Decision in SEC enforcement action against Coinbase suggests that transactions involving crypto are securities.

Although the “‘crypto’ nomenclature may be of recent vintage,” transactions involving crypto “fall comfortably within the framework that courts have used to identify securities for nearly eighty years.”[2]  To decide whether a transaction involving crypto amounts to a security, courts rely on precedent set by the U.S. Supreme Court in SEC v. Howey, 328 U.S. 293 (1946).

Howey Test for Crypto

Under the securities laws, an “investment contract” is a security.[3]  In Howey, the Supreme Court established the test used to determine when an “unconventional scheme or contract” constitutes an investment contract and therefore a security.[4]  The Howey test requires: “(1) an investment, (2) in a common enterprise, (3) with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”[5]

“The test ‘embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”’[6]  Moreover, the Supreme Court “has expressly stated that in assessing whether an investment scheme is an investment contract, ‘form should be disregarded for substance,’ and courts should focus on the ‘economic realities underlying a transaction, and not on the name appended thereto.”’[7]

Recognizing “several teachings that can be gleaned” from recent crypto cases in the Second Circuit, the court in SEC v. Coinbase noted that there doesn’t need to be a formal contract between transacting parties for an investment contract to exist under the Howey test.[8]  Courts have consistently rejected attempts to impose a “contractually-grounded” requirement into the Howey analysis.[9]  Instead, they focus on the broader context, evaluating the full set of contracts, expectations, and understandings surrounding the sale and distribution of crypto-assets to determine if they constitute an investment contract.[10]  Additionally, courts assess how issuers or promoters market the crypto-assets and what they invite investors to reasonably understand and expect.[11]  This involves examining various marketing materials, social media posts, investor materials, and other communications to identify investors’ expectations of profits.[12]

“Investment” Requirement

The “investment of money” requirement under Howey is met where investors “gave up some tangible and definable consideration.”[13] This requirement was not at issue in SEC v. Coinbase because it was undisputed that purchasers of crypto assets made an investment of money.[14]

“Common Enterprise” Requirement

In considering the second Howey prong—the existence of a common enterprise—courts may apply the “horizontal commonality” standard, or the “vertical commonality” standard.[15]  Horizontal commonality exists when “investors’ assets are pooled and the fortune of each investor is tied to the fortunes of other investors as well as to the success of the overall enterprise,” whereas vertical commonality exists when the fortunes of the investors are tied to the fortunes of the promoter.[16]

The Tenth Circuit, however, has rejected such “rigid” requirements and instead counsels courts to examine the “economic reality” so that when a transaction, in substance, involves an investment, the common enterprise will be present.[17]  The “determining factor of a common enterprise and the economic reality of the transaction is whether or not the investment was for profit.”[18] Under Howey, profit means an “income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment.”[19] Although not required, the pooling of investor funds supports the finding of a common enterprise.[20]

In SEC v. Coinbase, the SEC plausibly alleged horizontal commonality because the token issuers, developers, and promoters frequently represented that proceeds from crypto-asset sales would be pooled to further develop the tokens’ ecosystems, promising benefits for all token holders, thus creating a shared profit-seeking enterprise where the ability to profit “is dependent on both the successful launch of the token and the post-launch development and expansion of the token’s ecosystem.”  As such, “investors and issuers were joined in a common, profit-seeking enterprise.”

“Expectation of Profits” Requirement

The final Howey requirement is that the investment come with a “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”[21] The inquiry as to investors’ reasonable expectation of profits is an objective one. “If an objective investor would have perceived the defendants’ statements and actions as promising the possibility of such returns, the third prong of Howey is satisfied.”[22]

In SEC v. Coinbase, the SEC satisfied this requirement because it plausibly alleged that issuers and promoters of the crypto assets actively encouraged investors to purchase tokens through various means such as websites, social media posts, investor materials, town halls, and other mediums, by highlighting the potential improvements and technical efforts that would enhance the value of the assets, even after the tokens were available for trading on the secondary market.  “Accordingly, an objective investor in both the primary and secondary markets would perceive these statements as promising the possibility of profits solely derived from the efforts of others.”[23]

Ultimately, the court allowed the SEC to proceed with its claims against Coinbase, finding that it adequately pleaded that Coinbase customers engaged in transactions involving crypto assets that amounted to “investment contracts” under Howey.[24]

Navigating SEC Oversight of Crypto

As demonstrated by this and other recent decisions favoring the SEC, companies and individuals involved with crypto assets face the looming threat of securities investigations and enforcement actions. The type of conduct that could result in an investigation or enforcement action by the SEC or other securities regulators includes:

• Offering or selling crypto assets without a registration statement filed with the SEC, unless the securities qualified for an exemption from registration.
• Acting as a broker or dealer in transactions involving crypto assets without being registered as such with the SEC, particularly if engaged in the business of effecting transactions in securities for the account of others.
• Receiving transaction-based income, such as commissions, for soliciting or facilitating the purchase or sale of crypto assets.
• Regularly participating in securities transactions involving crypto assets, indicating a pattern of conduct consistent with the business of being a broker or dealer.
• Engaging in conduct that could be interpreted as fraud or misrepresentation, such as making false statements or omitting material facts regarding the nature of the crypto assets being offered or sold.
• Utilizing deceptive practices or schemes to induce individuals to purchase or invest in crypto assets.
• Failing to disclose pertinent information about the risks associated with investing in crypto assets.
• Operating schemes or programs that promise guaranteed returns or profits from investing in crypto assets without registering the offering with the SEC.
• Engaging in any other conduct that violates the anti-fraud provisions of Section 17(a) of the Securities Act or Section 10(b) of the Exchange Act in connection with transactions involving crypto assets.

Because companies and individuals often do not know whether transactions involving a particular crypto asset could be considered an “investment contract” and therefore a security subject to the securities laws, they may inadvertently engage in conduct that could trigger an SEC investigation or enforcement action.  In a securities investigation or action, whether a person did not know the transaction was a security is not a defense. When facing SEC inquiries and enforcement actions, reach out to a qualified and experienced securities attorney.

[1] S.E.C. v. Coinbase, Inc. & Coinbase Global, Inc., 2024 WL 1304037 (S.D.N.Y. Mar. 27, 2024).

[2] Id.

[3] 15 U.S.C. §§ 77b(a)(1); 78c(a)(10).

[4] SEC v. Telegram Grp., Inc., 448 F. Supp. 3d 352, 365 (S.D.N.Y. 2020) (citing Howey, 328 U.S. at 298-99).

[5] SEC v. Scoville, 913 F.3d 1204, 1220 (10th Cir. 2019) (citing Howey, 328 U.S. at 298-99).

[6] SEC v. Shields, 744 F.3d 633, 643 (10th Cir. 2014) (quoting Howey, 328 U.S. at 299).

[7] Shields, 744 F.3d at 643 (quoting United Hous. Found. v. Forman, 421 U.S. 837, 852 (1975)).

[8] S.E.C. v. Coinbase, 2024 WL 1304037, at *19-20 (cleaned up).

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] Berrios-Bones v. Nexidis, LLC, 2007 WL 3231549, at *5 (D. Utah Oct. 30, 2007) (quoting Int’l Bhd. of Teamsters v. Daniel, 439 U.S. 551, 559-60 (1979)); Telegram, 448 F. Supp. 3d at 368-69 (“[P]roviding dollars or euros in exchange for the future delivery of” a digital asset “establishe[s]” an “investment of money” under Howey); SEC v. Shavers, 2014 WL 12622292, at *5-6 (E.D. Tex. Aug. 26, 2014) (Bitcoin satisfies the “investment of money” requirement).

[14] S.E.C. v. Coinbase, 2024 WL 1304037, at *20.

[15] Telegram, 448 F. Supp. 3d at 369.

[16] Id.

[17] McGill v. American Land & Exploration Co., 776 F.2d 923, 925 (10th Cir. 1985) (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967)).

[18] SEC v. Art Intellect, 2013 WL 840048, at *15 (D. Utah Mar. 6, 2013) (emphasis added) (quoting Berrios- Bones, 2007 WL 3231549, at *5); Campbell v. Castle Stone Homes, Inc., 2011 WL 902637, at *4 (D. Utah, March 15, 2011) (same).

[19] Telegram, 448 F. Supp. 3d at 371 (internal quotation omitted); see Edwards, 540 U.S. at 394 (profits include “the increased value of the investment”); SEC v. SG Ltd., 265 F.3d 42, 53 (1st Cir. 2001) (purchaser may expect profits from “capital appreciation from the original investment”).

[20] Art Intellect, 2013 WL 840048, at *15 (common enterprise where “investor funds were commingled in common accounts”); see also SEC v. Mediatrix Capital Inc., 2020 WL 3469700, at *2 (D. Colo. June 25, 2020), aff’d sub nom. SEC v. Young, 2022 WL 2977080 (10th Cir. July 28, 2022) (common enterprise where defendants “commingled investor funds” and “traded those funds in an undifferentiated fashion”).

[21] Forman, 421 U.S. at 852.

[22] SEC v. Terraform Labs Pte. Ltd., 2023 WL 4858299, at *14 (S.D.N.Y. July 31, 2023); Telegram, 448 F. Supp. 3d at 371 (inquiry “is an objective one focusing on the promises … made to investors; it is not a search for the precise motivation of each individual participant”).

[23] SEC v. Coinbase, at * 22 (citing SEC v. LBRY, Inc., 639 F. Supp. 3d 211, 220 (D.N.H. 2022) (finding expectation of profits derived from the efforts of the issuer’s management team, because the issuer “signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any [token] purchasers”); and Terraform I, 2023 WL 4858299, at *14 (finding expectation of profits from the efforts of others when the issuer “repeatedly touted” that profitability would come about through its “investing and engineering experience”)).

[24] Id. at *23.