“Hashlets, Hasktakers and Hashpoints” – The Strange Quantum World of Cryptocurrency meets the Howey Test

It has been a rocky year for the cryptocurrency industry. The Federal Trade Commission has reported that cryptocurrency scammers have stolen over $1 billion from 46,000 people since the start of 2021. In February 2022, the Justice Department announced the arrest of a husband and wife team who allegedly stole approximately $4.5 billion in Bitcoin. And the industry has seen the crash of popular stablecoins, whose value is generally tied to underlying currencies, and therefore considered a relatively secure way to exchange digital assets in the crypto economy. While the industry has thrown up a variety of legal claims over the last several years which are being litigated in many forums in the United States and elsewhere, the most commonly litigated claims remain federal securities fraud claims, often in the class action setting. A recent class action case in the federal district court in Connecticut shows how complicated the questions can be of whether and how cryptocurrencies and related crypto products are “securities” for purposes of securities fraud claims.

A short primer on when financial products qualify as securities for purposes of securities fraud claims is needed. In order for either the Securities Exchange Commission (SEC) or private individuals to maintain claims for securities fraud under the Securities Act of 1933 (“the Act”), the financial transaction must qualify as a “security” under the Howey Test, first articulated by the United States Supreme Court in a 1946 securities case called SEC v. W.J. Howey Co. 328 U.S.C. 293 (1946).In addition to more easily recognizable securities such as stocks and bonds, a security under the Act can include an “investment contract,” defined as “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.” 328 U.S.C. 293, 298-99. In deciding that a leaseback agreement was an investment contract subject to registration requirements under the Act, the Howey court concluded that a transaction is an investment contract subject to federal securities regulations if 1) the transaction involves a monetary investment; 2) there is an expected profit associated with the investment; and 3) the money investment is a common enterprise and profit from the transaction comes from the efforts of a third party or promoter’s efforts. Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967)(summarizing the Howey factors).

The SEC has a short but generally successful history thus far of judicially imposed regulation of cryptocurrencies under federal securities laws. Prior to a SEC enforcement action against KIK Interactive, Inc., as issuer of a cryptocurrency called “Kin”, few courts had squarely addressed the question of whether cryptocurrencies meet the definition of investment contract under the Howey Test. On July 25, 2017, after Kik had announced its plan to issue Kin but before it made its distribution, the SEC issued its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (the “DAO Report”). Release No. 81207, 117 S.E.C. Docket 745, 2017 WL 7184670 (July 25, 2017); see also SEC Ex. 88, ECF No. 60-100. In the DAO Report, the SEC described its investigation into a German corporation’s sale of tokens to investors. The SEC determined that the tokens were securities, but no enforcement proceedings were initiated. 2017 WL 7184670, at *1, 8-12. The SEC “advise[d] those who would use … distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”

In 2019, the SEC initiated enforcement proceedings against Kik. After cross motions for summary judgment, the trial court in Kik held that cryptocurrency tokens are “securities” under the Howey test, thus triggering federal securities registration requirements. SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169 (SDNY 2020). The Kik court started its analysis by noting that in determining whether an investment contract could be a form of security, form should be “disregarded for substance and the emphasis should be on economic reality of the investment scheme.” Id. at 177. The Kik Court held the sale of “Kin” met all three factors of the Howey test. First, the Court found that the crypto tokens constituted an investment of money from purchasers of the tokens. The Court further found that a common enterprise existed because there was “horizontal commonality” between the investors – that is, each individual investor’s fortune was tied with the fortunes of other investors by the pooling of investment assets. Central to this conclusion was the Court’s observation that “Kin Tokens are intended to be used for all transactions within a Kin ecosystem comprised of digital services that participate in the right and opportunity to innovate and compete for compensation in the form of Kin Tokens.” Id. at 179. As to the third factor under Howey, the court concluded that the company’s issuance of the crypto tokens came with the reasonable expectation of profits to be derived from the managerial or entrepreneurial efforts of others. On this last point, the Kik court emphasized the Company’s marketing and promotional efforts that value would increase as demand rose because of the limited supply of the cryptocurrency.

Kik later settled the SEC matter, thus preventing appellate review of the court’s ruling. Nevertheless, the Kik ruling was seen as a blow to the crypto industry since it appeared to guarantee that, absent legislative action, cryptocurrencies would be forever subject to both SEC enforcement actions, and potentially to securities fraud claims, including class action lawsuits. Indeed, courts after Kik have reached the similar conclusion that cryptocurrency schemes should be considered investment contracts for purposes of federal securities law. See e.g., Securities and Exchange Commission v. NAC Foundation, LLC, 512 F. Supp. 3d 988, (N.D. Cal. 2021); Securities and Exchange Commission v. Ripple Labs, Inc. 2022 WL 748150 (SDNY). Not surprisingly perhaps, SEC enforcement actions have been on the rise after Kik. According to Cornerstone Research, in 2021 alone, the SEC brought a total of 20 enforcement actions against cryptocurrency companies, with 80% of those actions alleging that the respondents were engaged in the sale of unregistered securities.

A recent class action case involving cryptocurrency in the United States District Court for the District of Connecticut, Audet et al. v. Fraser 2022 WL 1912866, however, demonstrates how complicated a Howey analysis can be as the crypto industry spins off new products from the currencies themselves. Plaintiffs in Audet asserted fraud and related securities claims under Connecticut’s Uniform Securities Act (“the Connecticut Act”) relating to four cryptocurrency coins or products – “Hashlets,” “Paycoin,” “Hashstakers,” and “Hashpoints.” At trial, the court reserved ruling on defendant’s motion for judgment, which included arguments that the cryptocurrencies were not securities subject to the Connecticut Act because the products did not meet Connecticut’s version of the Howey test. The case was submitted to a jury, which returned a defense verdict on all counts. The jury specifically concluded that the none of the crypto products at issue were securities under Howey. Plaintiffs filed post-trial motions, which in part sought a new trial on the jury’s Howey analysis. The trial court’s opinion, which was just released on June 3, 2022, is instructive into how complicated a Howey analysis can be in the crypto world.

The Audet trial court reviewed the evidence submitted to the jury regarding the nature and purpose of each of the four products. According to conflicting trial testimony, Hashlets were either a computer used for mining cryptocurrency, including Bitcoin, or a percentage of the mining power at defendant’s crypto mining “farm.” WL 1912866 *3. Purchasers of Hashlets either purchased a specific share of the mining power at the farm, or they purchased a share of the profits generated by the mining activities. Id.Each Hashlet owner had the power to select different “pools” of data mining, and different payouts on the shares of Hashlets could be obtained based on the value of the different pools. WL 1912866 *4. Based on this evidence, the trial court concluded that a reasonable jury could have found that no horizontal commonality existed because Hashlet owners could make profits or sustain losses independent of the fortunes of other purchasers. WL 1912866 *13. The court further concluded that a finding of no vertical commonality was not against the weight of the evidence because there was no evidence that defendant directly benefitted from the data mining itself, and that defendant only earned fees via the sale of Hashlets.

The trial court reached a different conclusion regarding Paycoin. According to evidence submitted at trial, Paycoin was a new cryptocurrency launched by the defendant and promoted and offered to investors as an investment scheme. The trial found that the weight of the evidence did not support a finding by the jury that Paycoin was not an investment contract under the Howey factors. Central to this conclusion was evidence that Paycoin was to be used within a crypto “ecosystem” created by defendant in which the coins could be traded and used to make purchases. WL 1912866 *15. This ecosystem tied the fortunes of the Paycoin purchasers to each other as the value of the coins rose or fell within the ecosystem.

With respect to Hashpoints – which were described at trial was a form of “in-house credit” that could be traded for Paycoin, and Hashstakers – which was a specialized electronic wallet in which Paycoins could be housed – the trial court noted that the jury heard “very little evidence” about these products, and concluded that the mere fact each could be used for either the acquisition or holding of Paycoin was not sufficient to render these products investment contracts under Howrey. WL 1912866 *18.

Although some states have enacted regulations for the sale and trading of cryptocurrency, there is no uniform set of federal regulations specifically dealing with this rapidly evolving industry. While the trial court’s decision in Audet with respect to the Paycoin product squares with the federal decisions in Kik and elsewhere, the complicated set of products and facts described at trial in Audet suggest that the crypto industry may develop products and services which fall outside of judicial enforcement of existing securities regulations on the industry.