Congress can do better than the Howey test for crypto regulation


In general, cryptocurrencies are not subject to federal regulation unless they are considered “securities,” in which case the Securities Act of 1933 requires that they comply with the disclosure requirements and anti-fraud regulation of the Securities and Exchange Commission (SEC) if is offered to them. the public.

The evidence used by the SEC to determine whether a cryptocurrency is a security has been presented by the Supreme Court in Securities and Exchange Commission v WJ Howey Co. If the SEC claims that a cryptocurrency is a security, an alleged issuer seeking to challenge that claim must litigate. The criteria contained in the so-called Howey test are irrelevant for any rational public policy reason to regulate cryptocurrency. However, cryptocurrency companies are forced to spend millions on legal fees to try to prove that their products do not meet these criteria.

Howey, of course, has not dealt with cryptocurrency or any other form of modern technology. Rather, it was a 1940s scheme to market citrus-growing units in Florida along with a contract to grow and market the fruit of the grove and pay the profits to investors. The court held that an investment is an “investment contract” and therefore a guarantee as defined in the Securities Act, whether it is “a contract, transaction or scheme by which a person invests his money in a joint venture and benefits are expected exclusively from the efforts of the developer or a third party ”.

With respect to cryptocurrency, the crucial point of this test is usually whether the benefits result solely from the efforts of a promoter or a third party. Using this test, the SEC determined that Bitcoin, which is a decentralized network without a promoter, is not a security. Various forms of cryptocurrency follow the decentralized financing model, or “defi”, which relies on peer-to-peer payments without a promoter or financial intermediary. These forms of cryptocurrency are unlikely to be considered values ​​under Howey. Other forms of cryptocurrency, such as stable currencies with interest, would meet the Howey test because a promoter is paying interest. Does this distinction make sense?

In determining whether a financial product should be regulated, governments often consider the following factors: Do the people to whom the product is offered require protection from fraud or dishonesty? Do the markets in which the product is sold require regulation to preserve its integrity? Are there broader government interests at stake?

In the case of cryptocurrency, regardless of whether the profits result from the efforts of a developer, buyers have been defrauded of billions of dollars as a result of cyber-piracy and failures to disclose the risks or real assets and liabilities of cryptocurrencies. Cryptocurrencies are increasingly being traded through the same vehicles as more conventional financial products, including stockbrokers, mutual funds, and stock exchanges, and the integrity of these markets needs to be protected. Finally, important government interests force you to regulate. For example, since cryptocurrencies are often used by criminals, law enforcement and anti-money laundering regimes are involved. In addition, the government’s strong interest in preserving the primacy of the US dollar gives it an interest in overseeing potential competitors of the dollar. All of these factors are present for all cryptocurrencies regardless of whether or not they meet the Howey test.

Unfortunately, in the absence of congressional action to regulate cryptocurrency, the SEC is left with only Howey’s proof and its resulting illogicality. In designing a regulatory scheme, Congress has the luxury of directly considering the technologies involved, rather than applying a test that originated in the Florida citrus industry.

Several regulatory schemes have already been launched, especially for stablecoins, a form of cryptocurrency backed by financial assets. The President’s Working Group on Financial Markets has proposed that all stable currency issuers be regulated as banks with federal insurance. The cost of this regulation may make this nascent industry unprofitable.

Senator Pat Toomey (R-Pa.) Recently proposed a more prudent regulatory approach. It involves some kind of state or federal license for stablecoin issuers, proper financial disclosure of the assets supporting the product, and most importantly, a requirement that stablecoin issuers obtain audited financial statements so that buyers can view the its assets and liabilities. Such a regime, widely applicable to cryptocurrency, would protect consumers, financial markets, and government interests while allowing the market to ultimately determine whether the cryptocurrency experiment will succeed.

Howard B. Adler, a retired partner in corporate law and securities at Gibson, Dunn & Crutcher, LLP, served as Under-Secretary of the Treasury for the Financial Stability Oversight Board from 2019 to 2021. He is the co-author of the forthcoming book. “Surprised again! The COVID crisis and the new market bubble “.



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