The Howey Test vs The Token Taxonomy Act: Regulatory Clarity or More Uncertainty?

Freeing Crypto from the Bondage of a 72-Year-Old Law?

That header above makes a great headline but executing the concept is proving to be easier said than done. The Token Taxonomy Act (TTA) is splitting opinions among leading blockchain legal experts. The big question is whether the newest version of the TTA can deliver the regulatory clarity it promises to protect consumers and investors and encourage cryptocurrency legitimacy and growth in the blockchain industry.

Centralized finance is entrenched in legal traditions established in the 1930s which blockchain technology is disrupting across the board, from securities definitions to smart contracts to the SEC itself. In an interview with CNBC, head of the Blockchain Association and crypto-lobbyist Kristen Smith summed up the ongoing difficulty we’re experiencing in the transition saying, “These decentralized networks don’t fit neatly within the existing regulatory structure”.

So why have current crypto regulatory efforts been described in the CNBC report as analogous to fitting “square pegs in round holes”? In this article, I will unravel some of these tangled legal issues to help blockchain startups and investors make the most prudent informed decisions concerning the state of crypto now and what we may be facing in the immediate future.

But before we look to the future a brief history lesson is in order.

What is the Howey Test?

The key question in the debate is whether or not the TTA can indeed provide “regulatory certainty for businesses, entrepreneurs, and regulators in the U.S.’s blockchain economy” as promised by its bipartisan sponsors when it was introduced in April of 2019. Or are we better off as blockchain participants sticking to the tried and true Howey Test for categorizing most coins and tokens as securities? 

As things stand now, the IRS has already classified trading crypto-assets as a taxable event and the SEC has declared that most do seem to pass the Howey Test, and are therefore subject to securities regulations.

This regulatory burden clashes with the anti-authoritarian nature of the crypto-world. 

Bitcoin was originally intended to bypass third-party regulation altogether, relying instead on the distributed ledger’s built-in, decentralized security characteristics for internal regulation. 

Blockonomi founder, Oliver Dale, tackled the ICO/Howey Test correlation in his informative article, clarifying just how cryptocurrencies became recognized as securities after the German DAO group’s token was hacked in 2016.

The Howey Test is the result of a 1946 Supreme Court test case in which Florida citrus groves sold to outside investors by the WJ Howey Company were then immediately leased back to Howey who would harvest and resell the produce. The court ruled that the deal constituted an investment contract and investment contracts qualify as securities. Any financial instrument classified as a “security” then falls under the purview of the SEC. The Howey Test provides 4 criteria for an instrument to qualify as a security. They are:

  1. Investment of money
  2. Expectation of profit
  3. Common enterprise
  4. Profit generated by a third party

It seems that in many cases, digital tokens qualify as securities using the Howey Test. Passing the Howey test means that tokens should be subject to the same securities regulations as defined by the Securities Act of 1933 and the Securities Exchange Act of 1934, with all of their attending requirements for registrations, independently certified financial statements, management description disclosures, and regulations for secondary trading.

The TTA proposes to change all that, but as we’ll see, some industry watchers think we could be jumping from the frying pan and into the fire.

What is The Token Taxonomy Act of 2019?

Here’s the official summary for H.R.2144, the Token Taxonomy Act Version 2.0 straight from www.congress.gov:

A BILL

To amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude digital tokens from the definition of a security, to direct the Securities and Exchange Commission to enact certain regulatory changes regarding digital units secured through public key cryptography, to adjust taxation of virtual currencies held in individual retirement accounts, to create a tax exemption for exchanges of one virtual currency for another, to create a de minimis exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash, and for other purposes.

The bipartisan pitch sounds like the passage of TTA 2019 (version 2.0) is a no-brainer, one sure to induce instant “cryptophoria” in the blockchain community, but some leading blockchain legal minds disagree. 

The original version of the bill was presented to Congress late in 2018, so late that it “never really stood a chance of getting anywhere” according to Guillermo Jimenez’s report at Decrypt. Jimenez cites crypto-attorney Gabriel Shapiro to support his evaluation that TTA version 2.0 is actually worse than the original.

Shapiro stated, “I can’t imagine legislation that is worse for blockchain entrepreneurs, regulators or markets than this!” Shapiro was joined by Wall Street veteran Caitlin Long who tweeted that the “watered down definition” of digital tokens was so vague it removes any “taxonomy” from the bill. 

Worse, the bill claims federal preemption over state blockchain legislation, such as the legislative effort Long championed to make Wyoming “the blockchain state” and would wipe state token definitions off the books in up to 15 states where tokens have been or will soon be clearly defined.

Benefits of The Token Taxonomy Act

Most of the objections from certain crypto-focused lawyers have to do with “vague definitions” and “difficult to apply elements” in the bill. 

No doubt, the legislative transition will be a long evolutionary process, and TTA version 2.0 is just the first critical step. The TTA, for many, is a diamond in the rough worth polishing.

For the crypto-community, the primary objective of the bill definitely makes TTA worth pursuing. Excluding digital tokens from the definition of a “security” removes a major logjam and reinforces the original spirit of decentralized financing intended when Satoshi Nakamoto introduced Bitcoin in the revolutionary white paper in 2008.

Other major benefits for the digital token trade under a new TTA are the tax breaks cited in the bill summary. Active token traders can reap the rewards of tax exemption when exchanging one virtual currency for another, not to mention the tax break for tokens held in IRA accounts.

For the US economy, the ramifications of passing some version of  TTA 2019 go far beyond the lucrative tax incentives which the bill provides for individual crypto investors. 

If the regulatory confusion isn’t cleared up soon, harsh status-quo regulation under the Howey Test could drive the central hub of blockchain to other countries in Europe and Asia where the technology has been embraced.

The chief rival for the US is, as always, China, which leads the world in blockchain-based projects. 

According to the bill’s sponsor Congressman Warren Davidson, “Without [the Token Taxonomy Act], the U.S. is surrendering its innovative origins and ownership of the digital economy to Europe and Asia.”

Davidson cites the early days of the internet when Congress resisted the temptation to over-regulate while providing certainty as a model for achieving a similar win which will “unlock the blockchain industry” and secure the US position as a blockchain leader. His “light touch” regulatory philosophy harmonizes well with the original intent of blockchain innovation.

The Howey Test is not the answer but the TTA, in some form, might be.

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