The Howey Test

Digital Assets Sold on the Secondary Market Are Not Securities. Period.

INTRODUCTION

West New York, N.J. - This Article focuses on whether secondary market transactions in fungible crypto assets constitute investment contract transactions (and thus securities transactions). The term “crypto asset” refers to an asset that is uniquely identifiable through the use of cryptography and blockchain technology. The term “token” is also used to refer to a crypto asset that conforms to a certain industry standard. References in this article to “secondary market” transactions in crypto assets refer to transactions in these assets by persons other than the person or entity that created the crypto asset, by affiliates of that person or entity, or by persons acting, or deemed to be acting, as an agent of that person or entity.

Initial coin offerings (“ICOs”) are a type of fundraising transaction in which blockchain-based crypto assets are sold to investors, usually to raise funds intended to develop or promote a new technology platform, constructed around a finite or provably scarce number of fungible crypto assets. Although most ICOs constitute investment contract transactions (and thus securities transactions), substantially all fundraising sales of crypto assets conducted within the United States occur in transactions with accredited investors that qualify for the exemption from registration contained in Section 4(a)(2) of the Securities Act. See generally Lewis Rinaudo Cohen et al., The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities 36-72 (Nov. 10, 2022) (exhaustively surveying federal appellate cases applying Howey). The question we are interested in here is not the regulatory treatment of these fundraising transactions, which is reasonably clear. Rather, this article addresses the applicability of federal securities law to the crypto assets themselves.

The central question of whether the SEC has jurisdiction over a digital asset is whether it falls within the definition of a security. The Securities Act of 1933 (the “Securities Act”) requires every offer or sale of securities to be registered with the SEC or meet a condition for exemption from registration. The Securities Act defines a security to include an “investment contract,” which was in turn defined by the U.S. Supreme Court in SEC v. Howey Co., 328 U.S. 293 (1946). Under Howey and the case law that followed, an arrangement qualifies an investment contract if it is: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profits; (4) derived from the efforts of others. The test is not a “balancing test,” rather, all four factors must be present for the arrangement to constitute an investment contract. Several characteristics of digital assets may cause it not to meet the Howey test.

In SEC v. Wahi, et al., Defendants Ishan and Nikhil Wahi’s motion to dismiss is superbly drafted and raises many of the issues that must be addressed in order to provide regulation clarity to the U.S.-based digital asset markets and protect crypto investors. The following, in part, is a brief analysis of this motion to dismiss.

The SEC claims that a digital asset constitutes an “investment contract” (and thus a security). The SEC is wrong. The term “investment contract” requires - as the statute says - a contract. But there are no contracts, written or implied. The developers who create tokens have no obligations whatsoever to purchasers who later bought those tokens on the secondary market. And with zero contractual relationship, there cannot be an “investment contract.” It is that simple.

But even if there could be an “investment contract” absent contractual obligations of any kind, the SEC’s argument would still fail. The SEC claims there is an “investment contract” whenever a person is “led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one other than themselves.” SEC v. W.J. Howey Co., 328 U.S. 293, 298 (1946). But when standalone digital tokens are purchased over exchanges such token-buyers are not part of any “common enterprise”; they do not pool their assets together as part of some shared endeavor; and their fortunes are not tied to those of the original developers. In fact, such buyers do not put their money in an enterprise at all; they send their money to unrelated third-parties in exchange for an asset - no different from when someone buys a baseball card on the secondary market. Nor do these token buyers expect the tokens’ value to rise “solely” (or even predominantly) “through” the efforts of the original developers. Rather, the tokens’ value is driven by market forces, not managerial efforts - as evidenced by the fact that the tokens are almost all functional (i.e., they can operate without any centralized intermediary) and that each experiences wide price fluctuations, regardless of the status of the underlying platform.

If the SEC really believes digital assets are securities, it should engage in a rulemaking or other public proceeding explicating that view and providing guidance to regulated parties on its implications. That orderly process - one administrative agencies have dutifully followed for decades - allows the agency to receive public comments and facilitates a deliberative process, ensuring the agency’s position is well grounded in fact and law. Should regulated parties disagree with the agency’s views in its final rule, they would have an opportunity to contest those views in court. This process ensures the law is clear before consequences are imposed - rather than leaving people to guess about an agency’s intentions, order their affairs based on that guess, and then suffer substantial penalties via ex post enforcement actions if they guess wrong.

SUMMARY

The SEC wants to broadly regulate digital assets. But rather than obtain such authority from Congress, the SEC has sought to achieve it through the courts. In so doing, the SEC seeks to distort the federal securities laws beyond all recognition, and win for itself regulatory domain over an entirely new industry. That gambit is an abuse of power. Federal law clearly forecloses it.

The SEC believes that something can be an “investment contract” without anything that resembles a contract. That is wrong, as statutory text, history, and precedent all confirm. The very heart of an investment contract is - and always has been - the coupling of an asset with a binding promise: The sale of land plus the promise to manage orange groves on it; the sale of beavers plus the promise to raise them for fur; the sale of vineyards plus the promise to develop wine. But, for tokens sold on exchanges, there is no contractual relationship between token-holders and developers, and there are thus no binding promises running from the developers to the token-holders. There is just a naked asset sale. And such a sale - decoupled from any post-sale promises on the part of any developer - has never once constituted an “investment contract.”

The SEC’s attempt to reinvent the term “investment contract” will have implications far beyond the Wahi, et al case. It would establish sweeping SEC jurisdiction over an industry without any input from Congress. And it would, in so doing, subject an industry with tremendous potential to a regulatory apparatus that is an exceedingly poor fit for it. The securities laws exist to protect people with direct passive investments in ongoing enterprises - not to set the ground rules for blockchain technology, platforms built atop it, utility tokens, nonfungible tokens, decentralized autonomous organizations, or any of the myriad square pegs the SEC has tried to jam into this round hole.

There is also no need to stretch securities laws into the digital asset space, as excluding tokens from the SEC’s regulatory jurisdiction does not mean digital frauds and abuses will go unregulated. Countless other regulators already assert that digital assets are subject to the myriad financial regulations that prevent fraud and manipulation in traditional financial markets. And in addition, Congress and state legislatures are actively debating digital asset regulations that are properly tailored to the unique features of this cutting-edge technology.

I. DIGITAL ASSETS SOLD ON THE SECONDARY MARKET ARE NOT “INVESTMENT CONTRACTS” UNDER THE SECURITIES LAWS.

The term “investment contract” has a long history. Even before the federal securities laws - which themselves date to the Great Depression - the phrase “investment contract” was a term of art for financial dealings that differed in some way from traditional securities (like stocks and bonds), but that still had the essential “characteristics of a security.” Int’l Bhd. of Teamsters v. Daniel, 439 U.S. 551, 559 (1979). In the main, “investment contracts” cover business ventures that involve the sale of some asset (like land or an oil lease) coupled with certain legally binding promises by the seller to manage or develop that asset in a profitable manner. Examples include one-off enterprises like a businessman selling tracts of land upon which he promises to maintain profitable orange groves, Howey, 328 U.S. at 299.

Such ventures vary in the details, but the term “investment contract” has always carried certain core traits - most obvious, a contract, and one that captures the post-sale promises that transform an asset sale into something more. In using the phrase “investment contract,” Congress codified the term’s traditional definition into the federal securities laws. Howey, 328 U.S. at 298.

A. The Term “Investment Contract” Had a Settled Meaning in 1933 That Congress “Crystallized” Within the Securities Laws.

The federal securities laws do not specifically define the term “investment contract.” The term should accordingly be given its “ordinary meaning at the time Congress enacted the statute.” New Prime Inc. v. Oliveira, 139 S. Ct. 532, 539 (2019).

When Congress passed the Securities Act of 1933 and the Exchange Act of 1934 (both of which use “investment contract” as part of their near-identical definitions of “security”), “investment contract” was a settled term of art from state “blue sky” laws (i.e., state securities laws). And “when Congress employs a term of art, it presumably knows and adopts the cluster of ideas that were attached to each borrowed word.” FAA v. Cooper, 566 U.S. 284, 292 (2012). The federal securities laws are no exception. As the U.S. Supreme Court held in Howey, Congress incorporated into the securities laws the definition of “investment contract” that had “crystallized” in the states. 328 U.S. at 298. The Ninth Circuit has confirmed as much, reaffirming that “the term ‘investment contract’ retains the same meaning it possessed under predating state ‘blue sky’ laws.” SEC v. Rubera, 350 F.3d 1084, 1090 (9th Cir. 2003).

The definition of “investment contract” under predating state “‘blue sky’ laws,” Howey, 328 U.S. at 298, had several “essential ingredients.” Chief among them: An “investment contract” required a contract (written or implicit) that imposed post-sale obligations on the promoter, and also gave the investor a right to receive profits from the promoter’s venture.

1. The phrase “investment contract” is a term of art derived from state “blue sky” laws.

At the turn of the twentieth century, the American economy was booming, and entrepreneurs increasingly sought to capitalize on that boom by hawking investment opportunities to members of the country’s burgeoning middle class. See Jonathan R. Macey & Geoffrey P. Miller, Origin of the Blue Sky Laws, 70 Tex. L. Rev. 347, 355 (1991). Many of these schemes were genuine; but many were not. Some ultimately promised nothing more than “so many feet of blue sky.” State v. Gopher Tire & Rubber Co., 146 Minn. 52, 55 (1920). And in response to this problematic trend, the states started to adopt new securities laws that were designed “to put a stop to the sale of shares in visionary oil wells, nonexistent gold mines, and other ‘get-rich-quick’ schemes calculated to despoil credulous individuals of their savings.” By 1930, all but two states had adopted some version of a “blue sky” law.

Much as Minnesota was the first state to use the term “investment contract,” its courts took the lead in explicating its meaning. At its essence, an “investment contract” was the equivalent of a “contract which is an investment.” As the Minnesota Supreme Court explained in more detail, “the placing of capital or laying out of money in a way intended to secure income or profit from its employment is an investment as that word is commonly used and understood.” Gopher Tire, 146 Minn. at 56. And when that investment is folded into some kind of contractual relationship, an “investment contract” is then born. Evans, 154 Minn. at 99.

“This definition was uniformly applied by state courts to a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one other than themselves.” Howey, 328 U.S. at 298. As such, when Congress set out to create its own securities law regime, “investment contract” was thus a clear term of art.

2. Congress incorporated that term of art into the securities laws.

Following the stock market crash of 1929, Congress began work on a “Federal blue sky law.” Remarks by Senator William H. King, 77 Cong. Rec. 2992 (May 8, 1933). That effort culminated in the Securities Act of 1933, which incorporated verbatim the definition of “security” that the National Conference of Commissioners on Uniform State Laws had adopted some years prior when drafting its uniform state securities code. That definition, again, included “investment contracts.” (As does the Exchange Act’s definition of “security,” enacted one year later.)

There is no doubt Congress sought to incorporate the existing definition of “investment contract” into the federal securities laws. As the Howey Court reasoned, “investment contract” had a “common” and “uniformly applied” definition at the time. 328 U.S. at 298. And by “including an investment contract” within the federal securities laws, Congress “crystallized” that definition within federal law. See also SEC v. Edwards, 540 U.S. 389, 395 (2004) (reiterating importance of state “blue sky law cases”). As the SEC itself explained in Howey: “Congress must be deemed to have intended also to adopt that construction of the term which was uniformly followed by the state courts.”

 3. The traditional definition of “investment contract” has several “essential ingredients.”

“When a statutory term is obviously transplanted from another legal source, it brings the old soil with it.” Taggart v. Lorenzen, 139 S. Ct. 1795, 1801 (2019). Here, that “old soil” includes at least three fundamental characteristics that were “the essential ingredients of an investment contract.” Howey, 328 U.S. at 301. For an “investment contract” to exist, there must be (i) a contract, that (ii) imposes post-sale obligations on the promoter, among which include (iii) giving the investor a legal entitlement to share in the venture’s profits.

Before Howey, no state decision had ever found an “investment contract” without these three characteristics. See, e.g., Howey, 328 U.S. at 298 n.4. Same for the lower federal courts. See, e.g., id. at 299 n.5 (same). And in the many decades since Howey, neither the U.S. Supreme Court nor the Ninth Circuit has departed from that unbroken practice. Indeed, when pressed with this argument in the Southern District of New York, the SEC came up empty - unable to cite any genuine example of any court at any time finding an “investment contract” where the instrument did not have these fundamental threshold characteristics. Compare Defendants’ Memorandum of Law in Support of Their Motion for Summary Judgment at 19-21, SEC v. Ripple Labs, Inc., No. 20-cv-10832 (S.D.N.Y. Sept. 17, 2022) with Plaintiff Securities and Exchange Commission’s Memorandum of Law in Opposition to Defendants’ Motion for Summary Judgment at 19-21, Ripple Labs, No. 20-cv-10832 (S.D.N.Y. Oct. 21, 2022).

(a) A Contract

Most obvious, an “investment contract” requires a “contract” - specifically, a contract between the investor and the promoter. The SEC itself has historically recognized as much, explaining to the U.S. Supreme Court in Howey that an “investment contract” is a “contractual arrangement” that possesses certain additional characteristics. Or as one state court put it on the eve of Congress enacting the Securities Act: “The term ‘investment contract’ is not defined in the act, but it implies the apprehension of an investment as well as of a contract.” State v. Heath, 153 S.E. 855, 857 (N.C. 1930). Indeed, state courts evaluating whether a given venture amounted to an “investment contract” often followed a two-step process, first identifying whether there was a contract at all, and only then turning to whether it had the other necessary traits. See, e.g., Klatt v. Guaranteed Bond Co., 250 N.W. 825, 829 (Wis. 1933).

(b) Post-Sale Obligations

Nor can just any contract constitute an “investment contract.” As noted above, an “investment contract” is an asset sale coupled with legally binding promises by the promoter to manage or develop that asset in a profitable way. See, e.g., State v. Robbins, 185 Minn. 202, 204-05 (1932) (sale of muskrat breeding pairs plus promise to rear pairs until later sold for fur); Prohaska v. Hemmer-Miller Dev. Co., 256 Ill. App. 331, 334-35 (1930) (sale of land plus promise to harvest crops on it); Kerst v. Nelson, 171 Minn. 191, 193-95 (1927) (sale of land plus promise to cultivate vineyard, harvest crops, and market wine). Without binding post-sale legal obligations, there is just an asset sale.

In the years before the federal securities laws, state courts consistently treated the absence of such binding post-sale obligations as dispositive. In Lewis v. Creasey Corp., for instance, a wholesale grocery distributor gave a local supermarket the right to purchase groceries at a discount in exchange for a $300 deposit. 248 S.W. 1046, 1047 (Ky. Ct. App. 1923). The court held this contractual arrangement was not an investment contract because there were no post-sale obligations on the part of the distributor to use the supermarket’s money “in such a manner as to reap a profit to the investor.” Rather, the deal was simply a one-off payment for a discount. And the term “investment contract” did not extend to “contracts only containing mutual obligations, such as are daily entered into commercial life, and from which a profit can only be reaped by the uses which the investor alone makes of them.” Otherwise, the term “investment contract” could be manipulated to extend to all “exchange[s] of commodities” and “all [other] sorts and kinds of contracts,” contrary to the phrase’s well-established meaning. Id.

The requirement of post-sale obligations for an “investment contract” runs throughout the state blue sky cases. See, e.g., McCormick v. Shively, 267 Ill. App. 99, 103-04 (1932) (no investment contract where land sale involved “no obligation by promoter….to do anything other than to deliver a deed upon the payment of the purchase price); Hanneman v. Gratz, 170 Minn. 38, 41-42 (1927) (same where scheme only involved “purchase of lands”); Creasey Corp. v. Enz Bros. Co., 187 N.W. 666, 667 (Wis. 1922) (holding same grocery contract as above not a security).

(c) Right to Share Profits

Finally, an “investment contract” must give the investor a right to share in the venture’s profits. To borrow again from Lewis, an “investment contract” is a contractual scheme where “a profit is promised and expected without any active efforts on the part of the investor.” 248 S.W. at 1049. Or as the Minnesota Supreme Court put it, an “investment contract” is a contract that by definition “entitles the investor to participate in a profit-sharing scheme.” Kerst, 171 Minn. at 196; see also Evans, 154 Minn. at 99 (“If the defendant issued and sold its certificates to purchasers who paid their money justly expecting to receive an income or profit from the investment, such certificates might properly be regarded as investment contracts.”). As above, the absence of an entitlement to profit sharing has always been dispositive. In Enz Bros., for example, the Wisconsin Supreme Court held that a contractual arrangement was not a security because the investor “acquired no rights either in the capital or profits of the company.” 187 N.W. at 667.

When Congress passed the federal securities laws, it quite purposefully used a term of art that had a well-established meaning. In that light, then as now, the definition of “investment contract” is (i) a contract, that (ii) imposes post-sale obligations on the promoter, among which include (iii) giving the investor a legal entitlement to share in the business venture’s profits.

B. Digital Assets Do Not Fit the Traditional Definition of an “Investment Contract.”

The SEC cannot allege that digital assets involve contracts among developers and token-holders. In fact, digital assets impose no legal obligations on their developers after the time of sale. And they carry no legal entitlement to share in the developers’ profits. In no sense are digital assets securities under the “uniformly applied” definition of “investment contract” Congress “crystallized” into the securities laws. Howey, 328 U.S. at 298.

1. Digital assets sold on secondary exchanges do not involve a contract between the developers and the token-holder.

Foremost, there is no “contract” here that could give rise to an “investment contract.” When a token is sold on an exchange, there is (by definition) no contract between the buyer and the promoter. See, e.g., Michael J. O’Connor, Overreaching Its Mandate? Considering the SEC’s Authority to Regulate Cryptocurrency Exchanges, 11 Drexel L. Rev. 539, 582-83 (2019). Secondary sales are one-off transactions between someone who owns the token and someone else who buys the token, facilitated through blind bids done with an exchange. The token’s original developer is not a party to the transaction, and does not enter any contract in connection with it. That is dispositive.

Of course, digital assets could be the subject of investment contracts that qualify as securities. For example, certain primary offerings of digital assets (e.g., initial coin offerings (“ICOs”)) might constitute investment contracts depending on the nature of the agreement between the developer and purchasers. But no such contractual arrangements exist with respect to existing digital assets trading in secondary markets.

The SEC has taken the view that if digital assets were initially distributed by way of an investment contract - say, through an ICO where investors bought tokens from the developers directly - then the tokens are securities for time immemorial. But even assuming the premise of that argument is right, the SEC nonetheless conflates here the investment arrangement with the specific object that underlies it. Suppose investors agreed to give Mr. Howey money in exchange for him periodically sending them bushels of oranges from the groves he promised to manage. That agreement is certainly a contract and may - depending on the details - be an “investment contract.” But even if that arrangement were an “investment contract,” the items exchanged pursuant to it - the oranges - would not constitute federal securities, because they carry with them no enforceable rights and obligations running from the orange-holder back to Mr. Howey. Put differently, if Mr. Howey’s investors decided to resell those oranges at a farmers’ market, nobody would think they had engaged in some unregistered securities offering.

In other words, even if the initial sale of digital assets by their developers could have been deemed an investment contract, the tokens themselves were not. The resold oranges are not securities for the simple reason that they carry with them no contractual relationship between the orange-buyer and Mr. Howey. Resold digital assets are no different; they lack any contractual relationship connecting the buyer and the promoter. In sum, there is a fundamental difference between an investment transaction (which may give rise to an “investment contract”) and that transaction’s underlying asset (which cannot). Here, there is only the latter; a bushel of oranges.

Nonetheless, as noted supra, substantially all fundraising sales of crypto assets conducted within the United States occur in transactions with accredited investors that qualify for the exemption from registration contained in Section 4(a)(2) of the Securities Act.

2. Digital assets sold on secondary exchanges do not come with post-sale obligations on the part of the developers.

Developers of digital assets may make public declarations about how they intend to develop their platforms and protocols, and how token-holders would likely be able to turn a profit by flipping tokens on secondary exchanges.

However, public declarations by digital asset developers about the software they hope to create do not create post-sale legal obligations, and cannot convert tokens sold on secondary markets into investment contracts. Indeed, suppose Mr. Howey adopted a “roadmap” with a plan to heavily market his oranges nationwide, thereby boosting their price. Nobody would say that pledge transforms the oranges into securities, or the above farmers’ market into an unlawful exchange.

This is all because there is no “investment contract” absent a binding promise running from the developer to the token-holder. To continue the analogy to Howey, if Mr. Howey had suddenly stopped working on his orange groves, his investors could have sued him for breach of contract. That is because Mr. Howey had entered into an agreement with investors that imposed binding post-sale obligations on him. Similarly, and importantly, transferring a digital asset to a third-party is not like assigning a contract; tokens do not inherently confer any legal rights upon the token-holder that are enforceable against the developer.

Transferring a digital asset is analogous to selling a beanie baby - an asset that can either be played with or stored as an investment, but one that innately carries none of the obligations and rights that were part of any original transaction. Of course, a token-holder may expect their tokens will appreciate due to their “proximity” to the developers’ efforts - but that is not enough without an actual obligation on the developers to follow through. De Luz Ranchos Inv. Ltd. v. Coldwell Banker & Co., 608 F.2d 1297, 1301 (9th Cir. 1979); see also, e.g., Rodriguez v. Banko Cent. Corp., 990 F.2d 7, 11 (1st Cir. 1993) (sellers’ “strong and repeated suggestions” land would be developed did not create security without actual obligation to develop).

In sum, not every promotion creates a binding promise running to all asset-holders. Consider a baseball player who sells autographs while telling buyers he plans to hit more home runs. Or the musician who sells branded sneakers while promising to put out more hit albums. Or a bit on point, an entrepreneur who sells physical tokens as commemorative coins while stressing he will try to get celebrities to endorse them, thereby bumping their market value. In all of these examples, buyers - whether directly or on the secondary market - might expect their purchases to appreciate in value: homers drive autograph prices, platinum records boost the demand for merchandise, and celebrity endorsements enhance market value. But none of these examples features “actual commitments” on the part of the seller to the buyer of the asset that could transform the asset into a security. Happy Inv. Grp. v. Lakeworld Props., Inc., 396 F. Supp. 175, 181 (N.D. Cal. 1975). In each instance, the ballplayer, musician, or coin peddler is free to sell the relevant asset and then quit the business. And without a real “obligation” to “develop, improve, or manage” the underlying asset later on, there is no “investment contract.” De Luz Ranchos, 608 F.2d at 1301.

3. Digital assets sold on secondary exchanges do not furnish a legal right to share in profits.

Finally, digital assets do not come with a legal right for token-holders to share in their respective ventures’ profits. Again, there is a difference between being able to profit from the re-sale of an asset (e.g., an orange), and having an entitlement to share in the profits from a business venture (e.g., an orange grove). The latter can give rise to a security; the former cannot.

At most, for a few digital assets, token-holders may be able “share in the profits” if they help “stake” the token on its given network. But this is different in kind. “Staking” is when someone locks up some of their tokens to help support the operation of a platform in exchange for a certain yield or percentage of a transaction fee. (Conceptually, it is not all too different from putting money in a high-yield savings account at a bank and receiving interest payments in return.) The key point, though, is that staking is optional. And the option to make money with tokens by staking them does not convert the tokens themselves into an entitlement to share in the venture’s profits.

II. HOWEY FORECLOSES THE SEC’S ATTEMPT TO SCRAP THE TRADITIONAL DEFINITION OF AN “INVESTMENT CONTRACT.”

The federal securities laws use the traditional definition of “investment contract.” Indeed, the U.S. Supreme Court held as much in Howey, stating in quite plain terms that, “by including an investment contract within the scope of….the Securities Act, Congress was using a term the meaning of which had been crystallized by this prior judicial interpretation [in state blue sky cases].” 328 U.S. at 298.

Despite this straightforward sentiment, the SEC appears to contend the Howey Court actually replaced the traditional definition of “investment contract” with something else - a malleable standard that does not require any “contract,” much less the specific sort of contract uniformly required under the blue sky laws. The SEC is wrong. Neither the U.S. Supreme Court nor the Ninth Circuit has ever found an “investment contract” where the instrument does not satisfy that term’s traditional definition. See generally Lewis Rinaudo Cohen et al., The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities 36-72 (Nov. 10, 2022) (exhaustively surveying federal appellate cases applying Howey).

Once more, when a statutory term is “obviously transplanted from another legal source” it “brings the old soil with it.” Felix Frankfurter, Some Reflections on the Reading of Statutes, 47 Colum. L. Rev. 527, 537 (1947). The Howey Court thus held the term “investment contract” in the federal securities laws carried the “common” and “uniformly applied” definition from the state blue sky laws that preceded the federal securities laws. Howey, 328 U.S. at 298. Nevertheless, the SEC now claims that Howey actually (and covertly) displaced the traditional definition of “investment contract” with a new standard. That counterintuitive claim is wrong.

The SEC deeply misunderstands Howey. The opinion is not at war with itself; the Court does not recognize and endorse the uniform state law definition of “investment contract” in one breath, yet silently displace that settled definition in the next for something wholly new. Rather, the Howey Test is an elaboration upon - not a substitute for - the traditional definition of “investment contract.” In sum, the Howey Test captures the extensive array of business ventures that may conceivably fit within the four corners of an “investment contract,” but it does not eliminate the basic qualities needed for there to be an “investment contract” in the first place.

There is no question an “investment contract” may include “countless and variable schemes” - from orange production to muskrat rearing to real estate. But for those schemes to become federal securities, the prerequisites of an “investment contract” still must be present. There must be a contract that imposes post-sale obligations and carries a right to share in profits. To be sure, those pre-requisites are not exceedingly demanding, and allow for broad application. But they are at the heart of the “uniformly applied” definition that Congress “crystallized” into law. Howey, 328 U.S. at 298.

In arguing that an “investment contract” does not need a contract, the SEC latches onto Howey’s description of an “investment contract” as “meaning a contract, transaction, or scheme.” SEC Summ. J. Opp’n in Ripple, supra, at 15-16 (quoting Howey, 328 U.S. at 298-99). That too is mistaken. See Edwards, 540 U.S. at 397 (“We are considering investment contracts.”). Rather, the Howey Court was simply saying that courts need to look at the full picture, and consider the full “economic reality” of a business venture. 328 U.S. at 298. Sometimes, the full picture resides within a single contract. But often it does not, and a court should not disregard “substance” for “form” in doing its analysis. Id. Howey itself, for instance, involved two transactions - a sales contract for the land, and a management contract for the citrus groves atop that land. Id. at 295-96. Neither contract was alone an “investment contract”; but in combination, the overall scheme was. The SEC misapprehends Howey’s commonsense command to consider context as license for discarding the most elemental trait of an “investment contract” - an actual contract, whether written or implicit. See id. at 300 (investment contracts exist “regardless of the legal terminology in which such contracts are clothed”).

In sum, Howey elaborated upon the traditional definition of “investment contract.” It did not purport to replace it. The Howey Court meant what it said when it said the very opposite. The SEC’s attempt to regulate the digital assets sold on secondary markets, involving no contract, no post-sale obligations, nor any right to share in profits - deviates from the long-settled understanding of the securities laws’ scope.

A. The value of a digital asset is driven by market forces.

For there to be an “investment contract,” profits must come from “undeniably significant….and essential managerial efforts that affect the failure or success of the enterprise.” SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973). In Howey, the U.S. Supreme Court actually said profits must come “solely from the efforts of others.” 328 U.S. at 299 (emphasis added). That is, profits must come from significant managerial efforts as opposed to solely from external market forces. Once again, Howey is clear: There, investors either gained or lost money depending on how well Mr. Howey managed his groves. The Ninth Circuit has held there was no “investment contract” where a business sold silver bars to people, given that “the profits to the investor depended upon the fluctuations of the silver market, not the seller’s managerial efforts.” Noa, 638 F.2d at 79; see also, e.g., SEC v. Belmont Reid & Co., Inc., 794 F.2d 1388, 1391 (9^th Cir. 1986) (Howey’s third prong not met where primary purpose of purchase of gold coins was “to profit from the anticipated increase in the world price of gold”); Sinva, Inc. v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 253 F. Supp. 359, 367 (S.D.N.Y. 1966) (“In a sense anyone who buys or sells a horse or an automobile hopes to realize a profitable ‘investment.’ But the expected return is not contingent upon the continuing efforts of another.”).

Managerial efforts must drive price in order to satisfy Howey. See, e.g., SEC v. Mut. Benefits Corp., 408 F.3d 737, 744 n.5 (11th Cir. 2005) (“If the realization of profits depends significantly on the post-investment operation of market forces, pre-investment activities by a promoter would not satisfy Howey’s third prong.”); Grenader v. Spitz, 537 F.2d 612, 619 (2d Cir. 1976) (“While efficient management of the cooperative will enhance its desirability as a place of residence, it is hardly a factor which would result in the appreciation in value of the shares….Realistically, that will depend upon the general housing market, the status of the neighborhood and the availability of credit.”); Lehman Bros. Com. Corp. v. Minmetals Int’l Non-Ferrous Metals Trading Co., 179 F. Supp. 2d 159, 164 (S.D.N.Y. 2001) (holding no investment contract where “any gain likely would result in large part from market movements, not from capital appreciation due to Lehman’s efforts”).

To satisfy Howey, the SEC needs to plausibly allege that the value of a digital asset turns on significant managerial efforts rather than market forces.

Again, the Howey Test turns on the promises and circumstances surrounding a transaction, which is why that test can encompass investment schemes involving assets that range from beaver pelts to oranges. But when the promises and circumstances surrounding a transaction change, the nature of the transaction (as far as Howey is concerned) changes with it. In other words, as SEC Commissioner Peirce has noted, “an initial fundraising transaction can create an investment contract, but the token itself is not necessarily the security even if it is sold on the secondary market.” That is because forming an investment contract requires both an underlying asset (Howey’s land) and attendant contractual obligations (Howey’s promise to cultivate oranges on his investors’ behalf). Secondary sales of only the asset without promises by the promoter are categorically and fundamentally distinct.

CONCLUSION

The SEC deeply misunderstands Howey. The SEC claims that a digital asset constitutes an “investment contract” (and thus a security). The SEC is wrong. Secondary market transactions in crypto assets do not constitute investment contract transactions (and thus securities transactions). For an “investment contract” to exist, there must be (i) a contract, that (ii) imposes post-sale obligations on the promoter, among which include (iii) giving the investor a legal entitlement to share in the venture’s profits. Moreover, when standalone digital tokens are purchased over exchanges, token-buyers are not part of any “common enterprise” and the digital tokens’ value is driven by market forces, not managerial efforts.