Courts Are Grappling With The Application Of The Supreme Court's Howey Decision To Digital Currency

• Published date: 09 August 2023
• Subject Matter: Corporate/Commercial Law, Technology, Contracts and Commercial Law, Securities, Fin Tech
• Law Firm: Faruqi & Faruqi
• Author: Mr Thomas T. Papain

As the SEC and private investors continue to push on with civil litigation under the Securities Act of 1933 ("Securities Act") and the Securities and Exchange Act of 1934 ("Exchange Act") against developers and marketers of digital assets, the courts must rule on a threshold issue - whether the digital asset is a "security" that is subject to regulation.

A "security" is defined in the Securities Act and Exchange Act to include several types of economic instruments and arrangements, including stocks, futures, bonds, puts, calls, straddles, certificates of deposit, swaps, and "investment contracts", to name a few. See e.g.,15 U.S.C. '77b(a)(1); 15 U.S.C. '78c(a)(10). The SEC and investors have argued that crypto currency is an "investment contract" that subjects the issuers to SEC rules and regulations.

To determine whether a particular economic arrangement is treated as an "investment contract", the courts apply the three-pronged test set out in 1946 by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under Howey, an "investment contract" is "a contract, transaction, or scheme whereby a person [(i)] invests his money [(ii)] in a common enterprise and [(iii)] is led to expect profits solely from the efforts of the promoter or a third party." Howey at 298-99; see also SEC v. Edwards, 540 U.S. 389, 393, 124 S.Ct. 892, 157 L.Ed.2d 813 (2004), and Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009). The third prong - whether an investor is led to expect profits solely from the efforts of the promotor or a third party - has garnered attention in three recent decisions.

Two recent decisions from the Southern District of New York have taken different views on this third prong of the Howey test. In SEC v. Ripple Labs, et. al., 20 Civ. 10832 (AT), 2023 WL 4507900 (S.D.N.Y. July 13, 2023), the court distinguished between the sale of the defendant Ripple Labs's XRP digital tokens directly to sophisticated individual investors and the sale of XRP on digital exchanges through the use of trading algorithms. Whereas the sophisticated investors who bought XRP directly from Ripple would have purchased XRP with the expectation that they would derive profits from Ripple's efforts - because Ripple's marketing to these investors would have led them to believe Ripple would use the capital received to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP - the public buyers of XRP on the digital exchanges had no such...