proven that “a common enterprise” is an outdated threshold as to why a reasonable speculator might put their money in something, while HPOS10i completely turns the concept of “efforts of others” on its head (amongst others: “Imagine telling your coworkers you’re QUITTING because HPOS10i coin MOONED”.) The depth, liquidity, and volatility of all three of those markets (and many other coins) is reason enough to generate some form of the expectation of profit whether or not there’s any relation to the underlying idea behind the coin (if it exists) at all — that fact that it does trade means people will trade it, creating a sort of self-fulfilling recursion that Howey was never meant to handle.

The Ripple ruling highlights that this contradiction cannot just be ignored in the hopes it goes away like the SEC’s classification of Bitcoin as a commodity tried to do, especially if the Judge’s treatment of each type of transaction on its own merits remains the valid way to analyze such cases. (This is certainly up for dispute — note that in SEC v. Terraform Labs, a different Judge in the same District Court explicitly stated that he disagreed with applying Howey separately to each tranche of transactions). For that matter, the concept of a “traded security” might be outdated due to how high-tech markets have gotten. While AAPL shares were obviously registered as a security before trading on public markets, are all the intraday speculators really “investing” in Apple? Are their expectations of profits derived from the day-to-day work of employees who build Apple products or the fact that the market volatility just might work out in their favor? On a higher frequency level, is anyone that is market-making the stock or arbitraging a basket of stocks to their combined ETF value profiting “primarily from the efforts of others”?  The original intent of securities regulation was to prevent systemic risk due to massive losses in volatile markets by reducing the number of suspect offerings available to speculate on through heightening standards and increasing protections for products that met those standards. But now, speculation occurs while knowing there is nothing to an offering other than the liquidity and the volatility — this is a feature, and if one product is clamped down on by the SEC stretching to fit Howey to it, another will take its place. The SEC has no authority over the desire to speculate, after all, and the purposelessness of a market is not something people are demanding any protection from. Is securities regulation also supposed to extend to a rapper’s purchase of a Charizard card for $220,000?

The format of regulation going forward should not be trying more Howey cases in court with regards to cryptocurrencies. Beyond prosecuting outright fraud, labeling coins as unregistered securities seems to be a largely futile endeavor at this point. The money is already sloshing around in the system. Furthermore, a blanket ban on transacting in cryptocurrencies seems ill-advised as well. With the regulatory troubles of FTX and Binance, Coinbase seems like the player best suited to gain a major share of cryptocurrency trading going forward. Although they have been charged by the SEC for securities violations as well, it would be extremely ill-advised to entirely offshore all cryptocurrency trading due to the possibility that the industry continues to grow. Most importantly, they are a publicly traded company in the US and therefore are subject to a fair amount of regulation and compliance as a result — it is in their best interests to be transparent in their disclosures and forward guidance, creating an alignment of incentives that doesn’t exist with Binance, for example, who directly benefits from the increased need to circumvent securities laws. Endless cases do not need to be brought to court to get an idea of what is happening in the broader cryptocurrency space (and, if you really look into it, LBRY was filed over just $11 million in token sales from years ago — what was the point?)

The most logical path forward seems to be enabling businesses that want to build in the crypto space to not face a gamut of regulation because an attached token or product trades. At the end of the day, LBRY was building an actual product. Although tokens might trade in a quasi-equity style, they aren’t equity — they have no place in the cap stack and don’t actually represent any ownership in the company. They operate almost as a tradable representation of “hype”, like a wine from a vineyard that is growing in reputation might appreciate. Last time I checked, a case of Romanée-Conti wasn’t a security. Certainly, market manipulation should be monitored by the SEC in these tokens’ markets, but this should be trivially doable with the time & sales data across major chains mirroring the data they use to charge insider trading cases.

Perhaps a different categorization entirely can be drawn up for token-attached businesses to allow for such compliance.  Clear legislation that modifies the interpretation of “tokenization”, whether attached to a real product or not, would provide much-needed clarity to businesses that have adopted them as part of a marketing/hype mechanism and reduce the need for businesses to move offshore lest Gensler’s sweeping purview homes in on them. A “Tokenization Act of 2024” could still allow the SEC to regulate tokens, but full-scale Securities Act protections could be curtailed so legitimate businesses can operate without the fear of being shut down if their attached token is deemed to be a security (as this is effectively a death sentence for a business right now). Of course, if the token constituted some sort of stake in the business, then it would fall under Howey and be regulated as normal — this is specifically a carveout for tokens that exist outside the cap stack. Additionally, such legislation could allow for some amount of regulation over meme coins as they are still susceptible to manipulation and insider trading tactics that would be prosecutable in traditional securities. A meme coin classification would no longer force the SEC to contort the vapidness of HPOS10i or Dogecoin to the Howey framework to afford traders some protection, but rather it would formalize the postmodern concept where the market characteristics define the quasi-security but don’t actually represent anything at all.

This legislation would be mutually beneficial to all parties: business owners can safely market to a demographic that displays high enthusiasm for such projects, the SEC can crack down on illicit trading without blanketing the transacted vehicle itself, cryptocurrency traders don’t have to go through sketchy entities to transact in the market, and US companies can collect fees from facilitating such trading without fear of getting charged for operating an unregistered securities exchange. The Howey framework is incredibly useful, simple, and gets a vast majority of cases correct without controversy — it doesn’t need to go anywhere or be reimagined. But with regards to this class of assets, the application is highly unclear, sways with political winds, and only begets further litigation and confusion. At least for cryptocurrencies, it’s best if we gave Howey some rest.

Postscript: this is a (toned-down) formalization of other posts that have touched upon the same ideas. From here I’ll build to a concept of the “postmodern security” as I call it…