The Howey Test Framework is Wrong
I'm not a lawyer. I'm not a legal expert. I'm just a guy who likes to debate. Here's a fun thought experiment: the entire framework used to justify SEC jurisdiction is flawed.
After writing my reaction to the new crypto bill on Wednesday, I went down a path in my mind about the commodity vs security crypto argument. Which ones are securities? Which ones aren’t? The framework for determining what a security is is known as the “Howey Test.” While most cryptos are probably considered securities if we’re applying a black and white interpretation of the Howey Test, it made me question the validity of the Howey Test entirely.
What is the Howey Test?
I could get into the history of the Howey Test, but I don’t think my take would be very interesting. If you’re curious, you can read the Wikipedia page. The original case involves the harvesting of orange groves. I’m not kidding. Investopedia defines the test this way:
The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an "investment contract," and therefore would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. Under the Howey Test, an investment contract exists if there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."
Stripped down, there are four guiding principles for determining if something is a security. It requires that each of these four rules apply:
investment of money
in a common enterprise
with the expectation of profit
to be derived from the efforts of others
So there you have it. Under those guidelines we can put every single blockchain-based asset through the Howey test parameters to determine if they should be considered securities.
The Howey Test in Practice
Is Bitcoin a security? No. It’s the most decentralized crypto asset, period. I’d actually argue just about any proof of work coin that can be mined through any ASIC on the network is a commodity rather than a security. The Lummis/Gillibrand bill seems to get that right. A high yield account through an entity like Celsius? Almost certainly a security. Bored Ape jpegs? Probably securities.
But here’s the problem: I could argue the Howey Test is a fundamentally flawed framework. You know what else I can claim to be a security according to the Howey Test? Sports cards! That’s right. Fleer was selling me unregistered securities when I was 7 years old.
Lock. Them. Up! Lock. Them. Up!
Obviously I’m joking with the ‘lock them up’ silliness. But let’s put a Jordan rookie through the Howey Test:
investment of money (Yes)
in a common enterprise (Yes: only Fleer is considered to have MJ’s official RC)
with the expectation of profit (Uhm, Yes)
to be derived from the efforts of others (Yes: if MJ sucked, the investment goes bust)
The Fleer MJ rookie is potentially a security when put through the Howey Test. Should we do another one? Let’s do another one. What about Screaming Eagle wine? It’s one of the most popular labels in the US wine community. The prices have skyrocketed since the vineyard’s first vintages were bottled. Are Screaming Eagle wines securities? If the first buyers of the early vintages saw those wines as an investment opportunity, I think you could make the argument that they are also securities:
investment of money (Yes)
in a common enterprise (Yes)
with the expectation of profit (If intent is to resell, Yes)
to be derived from the efforts of others (Yes: if the winery loses consumer market interest, the investment potentially goes bust)
Now, I’m obviously not making the argument that basketball cards or rare wines should be considered securities. They’re not. I’m making the argument that the entire framework used to justify SEC jurisdiction over certain assets is flawed. Maybe we should look at changing it?
Disclosure: I’m not an investment advisor. I merely share what I do and why I do it. You shouldn’t take anything I say as investment advice and always do your own research when making investment decisions. Cryptocurrencies, tokens, STONKs, physical and digital trinkets could all go to zero.