The crypto community celebrated a court victory on Jan. 30 when the United States Securities and Exchange Commission (SEC) conceded in the LBRY case appeal hearing that secondary sales of their LBC coin were not security sales. John Deaton, a friend of the court, or in this case amicus curiae, was so excited that he created a video for his CryptoLawTV channel hosted on Twitter that evening.
Deaton, also an amicus curiae in the Ripple case, recounted a conversation he had with the judge that day. “Look, let’s not pretend. Aftermarket sales are a problem,” Deaton recalled.
Deaton was referring to the paper “The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities” by Lewis Cohen, Gregory Strong, Freeman Lewin and Sarah Chen of law firm DLx, which Cohen co-founded. Deaton previously praised the paper in November 2022 when it was filed in the Ripple case, where Cohen is also an amicus curiae.
There is a growing excitement around the newspaper. It appeared on the Social Science Research Network preprint repository on December 13. Speaking to Cohen in mid-January, Cointelegraph said the paper was the most downloaded in the site’s securities law category, with 353 downloads after about a month. That number more than doubled in the following two weeks. The paper has also garnered attention in mainstream and legal media, as well as crypto-related podcasts. Its unusual title is a reference to James Joyce’s Ulysses.
The Cohen paper digs deep into one of the timeless adages of crypto securities law: securities are not oranges. This refers to the Howey test introduced by the US Supreme Court in 1946 to identify a security. The paper exhaustively examines the Howey test and proposes an alternative to the current use of the test.
When Howey met Cohen
Not everyone advocates the use of Howey’s test on crypto assets, often arguing that the test is better suited for tracking fraud than as an aid to registration. Cohen himself agreed with this position in a Feb. 3 podcast. Nonetheless, the paper’s authors do not dispute the use of the Howey test – which arose from a case of orange groves – on crypto assets.
A brief summary does not come close to capturing the breadth of the paper’s analyses. In just over 100 pages plus appendices, the authors discuss SEC policy and cases involving crypto, relevant legal precedents, the Securities and Exchange Acts, and blockchain technology. They reviewed 266 federal Circuit Court and Supreme Court decisions — every relevant case they could find — to reach their conclusions. They invite the public to add other relevant cases to their list on LexHub GitHub.
The Howey test consists of four elements, often referred to as prongs. According to the test, a transaction is a security if it originates in (1) an investment, (2) in a joint venture, (3) with an expectation of profit, or (4) through the performance of others. All four test conditions must be met, and the test can only be applied retrospectively.
In extremely simple outlines, Cohen and co-authors argue that “fungible crypto assets” do not meet the definition of a security, with the rare exception of securities, which are securities by nature. This is the insight captured in the proverb about oranges.
The paper’s authors go on to say that a crypto asset offering in the primary market could be a security under Howey. However, they note, “To date, Telegram, Kik, and LBRY remain the only thoroughly informed and adjudicated cases related to the fundraising sale of crypto.”
Referring to the SEC’s lawsuit against messaging service Telegram, she claimed its initial $1.7 billion coin offering was an unregistered securities offering that was ruled in favor of the SEC in 2020. The SEC case against Kik Interactive also involved token sales and was ruled in favor of the SEC in 2020. The SEC also won its unregistered securities sales case against LBRY in 2022.
Related: The Aftermath of LBRY: Consequences of Crypto’s Ongoing Regulatory Process
The paper’s biggest innovation is its views on crypto asset transactions in secondary markets. The authors argue that the Howey test should again be applied to selling crypto assets on secondary markets such as Coinbase or Uniswap. The authors write:
“Securities regulators in the US have sought to address the many issues raised by the rise of crypto assets […] generally by applying Howey’s test to transactions in those assets. However, […] Regulators have gone beyond current case law to suggest that most fungible crypto assets are “securities” themselves, a position that would give them jurisdiction over nearly all activities that take place with those assets.”
The authors claim that for the most part, crypto assets in the secondary market will not fit the Howey definition. Mere ownership of an asset does not create “a legal relationship between the token owner and the entity that deployed the smart contract that created the token, or that raised funds from other parties through the sale of the tokens.” Thus, secondary transactions do not satisfy the second Howey pin, which requires a third party.
Based on their extensive study of Howey-related decisions, the authors conclude:
“There is currently no basis in the ‘investment contract’ law to classify most fungible crypto assets as ‘securities’ when transferred in secondary transactions as an investment contract transaction generally does not exist.”
what it all means
The effect of the paper’s reasoning is to separate the issuance of a token from a transaction with it on the secondary market. The paper says the creation of a token can be a security transaction, but subsequent trades will not necessarily be security transactions.
Sean Coughlin, a principal at law firm Bressler, Amery & Ross, told Cointelegraph, “I think so [Cohen’s] Acquiring the fact that emissions [of tokens] be regulated, and he tries to suggest a way to then have it [a token] Trade in an unregulated manner.”
Coughlin’s colleague Christopher Vaughan had concerns that the paper was “disingenuous” at times.
He said, “It disregards the realities that anyone who has ever traded crypto knows, which is that these liquidity pools and these decentralized exchanges don’t happen unless the issuer of the token facilitates them.”
Nonetheless, Vaughan praised the paper, saying, “I would love it if this were the be-all and end-all of crypto.”
John Montague, an attorney at Montague Law that focuses on digital assets, told Cointelegraph that custodial issues could complicate Cohen’s argument, specifically how self-custodial crypto assets impact Howey’s investment.
Montague acknowledged the high quality of the newspaper’s grant, calling it:
“Perhaps the industry’s most monumental train of thought on securities law of all time, […] definitely since Hester Peirce’s Safe Harbor proposal.”
In her final version of the proposal, SEC Commissioner Peirce proposed granting network developers a three-year exemption from the registration requirements of the Federal Securities Act to “facilitate participation in and development of a functional or decentralized network.”
Current: Crypto and Psychedelics: Clarifying Regulations Could Help Industry Grow
“One thing I like about the world of crypto is that it’s controversial,” Cohen told Cointelegraph. He said he hopes the paper will “raise the level of discussion.” It didn’t meet with much resistance in public reaction. However, there were expressions of cynicism.
“You are a novelist. They have found a sign in crypto that is best explained by law,” one network developer commented on Twitter.
“Smart legal opinions rarely move the needle in SEC opinions or enforcement cases,” said a financial services firm on LinkedIn.
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