Is It Time to Re-Assess Whether the Term “Investment Contract” in the Securities Act and Exchange Act is Unconstitutionally Vague?
I. Introduction
For years, courts viewed the “Howey” test as clear guidance as to whether a particular asset or investment was a security. Now, recent inconsistent decisions, particularly in the crypto space, have questioned that clear guidance. The effect is a rekindling the debate as to whether the term “investment contract” is void for vagueness because it fails to give people and businesses a reasonable answer as to what is or is not a security.
II. The Securities Act of 1933, Exchange Act of 1934, “Investment Contract”, and Howey Test
In the wake of the 1929 stock market crash and in the midst of the Great Depression, Congress passed the Securities Act of 1933 (“Securities Act”) and Securities Exchange Act of 1934 (“Exchange Act”) to establish registration requirements, disclosure obligations, rights, and liabilities vis-à-vis the purchase and sale of securities. Both statutes define a “security” as follows:
The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
15 U.S.C. § 77b(a)(1); 15 U.S.C. § 78c(a)(10). Once those statutes were in force, litigants and courts grappled for years with defining two of the 145 words in that definition: “investment contract.”
In 1946, “the Supreme Court held in no uncertain terms that ‘an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Sec. & Exch. Comm'n v. Terraform Labs Pte. Ltd., 23-CV-1346 (JSR), 2023 WL 8944860, at *13 (S.D.N.Y. Dec. 28, 2023) (quoting SEC v. W.J. Howey Co., 328 U.S. 293 (1946)); see also Teed v. Chen, 22-CV-02862-CRB, 2022 WL 16839496, at *11 (N.D. Cal. Nov. 9, 2022) (“The Ninth Circuit has distilled Howey's definition of an investment contract into a three-part test requiring (1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.”); United States v. Kane, 23-CR-20172-KMW, 2023 WL 8277602, at *2 (S.D. Fla. Nov. 30, 2023) (“The Eleventh Circuit has divided the Howey test into its three elements: (1) an investment of money, (2) a common enterprise, and (3) the expectation of profits to be derived solely from the efforts of others.”). “In analyzing whether a contract, transaction, or scheme is an investment contract, form should be disregarded for substance and the emphasis should be on economic reality and the totality of circumstances.” Sec. & Exch. Comm'n v. Ripple Labs, Inc., 20 CIV. 10832 (AT), 2023 WL 4507900, at *5 (S.D.N.Y. July 13, 2023), motion to certify appeal denied, 20 CIV. 10832 (AT), 2023 WL 6445969 (S.D.N.Y. Oct. 3, 2023) (internal quotations omitted).
Since 1946, therefore, the Howey test has guided U.S. businesses and individuals in assessing whether a particular financial product implicates the securities laws. Without that clear framework, good faith actors could not know whether a particular product might be an “investment contract” and, in turn, an unregistered security exposing buyers and sellers to rescission or other liabilities under the Securities Act or Exchange Act.
III. Courts Have Historically Rejected Challenges to the Term “Investment Contract” and/or to the Howey Test as Unconstitutionally Vague
In civil and criminal cases, litigants have challenged the constitutionality of the term “investment contract” and its accompanying Howey test. As explained below, those challenges have failed to date.
“A fundamental principle in our legal system is that laws which regulate persons or entities must give fair notice of conduct that is forbidden or required. This clarity requirement is essential to the protections provided by the Due Process Clause of the Fifth Amendment, and requires the invalidation of laws that are impermissibly vague.” Ripple Labs, Inc., 2023 WL 4507900, at *14 , (cleaned up). “In the absence of first amendment considerations, vagueness challenges must be evaluated based on the particular application of the statute and not ‘on the ground that [the statute] may conceivably be applied unconstitutionally to others in situations not before the Court.’” United States v. Zaslavskiy, 17 CR 647 (RJD), 2018 WL 4346339, at *8 (E.D.N.Y. Sept. 11, 2018) (quoting United States v. Coonan, 938 F.2d 1553, 1562 (2d Cir. 1991)); see also United States v. Bowdoin, 770 F. Supp. 2d 142, 148–49 (D.D.C. 2011) (“When the interpretation of a statute does not implicate First Amendment rights, a vagueness challenge will be assessed only as the statute has been applied, i.e., in light of the specific facts of the case at hand and not with regard to the statute's facial validity.”).
“When evaluating an as-applied challenge to a statute for vagueness, we employ a two-part test: we must first determine whether the statute gives the person of ordinary intelligence a reasonable opportunity to know what is prohibited and then consider whether the law provides explicit standards for those who apply it.” Zaslavskiy, 2018 WL 4346339, at *8; see also Ripple Labs, Inc., 2023 WL 4507900, at *14 (“Laws fail to comport with due process when they (1) fail to provide a person of ordinary intelligence fair notice of what is prohibited, or (2) are so standardless that they authorize or encourage seriously discriminatory enforcement.” (cleaned up)). As to the enforcement question, courts “may hold that a law does not authorize arbitrary and discriminatory enforcement based on a conclusion (1) that a statute as a general matter provides sufficiently clear standards to eliminate the risk of arbitrary enforcement or (2) that, even in the absence of such standards, the conduct at issue falls within the core of the statute's prohibition, so that the enforcement before the court was not the result of the unfettered latitude that law enforcement officers and factfinders might have in other, hypothetical applications of the statute.” U.S. Sec. & Exch. Comm'n v. Kik Interactive Inc., 492 F. Supp. 3d 169, 182–83 (S.D.N.Y. 2020). “Whether a law is impermissibly vague is an objective inquiry.” Id.
Applying those standards in criminal and civil litigation, courts have repeatedly rejected arguments that the term “investment contract” is unconstitutionally vague or otherwise violates due process:
“Howey binds the Court and, inasmuch as the Supreme Court in 1946 found the Securities Act, and specifically its use of the term ‘investment contract,’ not to be so vague as to prevent enforcement, this Court is not free to substitute its own judgment. Congress defined securities to include ‘investment contracts’ based upon multiple years of enforcement of that term by various States under state laws. The lineage of the term is too long and well-recognized for Mr. Bowdoin's 2011 claim of unconstitutional vagueness to stand. Mr. Bowdoin's attack on the facial vagueness of the term ‘investment contract’ as a type of security covered by the Securities Act is without merit. . . . It would be more than passing strange to conclude in 2011 that the Securities Act, passed decades ago and enforced thousands of times in the interim, is invalid because of facial vagueness and the Court finds no reason to do so.”
United States v. Zaslavskiy, 17 CR 647 (RJD), 2018 WL 4346339, at *8 (E.D.N.Y. Sept. 11, 2018) (cleaned up):
“The test expounded in Howey has—for over 70 years—provided clear guidance to courts and litigants as to the definition of ‘investment contract’ under the securities laws. Moreover, the abundance of caselaw interpreting and applying Howey at all levels of the judiciary, as well as related guidance issued by the SEC as to the scope of its regulatory authority and enforcement power, provide all the notice that is constitutionally required.”
U.S. Sec. & Exch. Comm'n v. Kik Interactive Inc., 492 F. Supp. 3d 169, 182–83 (S.D.N.Y. 2020) (cleaned up):
“First, the law regarding the definition of investment contract gives a reasonable opportunity to understand what conduct and devices it covers. Howey provides a clearly expressed test for determining what constitutes an investment contract, and an extensive body of case law provides guidance on how to apply that test to a variety of factual scenarios. That is constitutionally sufficient.
Second, for similar reasons, the law provides sufficiently clear standards to eliminate the risk of arbitrary enforcement. Howey is an objective test that provides the flexibility necessary for the assessment of a wide range of investment vehicles. Kik focuses much of its argument on the SEC's failure to issue guidance on securities enforcement related specifically to cryptocurrencies, SEC officials’ inconsistent public statements on the issue, and the SEC's failure to bring enforcement actions against other issuers of digital tokens. However, the law does not require the Government to reach out and warn all potential violators on an individual or industry level. . . . Furthermore, the vagueness inquiry does not call for a factual investigation into whether a statute has led to arbitrary enforcement; it asks, objectively, whether the statute authorizes or even encourages arbitrary and discriminatory enforcement. The statute at issue here does not.”
Sec. & Exch. Comm'n v. Ripple Labs, Inc., 20 CIV. 10832 (AT), 2023 WL 4507900, at *14–15 (S.D.N.Y. July 13, 2023) (cleaned up):
“The Court rejects Defendants’ fair notice and vagueness defenses as to the Institutional Sales. First, the caselaw that defines an investment contract provides a person of ordinary intelligence a reasonable opportunity to understand what conduct it covers. Howey sets forth a clear test for determining what constitutes an investment contract, and Howey’s progeny provides guidance on how to apply that test to a variety of factual scenarios.
Second, the caselaw articulates sufficiently clear standards to eliminate the risk of arbitrary enforcement. Howey is an objective test that provides the flexibility necessary for the assessment of a wide range of contracts, transactions, and schemes. Defendants focus on the SEC's failure to issue guidance on digital assets and its inconsistent statements and approaches to regulating the sale of digital assets as investment contracts. But the SEC's approach to enforcement, at least as to the Institutional Sales, is consistent with the enforcement actions that the agency has brought relating to the sale of other digital assets to buyers pursuant to written contracts and for the purpose of fundraising. Moreover, the law does not require the SEC to warn all potential violators on an individual or industry level.”
IV. In 2023, Courts Inconsistently Applied the Howey Test to Cryptoassets
As summarized, supra, courts have agreed that “the caselaw that defines an investment contract provides a person of ordinary intelligence a reasonable opportunity to understand what conduct it covers.” See, e.g., Ripple Labs, Inc., 2023 WL 4507900, at *14–15. But recent factual and legal developments could reasonably call that conclusion to question.
More specifically, federal judges have publicly disagreed as to how to apply the Howey test in crypto litigation. The disagreement, moreover, does not arise from differing results after applying the Howey test to dissimilar cryptoassets with discrepant facts. Rather, the disagreement arises from the proper meaning and application of the Howey factors. Because of that inconsistency, courts can disagree on whether the same asset is an “investment contract” under Howey. And if federal judges disagree as to what Howey means and how to apply the test, then how could a person of ordinary intelligence have a reasonable opportunity to understand what conduct the term “investment contract,” as construed under Howey, covers?
A. The S.D.N.Y.’s Ripple Labs, Inc. Decision
In Ripple Labs, Inc., Judge Torres applied the Howey test to purchases and sales of XRP (Ripple). The court identified and distinguished three categories of XRP transactions:
(1) “Institutional Sales,” meaning sales of XRP from Ripple to “sophisticated individuals and entities (the “Institutional Buyers”) pursuant to written contracts”;
(2) “Programmatic Sales,” meaning sales “to public buyers (“Programmatic Buyers”) on digital asset exchanges”;
(3) “Other Distributions,” meaning distributions pursuant to written contracts to employees as compensation and to third parties as part of Ripple’s Xpring initiative to develop new applications for XRP and the XRP Ledger.”
See Ripple Labs, Inc., 2023 WL 4507900, at *8 (S.D.N.Y. July 13, 2023) (“XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract. Rather, the Court examines the totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP.”). The Court then applied the Howey test to each category, with differing results.
First, the court concluded that the Institutional Sales were “investment contracts” and, therefore, “securities”:
Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts. From Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP. . . . Therefore, having considered the economic reality and totality of circumstances surrounding the Institutional Sales, the Court concludes that Ripple's Institutional Sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act.
Id. at *10 (cleaned up).
Second, the court concluded that the Programmatic Sales (i.e., to the public through exchanges) did not satisfy the final prong requiring an “expectation of profits produced by the efforts of others”:
Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, Programmatic Buyers could not reasonably expect the same. Indeed, Ripple's Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. Since 2017, Ripple's Programmatic Sales represented less than 1% of the global XRP trading volume. Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money. . . . Of course, some Programmatic Buyers may have purchased XRP with the expectation of profits to be derived from Ripple's efforts. However, the inquiry is an objective one focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant. Here, the record establishes that with respect to Programmatic Sales, Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it. In fact, many Programmatic Buyers were entirely unaware of Ripple’s existence.
Id. at *11–12.
Third, the court concluded that the Other Distributions “do not satisfy Howey’s first prong that there be an ‘investment of money’ as part of the transaction or scheme.” Id. at *13. The court reasoned:
In every case [finding an investment contract] the purchaser gave up some tangible and definable consideration in return for an interest that had substantially the characteristics of a security. Here, the record shows that recipients of the Other Distributions did not pay money or some tangible and definable consideration to Ripple. To the contrary, Ripple paid XRP to these employees and companies.
Id.
B. The S.D.N.Y.’s Terraform Labs Pte. Ltd. Decision
In Terraform Labs Pte. Ltd., Judge Rakoff considered whether, under the Howey test, UST, LUNA, wLUNA, and MIR were “investment contracts” and, therefore, “securities.” Sec. & Exch. Comm'n v. Terraform Labs Pte. Ltd., 23-CV-1346 (JSR), 2023 WL 4858299, at *10-15 (S.D.N.Y. July 31, 2023). The court concluded that those tokens satisfied every Howey factor and constituted “investment contracts” and, in turn, “securities.” Id. at *10-15. As to the second factor (reasonable expectation of profits), the court reasoned:
[T]he SEC's claim that the defendants held out to the coins’ consumers the possibility of profiting from their purchases is supported by specific factual allegations in the Amended Complaint, including readouts of investor meetings, excerpts of investor materials, and screenshots of social media posts made by Mr. Kwon and other Terraform executives.
Id. at *14.
Notably, the court explicitly distinguished the analysis from Ripple Labs, Inc., stating as follows:
There, that court found that, “[w]hereas ... [i]nstitutional [b]uyers reasonably expected that [the defendant crypto-asset company] would use the capital it received from its sales to improve the [crypto-asset] ecosystem and thereby increase the price of [the crypto-asset],” those who purchased their coins through secondary transactions had no reasonable basis to expect the same. According to that court, this was because the re-sale purchasers could not have known if their payments went to the defendant, as opposed to the third-party entity who sold them the coin. Whatever expectation of profit they had could not, according to that court, be ascribed to defendants’ efforts.
But Howey makes no such distinction between purchasers. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.
Id. at *15. The court concluded that “secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf.” Id.
Those courts’ divergent applications of the Howey test are irreconcilable. According to Judge Torres, the Howey test can result in an asset (e.g., XRP) acting as a security as to some buyers/sellers while simultaneously acting as a non-security as to other buyers/sellers. Judge Torres further held that the dispositive question under Howey’s second prong is whether the buyer purchased the asset as an initial sale from the issuer (i.e., primary market) or as a resale on an exchange (i.e., secondary market). According to Judge Rakoff, however, the Howey test does not distinguish between types of purchasers, and a purchaser’s market (primary market v. secondary is irrelevant to the analysis. Those paradigms conflict—i.e., the distinction between purchasers in the primary market versus the secondary market cannot simultaneously be a dispositive distinction and an irrelevant distinction under Howey.
In sum, the Ripple framework and Terraform framework materially differ. The former framework: (a) permits a single cryptoasset to be a “security” as to some sales (from issuer to original buyers) but not as to other contemporaneous sales (from original buyers to subsequent buyers); and (b) hinges on a determination of the objective viewpoints of different cohorts of purchasers. The latter framework: (a) requires an asset to either be or not be a “security” as to all buyers/sellers at the same time; and (b) hinges on a determination of the objective viewpoints of all purchasers.
V. Could Those Inconsistent Applications of the Howey Test Give Rise to New Challenges to the Term “Investment Contract” as Unconstitutionally Vague?
These discrepant iterations of the Howey test suggest that historical analyses of the constitutional vagueness of “investment contract” may be obsolete. Courts have consistently held that the term “investment contract” and the Howey test give the person of ordinary intelligence a reasonable opportunity to know what is prohibited and provide explicit standards for those who apply the securities laws. But buyers and sellers of a new cryptoasset cannot know how to apply Howey or what conduct is prohibited.
Under the Ripple framework for example, the Securities Act and Exchange Act do not impose any obligations, protections, rights, or liabilities as to the billions of XRP transactions between buyers and sellers on the secondary market. Ripple and its executives are responsible only to direct purchasers of XRP and have no obligations to subsequent purchasers when XRP is resold. Those secondary market transactions would not be transactions in “securities.” Accordingly, no one in the secondary market is entitled to receive the information normally given in a registration statement, prospectus, 10-Ks, and 10-Qs. No one in the secondary market is protected by the securities laws’ prohibition of material misrepresentations and schemes to defraud. No one has a duty to those purchasers in the secondary market.
Under the Terraform framework, however, Ripple and its executives would have robust obligations as to buyers of XRP in the secondary market. Those buyers would be similarly situated to the buyers who had purchased XRP directly from Ripple. Therefore, the securities disclosure requirements and protections would continue to apply as XRP was sold and resold in a secondary market.
Simply put, the same cryptoasset might be a security under one Howey framework but not under another Howey framework. And a seller’s disclosure requirements, obligations, and liabilities as to that asset will drastically change if the asset is a security. Consequently, a person of ordinary intelligence arguably lacks a reasonable opportunity to know what is prohibited by the term “investment contract” as assessed under the Howey test. Indeed, prior to the Ripple decision, would a person of ordinary intelligence have reasonably known that her purchases of XRP from Ripple were subject to the securities laws but her simultaneous resales of those XRP were wholly outside those laws? If that person lacked a reasonable opportunity to know those distinctions , the law is arguably unconstitutionally vague.
Furthermore, the historical rationales—upholding the constitutionality of “investment contract”—may collapse under the weight of the modern discrepancies under Howey. In rejecting vagueness challenges, courts repeatedly highlighted the guidance provided by decades of abundant caselaw applying Howey in assorted factual scenarios. See Section III, supra. For multiple reasons, however, that precedent does not provide the same guidance as to Howey and cryptoassets.
First, cryptoassets pose novel factual scenarios that litigants and courts could not have addressed until recently. Indeed, it is unprecedented for dozens of businesses to issue—and millions of consumers and investors to transact in—trillions of units in a new, undefined asset class.
Second, prior to 2023, Howey’s progeny did not indicate that an asset, at a single point in time, can be a security as to one seller/purchaser but not as to another seller/purchaser (as held in Ripple Labs, Inc.). Therefore, issuers, investors, and consumers in XRP, for example, likely received minimal benefit from the decades of Howey guidance repeatedly cited by courts.
Finally, the disagreement in the Terraform Labs Pte. Ltd. decision suggests that the historical Howey precedent does not support or provide guidance for the novel holdings in Ripple Labs, Inc. If Judge Rakoff gleaned different guidance than Judge Torres from decades of precedent, then how could reasonably intelligent members of the public have clear guidance from that precedent?
In sum, it is unclear under Howey whether: (a) an asset can be an investment contract as to some buyers or sellers but not as to others; and (b) the “expectation of profit” prong should be assessed from the perspective of all purchasers or separately assessed from the perspective of different cohorts of purchasers. If the public cannot reasonably answer those questions about the meaning of “investment contract,” then the term may prove unconstitutionally vague.