The Crypto industry has had a tough couple of years. It seems like only yesterday that issuers were buying Super Bowl ad space and speculating on the bright future of Dogecoin. Then came a 2022 pock-marked by scandal, fraud, and free-falling prices.
Two years ago, cryptocurrency surged into mainstream popularity. But now is a time of backlash.
If you think about it, it’s actually a lot like disco. For a few minutes in the late ‘70s, everybody loved disco. Then, everybody was mad at disco. Then eventually, we all accepted that disco is just a part of who we are. After all, we love the nightlife. We love to boogie.
But crypto isn’t there yet.
Today, it’s all backlash for crypto, and much of it is happening in the courts. And at least for the moment, it isn’t going great for the crypto biz.
The latest rulings have tilted the scales toward the SEC, and toward plaintiffs who argue that crypto tokens are securities. Should that view ever become precedent, it would have far-reaching consequences for the blockchain industry.
But our guest on next week’s episode of Let’s Talk Markets, Lee Schneider says this is a steaming pile of legal wrongheadedness.
Avalanche
Lee is a financial services and technology lawyer with extensive experience in blockchain. Lee previously co-hosted the Appetite for Disruption podcast with Troy Paredes, is the contributing editor for the Chambers and Partners Fintech Practice Guide, and co-founded Global Blockchain Convergence. He also serves as General Counsel for Ava Lab, which is the birthplace of the Avalanche Smart Contracts Platform.
Full disclosure. Urvin CEO Dave Lauer is on record as being a fan of Avalanche. Arguing that the future of blockchain innovation will ultimately be won out by those with the best technology, Dave calls Avalanche “the most promising and mature tech in crypto outside of Bitcoin and Ethereum. The network is properly decentralized, and it's a proof-of-stake chain that has sub-second finality along with a uniquely flexible approach to sub-chains called subnets.”
That’s why we’re so excited to have Lee on our Podcast, particularly in light of all the legal wrangling in the crypto space today. Indeed, Lee comes from a slightly different perspective than our own.
We’ve noted all along that we have mixed feelings on the SEC’s handling of crypto.
On the one hand, we view the approach taken by the Commission as scattershot, reactive, and unlikely to yield any real lasting precedent.
On the other hand, we tend to agree that the industry is in need of regulatory oversight, especially to the end of protecting investors against fraud.
Lee’s position is that the SEC is simply wrong; that crypto tokens aren’t securities; and that the legal test the courts are using to address the question is being applied incorrectly.
That test is the Howey Test. If you’ve been paying attention to the spectrum of legal cases coming down the pike right now, the Howey Test may already be familiar to you. But let’s take a closer look.
Test Me, Test Me, Why Don’t You Arrest Me
We’ve explored the implications of the Howey Test several times, mostly because it has been the central precedent used to shape recent court decisions on crypto.
In brief, the Howey Test is a Supreme Court standard adopted in 1946 to determine what is or isn’t an “investment contract.” If the application of the Howey Test demonstrates that an investment contract has been entered into, the issuer of any shares in this contract must register these investment opportunities as securities through the SEC.
The Howey Test was originally based on a case surrounding the investment in a business whose profitability was based on oranges. In that case, the investment contract was found to refer to the totality of an arrangement that involved the real estate, resources, and assets used to create a profitable business. Therefore, the investment contract is none of these things individually, but all of these things taken together.
In other words, the oranges are not a contract. The orange groves are not a contract. The real estate on which these groves rest is not a contract. The contract is the arrangement itself, wherein the issuer channels all of these things into a stated pursuit of profit, and wherein the investor pays for a share in this profit.
Torres v. Rakoff
Just a few weeks ago, we did our best to zero in on the moving legal target that is crypto. First, we took on the decision by Judge Analisa Torres of the U.S. District Court of the Southern District of New York, which found that stablecoin issuer Ripple’s sale of XRP tokens were securities when sold to institutional investors, but were not securities when sold to individual investors.
We suggested that perhaps those decisions didn’t make a ton of sense.
Incidentally, Judge Jed Rakoff, opining just a week later, also said it didn’t make a ton of sense. Speaking from the very same bench as Torres, but judging on a plaintiff-raised case against Terraform, Rakoff found that the stablecoin issuer’s promise to investors qualified as an investment contract.
In addition to finding for the plaintiff, Rakoff also demolished the Torres decision. No distinction should be made between tokens which have been sold to institutional or individual investors.
All of the transactions involving the token qualified as investment contracts, says Rakoff. Thus, the current holding of the courts–subject to appeal–is that both Ripple and Terraform are guilty of selling unregistered securities.
Orange You Glad I Didn’t Say Solana?
Stop. You’re both wrong! That’s what Lee Schneider says.
Schneider calls the SEC’s Framework for “Investment Contract” Analysis of Digital Assets a Fallacious Framework…which doesn’t sound like a compliment.
What makes it fallacious? Schneider argues that the SEC (and most disgruntled plaintiffs) are using the Howey to argue that “any asset, item, or thing on a blockchain can be an investment contract and hence a security under the federal securities laws.”
That’s what Schneider says of the plaintiff-raised case against Solana, and its SOL token. Schneider characterizes Solana as “the latest victim of a scurrilous attack by plaintiffs’ lawyers claiming that yet another blockchain token is an investment contract under the test famously set forth in S.E.C. v. W.J. Howey.”
What makes the Howey test so fascinating is that it is rooted in a uniquely tangible case study. The whole orange grove arrangement lends itself easily to any number of analogies. And to Schneider’s way of thinking, this analogizing makes it easy to apply Howey to crypto…and to subsequently reject its use.
That’s Not How This Works
Using the Howey analogy, crypto tokens are oranges; blockchain is the orange grove; and collectively, we really believe in the future of the orange juice biz.
But if we really believed in the future of orange juice, then we would do a whole lot more than buy oranges. We would invest in the organizational infrastructure that turns real estate and orange groves into juice.
Otherwise, you’re just buying oranges. This gives you a right to a mimosa with brunch, but not so much the right to assume the company is working to increase the value of your orange.
Schneider concedes that the Howey Test is both sensible and occasionally difficult to fully navigate, especially when it comes to potentially new applications. But that difficulty does not excuse what he argues is a complete misunderstanding of the test altogether.
From this perspective, the Torres and Rakoff decisions both cast the oranges themselves as securities.
This, suggests Schneider, is absurd.
But arguments for the plaintiff in the Solana case hinge on a pretty wide range of allegations, including the claim that its auction style token drop qualified as an Initial Public Offering (IPO), that the internally concentrated ownership of profits from token sales undermine Solana’s claims of decentralization, and that the network has been prone to outages and internal improprieties.
In other words, the case is pretty far reaching. Where legal action is concerned, the firm may be SOL.
But that doesn’t mean this legal case will yield any kind of meaningful precedent. Schneider’s dissection of Howey, and the bevy of murky court cases before us, suggest that we’re no closer to a clear regulatory path on crypto.
Don’t Stop ‘til You Get Enough
To reiterate a point though, if crypto was disco, this is about the point in its history when Chicago White Sox fans were burning records and the Feds were raiding Studio 54. We’re in the flush-the-coke-before-they-bust-in-the-bathroom-door stage of development. (Sam Bankman-Fried–we’re looking in your direction).
But here’s the good news for crypto…at least in the long term. Disco never really went away. We just learned how to peacefully coexist with the Bee Gees, John Travolta, and sequined jumpsuits. (I for one, wouldn’t have it any other way.)
What’s the point of this deep and seemingly irrelevant tangent? Dark times though these may be for crypto, normalcy and clarity will one day prevail. We just aren’t anywhere near that day yet.
Dave Lauer is a co-founder and CEO of Urvin Finance, where he leads the team in building Urvin Terminal. Prior to founding Urvin Finance, Dave spent over a decade advocating for financial market reform after quitting his job as a high-frequency-trader.