With the dueling summary judgment motions filed by Ripple and the SEC in SEC v. Ripple Labs, Inc., et al, Case No. 20-CV-10832 (S.D.N.Y. ), it is time once again to revisit the hot topic of the Howey test and its application to digital assets. There has been lots of talk of what constitutes “sufficient decentralization” which is not a term used anywhere in the Howey test or other legal precedents on securities. The term was made popular from the now infamous Hinman speech where Bill Hinman, the then acting Director of the SEC’s Division of Corporate Finance, gave a speech in which he stated (in his personal capacity): “If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. “
There have been many scholarly articles on what constitutes “sufficient decentralization” and how it fits in the “efforts of others” prong of Howey. I greatly enjoy the article from Prof. Todd Henderson and Max Raskin which put forth a proposal for a “Bahamas Test” for decentralization which they summarize as: “If the sellers fled to the Bahamas or ceased to show up to work — like Satoshi Nakamoto — would the project still be capable of existing? If the answer is ‘yes,’ then the risk of fraud is sufficiently reduced such that the instrument is not a security.”
Along those same veins, and in light of the briefing from the Ripple case, I would like to propose a new test: The Wakanda Test. I explain below, but to summarize: if the asset being sold exists prior to time of sale and has some independent utility value like the Vibranium metal discovered in Wakanda, then whether those sale proceeds are used to further add technical value to the asset are irrelevant and the asset is a commodity.
NOTE: The Wakanda Test is designed for fungible tokens. This test is not designed to be applicable to non-fungible tokens, which require a different analysis in determining the applicability of securities laws.
Wakanda Test Background
Bitcoin is often referred to as “digital gold” and, like gold, is at this point universally acknowledged to be something other than a “security” for US legal purposes. See CFTC statement (claiming Bitcoin is a commodity); FinCEN guidance (labeling it a convertible virtual currency).
Enter this hypothetical: say you bought a large track of land in Africa. We’ll call that land “Wakanda” (purely for demonstrative purposes/don’t sue me Disney). Now say on that land, you discovered an exceedingly rare metal which we will call “Vibranium” (again, don’t sue me Disney. Just trying to put into terms that zoomers can understand). Vibranium only exist on earth in Wakanda, which you are the sole owner of. There are tons of potential uses for this rare metal due to its unique features, but because it was just discovered those uses largely haven’t been put into practice yet.
You, as the sole owner of Wakanda and the Vibranium thereon, mine a portion of it yourself, and sell that Vibranium to the general public (including anonymous US citizens). At the same time, you raise funds through traditional methods to fund further mining and/or scientific research into best possible uses for this Vibranium. Obviously, if you come up with a hugely beneficial use for the Vibranium then those people who bought it from you early would benefit, but also you as sole owner of remaining Vibranium would benefit. Similarly, there is nothing stopping anybody else from coming up with valuable uses for this metal.
Even the SEC would not argue this new form of metal is a security under US laws. It doesn’t matter that the sale of this metal was used to fund a business which, if successful in its innovation efforts, can greatly increase the value of the metal. In the same way a car manufacturer’s first car sales are not securities while buying equity in that manufacturer are. They are both used to fund the business. So how do we separate when a digital asset is sold to raise money in the way traditional securities like stocks or venture investing is done, and when digital assets are sold as assets with independent value?
Wakanda Test As Applied to Digital Assets
On its face, the primary difference between the Vibranium example above and $XRP, is that one is a physical asset and one is a digital asset. Both seemingly would fit the Howey test on its face. If you bought either $XRP or Vibranium, that purchase was likely (1) an investment of money; (2) in a common enterprise (new physical or digital asset); (3) with an expectation of profits; and (4) to be derived from the efforts of others. You wouldn’t expect every purchaser of the metal to be scientifically developing the highest/best use for it in the same way you wouldn’t expect every purchaser of $XRP to turn into a smart-contract developer. At the same time, any person can improve upon that asset; it’s just the person with the most quantity has the highest motivation to actually do that improvement.
In the Ripple case, counsel for Ripple argue that based on 1930’s “Blue Sky” law definitions of “investment contract” the distinction between an investment contract (i.e., a security) and a commodity/asset sale is some continuing services obligation on the seller after the sale. While it is a persuasive argument and may be legally correct, the problem with trying to use 1930’s securities laws for modern digital assets is they don’t quite fit with modern consumer behaviors. It cannot be the case that any developer should be allowed to sell any shitcoin to the general masses simply by disclaiming further development obligations. Maybe that was OK before the general public was buying digital assets and those sophisticated buyers could do their own due diligence into the smart-contract capabilities, but securities laws and the intent behind them to protect consumers do still serve a purpose.
So how do we distinguish the selling of digital assets as an evolution of venture funding (i.e., securities) from the selling of digital assets as a product? How to we distinguish Vibranium from stocks? Here is what I propose would make a digital asset not a security, and thus not require the same level of disclosure/consumer protection:
(1) The Network Has Been Fully Developed
Frequently, developers sell tokens through things called Simple Agreements for Future Tokens (SAFTs). These sales are done to early investors to raise capital needed for initial network development. These look and act like traditional venture investing, and likely deserve security regulation protections. However, when there has been a fully operational network already developed, then selling the digital assets which run the network seems to be more the sale of assets than the sale of equity. In a perfect world, the only government oversight would be potentially requiring a third-party audit to confirm the network is online and fully functional (albeit, subject to be changes in the same way any chain is subject to change upon reaching the appropriate consensus).
As a subset of this, the tokens which run the network must have some existing utility at the time of sale. Because virtually every token will have the utility of being a bridge currency for cross border payments, this is likely a distinction without a difference. However, it would prevent a company from launching its network and selling that network’s tokens without real functionality being achieved.
(2) There is a Fixed Supply of Digital Asset
In the same way there is a fixed supply of Vibranium (although, a potentially unknown fixed supply), having a fixed supply would provide consumers with necessary information without requiring further disclosures. With knowledge of that supply, there is no need to rely on developers for disclosures because third-parties are capable of seeing what the total supply is (or will be) and where that total supply is held (or will be held). The goal of security disclosure law is to remove asymmetrical information; a fixed supply is a step to doing so.
(3) There is no Contractual Obligation for Further Development
The sale of an orange grove alone is not a transaction covered by US securities regulations. However, when combined with a services contract or other ongoing obligations by the seller, it can be turned into a sale of securities (as was the case in Howey). Nor is the sale of live beavers a securities transaction, as was the case in Continental Marketing Corp. v. SEC, 387 F.2d 466 (10th Cir. 1967), except when combined with caretaking services of a professional rancher. When you buy a stock in a company, that company’s officers and directors owe a continuing fiduciary duty to its shareholders.
Those ongoing duties: the management of orange groves, caretaking of beavers, and running of businesses, are key distinguishing features from an investment contract as opposed to any other contract. It is these ongoing obligations and the potential abuse of asymmetrical information as to the status of those obligations which securities laws were enacted to protect consumers against.
Similarly, when you buy any consumer good, it comes with it the implied warranty of merchantability. Namely, that the good or service will do what is promised by the manufacturer. In the Vibranium example, if you are sold a metal with the promise that metal can be used in a specific form of microchip manufacturing, then you are protected by consumer laws if it turns out that it cannot be used in that specific form of microchip manufacturing. There is no need to protect against asymmetrical information because you, as the owner of that consumer good, are perfectly capable of determining how that consumer good can be used.
That is why the lack of continuing contractual obligations is important for a digital asset to not be classified as a security. If you sell a digital asset with the promise that it can be used to make near instantaneous cross-border transactions, that is different than selling a digital asset with the promise that in a year it will be possible to be used to make near instantaneous cross-border transactions. One looks like a security (i.e., an investment based on trusting the continuing efforts of others to reach fruition) and one looks like Vibranium (i.e., a purchase of an asset with current utility, even if the purchase has some hope of future alternative uses as well). One consumers are appropriately protected under securities laws; the other consumers are appropriately protected under consumer protection laws.
(4) No Single Entity Maintains Effectively Complete Control over Network Functionality
This is where $XRP might fail my proposed Wakanda Test. Going back to shareholders of traditional corporations, controlling shareholders have fiduciary duties to minority shareholders to act with good faith. While blockchain networks do not have shareholders, they can have token holders who have a controlling interest and whom lesser holders may need legal protections in the form of securities regulations and government oversight.
In the example of Vibranium, anybody can find a new use for that metal without the person with the biggest supply’s input or agreement. However, with blockchain networks, that approval may be needed if the new use requires changes to the network which the digital asset runs. If I want to use Vibranium in a way which the miner hasn’t currently developed the technological capacity to do themselves, I can do that. The same is not true for digital assets unless I can propose network changes which no single entity (or an affiliated group of entities) can effectively veto.
While this may seem like a conflation of the “efforts of others” analysis, under the Wakanda Test there can still be a dependence on the efforts of others. Those “others” just need to be truly capable of being and third-party and not just the original manufacturer. Without that, there is still the potential for abuse of asymmetrical information/power which securities laws are intended to protect against. **
Virtually every token will, at some point, be effectively completely controlled by a single entity or group of affiliated entities. To make those original token sales compliant with the Wakanda Test, that issuing entity could deposit a network controlling stake with an escrow agent to facilitate those sales, or use a smart-contract controlled locking mechanism which would prevent control of the network by the token issuer until sufficient tokens are distributed to third-parties as to remove the issuer’s effectively complete network control.
(5) The Network Governance is Separate from the Issuer Governance
Similar but separate from any single entity maintaining effective control over the network, there should be a distinction between network control and issuing entity control. Control over the legal entity which issued the digital asset and continues to develop it (to pump its own bags) is effectively a stock share with some other utility. While in most instances, one would think that the incentives over network development and issuing entity’s development efforts would be aligned, there needs to be possibility for clashes of ideals. What is good for the issuing entity cannot always be good for the network and vice-versa. Otherwise the fourth factor of the Wakanda Test loses all value.
Conclusion
I know there are some decentralized maxis who I highly respect that will disagree any securities analysis is needed and shout code-is-law until their throats bleed. But not everybody can read code, and with mass adoption of blockchain technology there is also a need to protect these unsophisticated buyers from the 1% of scammers and snake-oil salesmen who are holding back the other 99% from unleashing this technology’s true potential for integration into so many different facets of life.
Consumer protection laws serve a good and valuable purpose to society (don’t tell my fellow primarily defense attorneys I said that). Law enforcement serves a good and valuable purpose to society. Securities laws serve a good and valuable purpose to society. If we cannot find a compromise which both protects unsophisticated consumers from frauds and scams while also allowing for development then we will be stuck with two worlds of digital assets: one world which the masses use and are highly regulated/have no decentralized elements/end up being controlled by the government and 2-4 major corporations similar to current state of Web2; and one world which operates in the shadows and is only accessible to the 50,000-100,000 people tech savvy enough to get around those government and corporate censorship efforts.
I personally would prefer for there to be common sense rules in place rather than no rules at all, or rules from the 1930’s being applied to 2022 digital assets and technologies. My hope is that through discussion of things like the above proposed Wakanda Test or previously cited Bahamas Test, we can reach a judicial and regulatory middle-ground.
**Note: I know that Ripple holds +51% of total supply of $XRP, and that it has thus far refrained from using that veto or overriding power regarding XRP Network changes. I do not know enough to say if this is something they are incapable of doing due to their assets being vaulted in a way which makes it impossible for them to use that majority power, or they have simply refrained due to a business decision they can change their mind on at any point. While the Wakanda Test was inspired in part by the Ripple lawsuit briefing, it is not intended to advocate for or against any particular digital asset (including $XRP) being legally treated as a commodity or a security.
The NFTtorney 