Evaluation of “Investment Contract” and the Crypto Industry
Is It Time to Re-Assess Whether the Term “Investment Contract” in the Securities Act and Securities Exchange Act Is Unconstitutionally Vague?
I. Introduction
It is no secret that the term “investment contract” in the United States’s federal securities laws has had an outsized effect on the global crypto industry. Under U.S. law, an “investment contract” is a “security,” and since 1946, courts have consistently applied the Howey test to determine whether a particular transaction is an “investment contract.” That test has provided the necessary notice, knowledge, and consistency for legal and natural persons to assess whether a transaction involves a “security” and triggers the application of the securities laws.
With the advent of crypto asset transactions, however, the term “investment contract” and the Howey test may not give a person of ordinary intelligence a reasonable opportunity to know what is prohibited and may not provided explicit standards. In other words, the term “investment contract” as applied to crypto assets may be unconstitutionally vague. Indeed, recent holdings suggest that some but not all transactions for the same crypto assets may be “investment contracts,” depending on who is buying, who is selling, who created the asset, who issued the asset, what the issuer stated about the asset, what the buyer thought about the asset, the asset’s technology, and/or the asset’s use. In that morass, buyers, sellers, exchanges, and other stakeholders cannot know beforehand whether the securities laws—including registration and/or accredited investor requirements—apply to putative transactions. Because of the ambiguity, moreover, no one can actually comply with the securities laws, file a registration and prospectus, and issue a crypto asset as a publicly traded security. Accordingly, the term “investment contract” may be too vague to provide notice (or facilitate compliance).
In light of recent challenges by private actors against the SEC and its authority, moreover, large crypto stakeholders may have the resources, sophistication, motivation, and opportunity to challenge the term “investment contract” as unconstitutional when applied to crypto assets. In recent federal suits, for example, Crypto.com and 18 state AGs sued the SEC over crypto policy. Perhaps other stakeholders could follow suit but set their sights higher. Instead of challenging the SEC’s rule-making process or final agency action(s), plaintiffs could ask federal courts to hold unconstitutional the application of the term “investment contract” to crypto assets. The SEC and federal courts have focused on that particular term as the basis for fitting assorted crypto assets into the definition of “security.” Thus, if “investment contracts” are no longer defined as “securities,” the SEC would lose its ability to regulate crypto assets, and lawmakers would be free to fill the current regulatory vacuum that has been swallowing businesses whole and stalling U.S. innovation with fintech.
II. The Securities Act of 1933, Securities 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:
Securities Act, 15 U.S.C. § 77b(a)(1)
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.
Exchange Act, 15 U.S.C. § 78c(a)(10)
The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, 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 instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.
Once those statutes were in force, litigants and courts grappled for years with defining two words: “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) (internal quotations omitted).
Since 1946, therefore, the Howey Test has guided U.S. businesses and individuals in assessing whether and to what extent 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 Consistently Rejected Historical 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. To date, those challenges have failed.
“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.” Sec. & Exch. Comm'n v. Ripple Labs, Inc., 20 CIV. 10832 (AT), 2023 WL 4507900, at *14 (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) (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, 17 CR 647 (RJD), 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, courts have repeatedly rejected arguments that the term “investment contract” is unconstitutionally vague or otherwise violates due process:
United States v. Bowdoin, 770 F. Supp. 2d 142, 148–49 (D.D.C. 2011) (internal citations and quotations omitted):
Howey binds the Court and, in as much 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.
Even were Howey not dispositive, the Court would deny Mr. Bowdoin's motion to find the Securities Act too vague for constitutional enforcement.
* * *
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) (internal citations and quotations omitted):
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) (internal citations and quotations omitted):
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.
Kik cites one case where the Second Circuit, in assessing an as-applied vagueness challenged, took account of uncertainty in the SEC's interpretation of a provision. See Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996). In Upton, the SEC had been inconsistent in its enforcement of a rule as applied to the same practice occurring consistently across the industry for years. Id. at 98. By contrast, as Kik acknowledges, every cryptocurrency, along with the issuance thereof, is different and requires a fact-specific analysis. 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), motion to certify appeal denied, 20 CIV. 10832 (AT), 2023 WL 6445969 (S.D.N.Y. Oct. 3, 2023):
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,20 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. Courts Have Inconsistently Applied the Howey Test to Crypto Assets
As summarized above, 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 into 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 crypto assets 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 July 2023 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:
(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, e.g., Sec. & Exch. Comm'n v. Ripple Labs, Inc., 20 CIV. 10832 (AT), 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.
Ripple Labs, Inc., 2023 WL 4507900, at *10.
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.
* * *
It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple's efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple.
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.
Ripple Labs, Inc., 2023 WL 4507900, 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.” Ripple Labs, Inc., 2023 WL 4507900, 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.
Ripple Labs, Inc., 2023 WL 4507900, at *13.
B. The S.D.N.Y.’s July 2023 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., 684 F. Supp. 3d 170 (S.D.N.Y. 2023). The court concluded that those tokens satisfied every Howey factor and constituted “investment contracts” and, in turn, “securities.” Id.. 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 197.
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. 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. at 198.
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. And the dispositive question under Howey’s second prong is whether the buyer purchased the asset from the issuer (i.e., primary market) or on a secondary market.
According to Judge Rakoff, however, the Howey test does not distinguish between types of purchasers—let alone highlight a purchaser’s status as a dispositive element of the test. Rather, Judge Rakoff concluded that a purchaser’s market is irrelevant under the Howey test. See Terraform Labs Pte. Ltd., 2023 WL 4858299, at *15 (noting that “Howey makes no such distinction between purchasers” and that a purchaser’s market “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” (emphasis added)).
Hence, 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.
C. The S.D.N.Y.’s March 2024 Decision in SEC v. Coinbase
In the SEC’s enforcement action against Coinbase, the court assessed allegations that transactions involving 13 crypto-assets—SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO—were transactions involving investment contracts. The court identified the following relevant principles:
[W]hen conducting the Howey analysis, courts are not to consider the crypto-asset in isolation. Instead, courts evaluate whether the crypto-assets and the full set of contracts, expectations, and understandings surrounding its sale and distribution—frequently referred to using the shorthand “ecosystem”—amount to an investment contract.
Finally, in assessing the circumstances surrounding the sale of a crypto-asset, courts should look to what the offeror invites investors to reasonably understand and expect. To do so, courts examine how, and to whom, issuers or promoters market the crypto-asset.
Sec. & Exch. Comm'n v. Coinbase, Inc., 726 F. Supp. 3d 260, 289 (S.D.N.Y. 2024) (cleaned up). Applying those principles, the court concluded that the SEC’s “factual allegations, taken as true at this stage, support the SEC’s claim that investors in a common enterprise were motivated to purchase certain crypto-assets based on an expectation of profits solely derived from the efforts of others” and “that the SEC has adequately pleaded that Coinbase customers engaged in transactions involving the Crypto-Assets that amounted to ‘investment contracts’ under Howey.” Id.
Disagreeing with the Ripple framework, moreover, the court further reasoned that secondary market transactions in the subject crypto assets are not excepted from Howey’s scope:
And with specific regard to the Crypto-Assets at issue here, there is little logic to the distinction Defendants attempt to draw between the reasonable expectations of investors who buy directly from an issuer and those who buy on the secondary market. An investor selecting an investment opportunity in either setting is attracted by the promises and offers made by issuers to the investing public. Accordingly, the manner of sale has no impact on whether a reasonable individual would objectively view the issuers’ actions and statements as evincing a promise of profits based on their efforts.
Id. at 293.
D. The N.D. Cal.’s August 2024 Kraken Decision
In the SEC’s enforcement action against Kraken, the Northern District of California confirmed that an “investment contract” may exist even if there is no contract between the parties:
Investment contracts are not limited to actual contracts. Numerous courts have found that crypto assets were properly alleged to form investment contracts in cases where there was no underlying formal written or oral contract. That principle is well-settled: Investment contracts are not limited to actual contracts. Numerous courts have found that crypto assets were properly alleged to form investment contracts in cases where there was no underlying formal written or oral contract.
Sec. & Exch. Comm’n v. Payward, Inc., No. 23-CV-06003-WHO, 2024 WL 4511499, at *9 (N.D. Cal. Aug. 23, 2024). Under that expansive reading, the Court left open that any of the crypto assets identified by the SEC could “form the basis of investment contracts”:
The SEC confuses its case by referring to the assets at issue as “crypto assets securities” throughout its complaint. But this is a semantics error that does not obscure the SEC's theory of liability. The SEC's theory of liability is that Kraken violates federal securities laws by “operating a platform on which crypto assets are offered and sold as investment contracts,” and that Kraken customers can buy and sell crypto assets which “form the basis of investment contracts covered under U.S. Securities laws.” This is a theory that other courts have allowed to advance and is consistent with Howey. The SEC alleges that the circumstances surrounding the sale, purchase, or exchange of crypto assets on Kraken are such that those transactions involve investment contracts. Whether or not that is true will be determined after discovery.
Id. Of course, the Court required discovery in order to determine whether any particular types of transactions (e.g., purchases, sales, or trades) on Kraken of any particular types of crypto assets involve investment contracts.
The Court further assessed whether “secondary market transactions” on Kraken were “investment contracts” Id. at *10. Disagreeing with the Ripple framework, the Court held:
In short, binding authority requires the court to evaluate whether an investment contract is formed in a secondary market to consider the features of that secondary market transaction. It does not require that the court ignore anything that happened in a primary market transaction; if a reasonable investor would understand representations made during the primary market transactions to carry forward into the secondary market, then those representations may be considered. What matters are the reasonable expectations of the investor. That a transaction does not involve the asset's primary issuer does not foreclose the possibility that the primary issuer's representations follow the asset through to the secondary market.
Id. at *11.
V. These Inconsistent Applications of the Howey Test Could Give Rise to New Compelling Challenges to “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, sellers, traders, or brokers of a new crypto asset 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. 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. As to XRP, those buyers would be similarly situated to the buyers who had purchased XRP directly from Ripple; in other words, the securities disclosure requirements and protections would continue to apply as XRP was sold and resold in a secondary market.
These disparate holdings—as to how to apply a decades-old term to a new class of emergent technology—create more ambiguity than guidance as to whether and when securities laws apply to crypto transactions. Even if there is no legal contract, there may be an “investment contract.” The same crypto asset might be a security under one Howey framework but not under another Howey framework. Some transactions surrounding that crypto asset may be securities, whereas other transactions are not. The answer may depend on the expectations of the buyers or sellers, the objective technological components of that crypto-asset’s ecosystem, or the status of the transactions as direct or secondary.
Furthermore, those amorphous and potentially inconsistent principles apply to thousands of cryptoassets with unique attributes and ecosystems that affect the goals, coordination, efforts, and profits of assorted stakeholders. Meanwhile, good faith actors—whether creators, issuers, brokers, exchanges, buyers, sellers, or consumers—cannot know for certain whether a transaction involves a “security.” The SEC has not provided a specific framework other than miscellaneous enforcement actions yielding inconsistent decisions from federal courts. Stakeholders, therefore, cannot know if they have disclosure requirements, obligations, liabilities, or protections arising from the securities laws.
In sum, 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. Without providing that reasonable opportunity, the law is arguably unconstitutionally vague. In rejecting historical vagueness challenges, moreover, courts repeatedly noted the guidance provided by abundant case law applying Howey. For the foregoing reasons, however, that precedent arguably provides more ambiguity and confusion than guidance for those involved in crypto asset transactions in the United States.
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