The US government is using rules created before computers to regulate the Fourth Industrial Revolution. They’re often antiquated and use old-economy paradigms to categorize technology that has no precedent.
The regulation du jour for the SEC is the Howey Test. It is as follows:
“The test of whether there is an ‘investment contract’ under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.”
To recap, the Howey Test is met if there’s an:
- Investment of money
- In a common enterprise
- With an expectation of profits
- Solely from the efforts of others
There is one very very important word here: “solely”
This word is how crypto utility and governance tokens have avoided being designated securities. Their value comes in part from the efforts of others (the developer and management team building/maintaining the app) and also from other factors. The growth and usage of the network and application drives most of the value for a token, so not only is it not “solely” a result of the effort of others, it’s often a minority amount.
Think of it like oil. No doubt some of the value of oil comes from the companies dedicated to extracting it from the ground and making it usable for energy. However most of the value of it comes from demand of the resource itself for consumer use cases. This is why crypto tokens are considered commodities, not securities.
Altcoins are enough of a commodity that they don’t fit the Howey legislation as written. Naturally, the SEC’s strategy is to remove “solely” from the equation so it can bring the entire DeFi industry under its purview.
Howey is a Supreme Court case ruling. It’s the law of the land. This doesn’t matter much to the SEC, they dislike the word "solely" because it disallows them from doing what they want. The SEC has explicitly admitted it disregards the word: “as interpreted by the courts and Commission, profit need not by solely from the effort of others.”
Laws amirite! If you don’t like how they’re worded, just interpret them as if different words are there. You of course don’t have that luxury, but US regulatory agencies sometimes do. Lower courts do this too, because, well, because they can.
They then justify continued undermining of the original law with the ever-convenient use of “precedent”. You don’t need legislators to make amendments to laws when you have regulators do what they want and lower courts that enable them.
A recent decision of interest: LBRY vs the SEC. In it you will see an explicit admission from lower courts that “solely” isn’t that big a deal to them. See the following excerpt:
That circled part tells the story. Yes there is some expectation of profit from management efforts. However the judge directly concedes that LBRY credits had practical use in the platform. That’s a commodity-type use case. That is a direct admission that it is not “solely” coming from the actions of management. This is deeply concerning about how the US may start approaching our industry.
The Supreme Court has been asked twice by the SEC to remove the word “solely” from Howey test legislation, once in 1975 and then again about 20 years later. They refused to remove the word, advising its review wasn’t necessary for the cases at hand. Judges have openly admitted that the word “solely” had simply been ignored by lower courts, and they will (at their discretion) follow that precedent.
The SEC is incrementally advancing legal subterfuge to regulate DeFi, however they’re not coming out with clear guidance on how they intend to approach it. They seem to be selectively choosing targets to hammer and make an example of. Regulation by enforcement.
Businesses need clarity and predictability behind laws and their implementation. They also need to have confidence that the law-enforcers actually respect the laws as written.
A related point: the USSR had a much more expansive and detailed Bill of Rights than the US (really, it promised many more rights). That didn’t matter when the Soviet government wanted to do something that infringed on those 'rights'.
The US Founding Fathers had a good phrase for this: “parchment guarantee”. Meaning laws are just words on paper, the words only matter if they’re respected and enforced. In a way, laws are a meme. If the collective believes in them, then they matter.
This is worth reading:
If this one word goes away, or if regulators keep pretending like it doesn’t exist, the most consequential sector of the 21st century will get driven offshore of the United States.
DeFi projects are not going to go through the pageantry and genuflection of engaging with the SEC for every new project and token when it's clear they're acting in bad faith. They will either go completely anonymous, or they will leave. Probably both.
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