Once FTT is confirmed as a security, other platform tokens will inevitably face regulatory crackdown.
Written by: Nancy
Platform tokens may be facing a regulatory storm. On December 22, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against FTX co-founder Gary Wang and former Alameda Research CEO Caroline Ellison, stating that FTX's trading token FTT, sold as an investment contract from the time of its issuance, is a "securities," a move that could have a wide-ranging impact on the industry.
The Howey Test has long been a sword of Damocles hanging over crypto assets. Numerous projects, including Ripple, Telegram, and Blcok.one, have been sued by the SEC for securities classification, paying hefty settlements or even failing to materialize. If FTT is confirmed as a security, other platform tokens will inevitably face regulatory scrutiny.
FTT was recognized as a security, or it may have been "forced" to do so in order to mitigate penalties.
In the latest investigation, two core members of FTX and Alameda admitted that FTT is a security.
The SEC filing alleges that FTX will use proceeds from token sales to fund its development, marketing, business operations, and growth, while emphasizing that FTT is an "investment" with profit potential. The lawsuit states that "if trading demand on the FTX platform increases, demand for FTT tokens is likely to increase, therefore any price increase in FTT will benefit FTT holders equally and proportionally to their FTT holdings. The large allocation of tokens to FTX incentivizes the FTX management team to take steps to attract more users to the trading platform, thereby increasing demand for FTT tokens and raising their trading price. The FTT buy-and-burn program is similar to a stock buyback, using revenue from FTX to buy back and burn FTT, thereby increasing its value." The FTT materials also explicitly state that the efforts of the FTX core management team will drive FTX's development and ultimate success.
To understand why FTTs are classified as securities, it's essential to first understand the definition of the Howey Test. The Howey Test originated in 1946 with a Florida company called "Howey." At that time, Howey sold large citrus orchards to buyers in Florida to raise funds. The buyers then leased the land back to Howey. Howey was responsible for maintaining the citrus orchards, while the buyers could share in the profits without having to manage the land themselves.
However, the SEC sued Howey, arguing that the transaction constituted an investment agreement, which falls under the definition of a security under U.S. securities laws. The court ultimately ruled that Howey was required to comply with U.S. securities laws. Thus, the Howey test became the legal standard used in the United States to determine whether something is a security, and it remains in use today.
The Howey test requires an investment contract to meet all four of the following conditions: (1) it involves the use of money to make an investment; (2) it involves an investment in a common enterprise; (3) it is expected to generate a profit for the investor; and (4) it is solely due to the efforts of the sponsor or a third party.
Of course, the SEC and the Supreme Court have also pointed out that the Howey test is a flexible rather than a static standard. For crypto assets, once they are classified as "securities," they must comply with SEC regulations and fulfill compliance obligations. Crypto assets not only include virtual currencies but also stablecoins, NFTs, and others. For example, Yuga Labs, the parent company of the leading NFT project Bored Ape Yacht Club, was recently investigated by the SEC for potential violations of federal securities laws by its NFTs and ApeCoin.
Furthermore, the SEC's jurisdiction is not limited to the United States. For example, in May 2020, Telegram, registered in the UK and operating in Dubai, was shut down by the SEC for selling tokens to some US investors and failing to disclose key information to the public, even though Telegram claimed it could issue tokens only to non-US investors. In the recent FTX collapse, although the company's headquarters have moved to the Bahamas, its founder SBF and executives are still charged by US regulators, and former Alameda Research CEO Caroline Ellison and FTX co-founder Gary Wang have pleaded guilty to criminal charges.
However, it's possible that Caroline and Gary pleaded guilty to the FTT being a securities transaction in an attempt to mitigate their sentences, given that they face seven counts carrying a maximum sentence of 110 years imprisonment and four counts carrying a maximum sentence of 50 years imprisonment, respectively. Furthermore, Caroline and Gary's release on $250,000 bail was not solely contingent on signing plea agreements; to receive a lighter sentence, they must contribute to the case and not violate the agreements.
The encrypted version of Howey is about to be released for testing.
If FTT is designated a security by the SEC, other trading platform tokens will face regulatory investigations or lawsuits. Historically, "paying to avoid trouble" is often a last resort.
For a long time, the Howey Test has been a powerful tool for the SEC in its pursuit of accountability, but it has not been widely accepted by crypto projects and companies. For example, Kin, an ERC-20 token initially issued on Ethereum, engaged in a year-and-a-half-long debate with the SEC over whether its assets should be classified as securities or cryptocurrencies. Kin even launched "Defend Crypto" to sue the SEC, but ultimately chose to settle and was fined $5 million. Furthermore, Michael Arrington, founder of XRP Capital, responded to the SEC's lawsuit against Ripple, stating that the Howey Test is outdated and absurd.
While many believe that the new technology of cryptocurrency clashes with the existing regulatory framework, SEC Chairman Gary Gensler has repeatedly stated that most crypto tokens in the current market are securities because they possess the characteristics of securities as defined by the Supreme Court in the 1940s. Therefore, the issuance and sale of these security-type crypto tokens are subject to securities laws. "Some in the crypto industry have called for clearer guidance, but the SEC's voice has been very clear over the past five years." Furthermore, former SEC Chairman Jay Clayton also mentioned that, without prior assessment of any particular token, most crypto tokens fall under the Howey Test's investment contract category.
In recent years, the SEC has filed dozens of complaints against crypto asset companies/projects for failing to register. However, in a recent podcast, Hester Peirce, a pro-cryptocurrency SEC commissioner known as "Crypto Mom," pointed out that the so-called Howey Test, used by the SEC to determine whether digital assets should be classified as securities, still has some limitations.
Hester Peirce points out that the Howey Test defines an "investment contract" as "a contract, transaction, or scheme by which a person invests his or her funds in a common enterprise and is directed to profit solely from the efforts of the initiator or a third party." However, the Howey Test does not address whether crypto assets themselves are securities, because investment contracts are centered not only on the asset but also on the promises attached to the asset, and these two components should be separate from each other.
Following Coinbase's SEC accusation of unregistered securities, its founder Brian Armstron recently published "Advice and Predictions for Crypto Industry Regulation in 2023," pointing out that perhaps the most complex issue surrounding cryptocurrencies that needs clarification is defining whether they are commodities or securities. The CFTC and SEC have been debating this issue in the US for years, yet have provided no clear information to the market. At this point, Congress clearly needs to intervene and pass legislation. This could be accomplished with an updated version of the Howey test, which applies to crypto tokens that may fall under the definition of an investment contract.
Brian Armstron explains that the modern cryptocurrency Howey test must include the following: (1) If the issuer of a crypto asset does not sell assets to raise funds for the project, then it is not a security; (2) For a crypto asset to be a security, it must be controlled and operated by a centralized organization like a company. If a project has become sufficiently decentralized, then it is not a security; (3) If the primary purpose of a crypto asset is some other form of utility (voting, governance, community incentives, etc.), then it is unlikely to be considered a security; (4) If the expected profit comes primarily from participants unrelated to the issuance of the asset, then the project is sufficiently decentralized and will not be considered a security. It is important to note that all four conditions must be met for an asset to be considered a security. Meeting only a few of them is not enough. For example, people invest in gold or Picasso paintings with the expectation of making a profit, but these are not securities because the expectation of profit does not come from ordinary businesses (or the efforts of others).
In short, if platform tokens are recognized as securities, it will inevitably have a significant impact on various crypto exchage. However, as Brian Armstron stated, the role of financial regulators should be limited to centralized participants in the cryptocurrency space, allowing their decentralized counterparts to innovate. Regulators should provide ample room for innovation in the cryptocurrency industry.
