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The Howey Test Is Unsuitable For Crypto Regulation Research Paper Argues

The Howey Test Is Unsuitable For Crypto Regulation Research Paper Argues

Ripple’s University Blockchain Research Initiative (UBRI) has funded the Fintech and Blockchain Collaboratory by Rutgers Center for Corporate Law and Governance led by Professor Guseva. This investigative collaboration has resulted in a research paper emerging that outlines the inconsistencies by the SEC with regards to regulating cryptocurrency. 

The Howey Test is a financial regultory function created by the Supreme Court to determine if specified transactions are investment contracts. This test, which has been used for over 70 years, determines that transactions that are considered securities are subject to disclosure and registration requirements. The Howey test is problematic for crypto because it was thought up at a time before digital currencies, and according to the recent research by Guseva, is no longer suitable for judging innovations in digital currency.

“I am worried about the dynamic inconsistencies in the recent SEC enforcement actions. Together with the broad reach of the Howey test, the inconsistencies in enforcement may exacerbate uncertainty and fail to provide market participants with a clear ex ante understanding of the securities laws”.

Last December the U.S. Securities and Exchange Commission tried to sue Ripple Labs for not registering their tokens, with the view that the cryptocurrency XRP is a security, despite excluding Bitcoin and Ether from being regulated like stocks or bonds. Ripple contested this lawsuit, based on the flaws in the Howey test:

“The SEC’s filing, based on an overreaching legal theory, amounts to picking virtual currency winners and losers as the SEC has exempted Bitcoin and Ether from similar regulation,”

The research conducted by Kuseva cited Ripple, Telegram, and Kik Interactive as examples of the inconsistency of the securities laws, which penalised the aforementioned companies with fines of up to $5 million in the case of Kik, and banned Telegram from selling its cryptocurrency.  If the SEC successfully sues Ripple Labs, the consequences for other decentralised cryptocurrencies could be severe. 

The SEC has outlined the important difference between cryptocurrencies and tokens, as SEC Chairman Jay Clayton recently stated:

”There are different types of crypto assets. Let me try and divide them into two areas. A pure medium of exchange, the one that’s most often cited, is Bitcoin. As a replacement for currency,that has been determined by most people to not be a security.Then there are tokens, which are used to finance projects. I’ve been on the record saying there are very few, there’s none that I’ve seen, tokens that aren’t securities.”

The current framework in place by the SEC utilises the Howey test to determine whether a digital asset is an investment contract when there is “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”, but the test fails to specify the difference between a utility token, currency, and a security. 

If the SEC successfully sues Ripple Labs and determines their XRP token is a security, then the consequences for other crypto tokens are likely to be far reaching. In the meanwhile the cryptocurrency market continues to expand.

Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.

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