SEC Commissioner Hester Peirce Outlines Problems With the SEC’s Howey Test

SEC Commissioner Hester Peirce says the so-called Howey test, used by the Securities and Exchange Commission to determine whether a digital asset should be classified as a security, has some limitations.

The test stems from a landmark Supreme Court case decided in 1946, establishing criteria under which a financial agreement qualifies as an “investment contract” and is therefore subject to federal securities law.

As it relates to crypto, Peirce described why the test is so significant for the industry.

“There’s been a lot of emphasis on the Howey test in the crypto world because […] a lot of these things were sold as tokens plus a promise that we’re going to build a network,” she said on the latest episode of Decrypt’s gm! podcast.

The court case that led to the creation of the Howey test centered on the sale of units in a Florida-based citrus grove development, where investors could share in the profits of efforts to cultivate produce. 

It determined an “investment contract” is “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.”

In August, SEC chairman Gary Gensler said “many tokens may be unregistered securities” because “folks buying these tokens are anticipating profits, and there’s a small group of entrepreneurs and technologists standing up and nurturing the projects.” 

Peirce argued that the existence of an investment contract doesn’t just center on the asset but also the promises that are attached to it. She put forth the opinion that the two components are separate from each other.

“Just because I sold you the orange grove as part of an investment contract doesn’t turn the orange grove into a security,” she said. “The orange grove, plus the promises I made to you about how I was going to tend the orange grove and generate profits for you—that was the securities offering.”

Whether or not a crypto asset itself is a security is something that isn’t addressed by the Howey test, said Peirce.

“You can say, ‘Well, look, a lot of these initial sales sure look like securities offerings,’ but then the question is, is that token, is the crypto asset itself, a security?” she asked.  “That’s a much harder question to answer, and I think it’s one that people answer differently.”

The agency’s reliance on the Howey test is also somewhat flawed, said Peirce, because of the interpretation’s apparent permanence.

In 2018, the SEC’s director for the Division of Corporation Finance, William Hinman, said he believes Bitcoin and Ethereum are not securities because they had become “sufficiently decentralized,” a threshold undefined by the Howey test.

“We’ve said that orange grove is going to be treated as a security in perpetuity,” she said. “I don’t know when it stops being a security, and that doesn’t make sense.”

Peirce said providing clarification on how a digital token could go from being considered a security to a commodity would address some criticisms that actors in the crypto space have with the SEC’s regulatory approach.

“If we were more precise, I think that there would be fewer objections to applying the Howey test and saying, ‘Hey, that initial time when you sold it, that might well have been a securities offering,’ but that doesn’t mean that the token continues to be a security for the rest of its life,” she said.

Whether or not specific digital assets are considered a security is a matter that Gensler has largely tiptoed around since he was appointed as head of the SEC. Gensler has only publicly said that Bitcoin isn’t a security and refrained from commenting on other coins.

“A lot turns on whether something is a security, and so that’s why we have to get clarity around that question,” said Peirce.

Since Peirce joined the SEC in 2018, she said there’s been “no real positive movement” on crypto regulation despite lots of conversation and efforts to better understand the technology, describing the lack of progress as frustrating. She also said the inaction of government is impacting the way people operate in the crypto space.

“The wheels of regulation and legislation move very slowly, and I think that that can be both good and bad,” she said. “In the crypto world, we’ve seen for a long time that there’s been a lack of clarity, which I think has led people to do things that they wouldn’t have done had there been clear guidelines.”

Peirce explained she wasn’t specifically thinking about crypto when she became a part of the SEC but gradually gravitated towards the technology as part of a focus on how the SEC was facilitating or inhibiting innovation.

“I think it’s great that people are challenging the way we’ve done things; sometimes those challenges are going to fall flat and sometimes they’re gonna succeed,” she said. “But we just need to make sure that it’s not regulation that’s picking winners and losers–It’s people who are picking winners and losers.”