The Howey Test: Would Your Crypto Offering Pass or Fail?

Before you launch your next crypto token, you should see if you can pass the test.

It is not the smell test with investment bankers.

The Howey test will help you understand if your crypto is one of many digital securities which would present more legal responsibilities, such as disclosure and registration requirements.

The U.S. Securities and Exchange Commission (SEC) v. W.J. Howey Co. was a 1946 Supreme Court decision about citrus grove buyers in Florida. The Howey Company sold citrus groves to investors who leased the land back to Howey. The company’s employees managed the groves and sold the fruit on behalf of the investors. Both the company and the investors profited from the venture.

The investors only needed to supply capital to the arrangement, while others took care of all the other details. An investment contract is what you get when your transaction passes the Howey test.

Of course, this concept impacts things beyond citrus fruit. It is also applicable to the cryptocurrency market. In fact, there are four factors to consider which separate a security from a commodity:

  • An investment
  • A common enterprise
  • A profit expectation
  • Generated from the work of third-parties

In the U.S., the SEC has deemed bitcoin not to be a security. The issuer, an anonymous Satoshi Nakamoto, released all 21 million tokens at once as part of a contract. None of the tokens went to him or a company treasury. When the tokens were released, they had no value, and when they gained value, Nakamoto did not receive any benefit.

In effect, he removed any possible connection between “common enterprise” from the other factors, which disqualifies the venture as a security under the Howey test.

SEC Chair Gary Gensler said, “at the core, these (altcoin) tokens are securities because there’s a group in the middle and the public is anticipating profits based on that group,” during an interview with New York Magazine.

However, Rostin Behnam, the chairman of the Commodity Futures Trading Commission (CFTC), said Bitcoin is not the only commodity. He called another crypto coin—Ethereum—a commodity during a hearing before the Senate Agriculture Committee. In fact, Ethereum has been listed on CFTC exchanges for some time.

An interagency council comprised of state and federal banking officials, as well as commodity, securities and consumer protection groups, agreed in a report that there is not a comprehensive regulatory framework for digital assets. Hence, the reason for differing stances within the industry.

Right now, asset classification dictates how digital assets are regulated. If it is a payment, then it falls under the purview of Money Services Business and the Office of the Comptroller of the Currency. Likewise, CFTC oversees commodities, and the SEC has jurisdiction over securities.

Recently, the SEC has filed a complaint against Binance and Coinbase, alleging that they are selling unregistered securities. The complaint mentioned several coins that could be viewed as securities: Polygon, Cardano and Solana. Soon after the announcement, Robinhood—another crypto exchange—delisted the three mentioned coins.

Binance.US has decided to become a crypto-only exchange, ending US dollar deposits and withdrawals. The SEC wants a federal judge to freeze the exchange’s assets, including $2.2 billion in crypto and $377 million held in dollars.

Either the Coinbase case or the Binance case could make its way to the U.S. Supreme Court, which could in effect create the path for industry regulation with its ruling. As part of a possible outcome, the High Court could also rewrite the Howey test or revise it in relation to digital assets.

At the 2023 Global Exchange and Fintech Conference, Gensler said congressional action is not needed because the laws are already on the books. “Not liking the law, not liking the rules is different than not hearing it or not getting it,” he said. However, this view fails to recognize that the current regulatory framework is not black and white for investors and institutional players.

Under federal securities laws, a company must register with the SEC before offering or selling securities. As part of the registration process, an issuer must disclose financial statements that have been audited by a public accounting firm. These documents provide important information that helps investors make informed decisions about their investments.

As the digital financial assets space grows, more large corporations can be found with crypto on their balance sheets. A 2022 Deloitte Global Corporate Treasury Survey found that 40% of interviewed finance executives said they have already implemented blockchain or they are considering it.

In the short term, issuers will need to work with a law firm with expertise in crypto and digital currencies to navigate the impact of the courtroom rulings and the subsequent new era of regulation on their business.

Make sure your company will be able to pass the test in the evolving legal landscape.

(Joseph M. Pastore III is chairman of Pastore, a law firm that helps corporate and financial services clients find creative solutions to complex legal challenges. He can be reached at 203.658.8455 or jpastore@pastore.net.)

7 Ways to Align Executive Pay with Dodd-Frank

Connecting executive compensation with financial performance took a while to implement—and it wasn’t easy.

Toward the end of last year, the U.S. Securities and Exchange Commission voted 3-2 to accept the “clawback” rules, which are intended to discourage senior leadership from making risky corporate decisions for short-term gain, resulting in restated financial statements.

In short, the SEC called out two types of triggering events involving material and non-material changes to financial statements. And the last part, referred to as “Little Rs,” is why the SEC vote was not unanimous.

Two SEC Commissioners, Hester Peirce and Mark Uyeda, voted no because the new rule included non-material changes.

SEC Chair Gary Gensler, however, supported the rule, citing the fact that corporate restatements have increased to nearly 75% from 35% in recent years. “If the financials are inaccurate, why should executives be getting paid incentive comp on financials that were inaccurate,” he said in an interview with Thomson Reuters.

Here are seven insights to ensure your executive compensation is aligned with the Dodd-Frank Act:

 

Require Shareholder Advisory Vote

Public companies are required to hold a non-binding advisory vote for their shareholders on the topic of executive compensation at least once every three years.

Although the frequency vote gives shareholders four options, including “abstain,” making the vote an annual tradition is the best practice.

At the end of May, Russell 3000 companies have only failed 1.5% on Say on Pay, according to Harvard Law School Forum on Corporate Governance. The current failure rate is 130 basis points lower than last year. In addition, the percentage of Russell 3000 companies receiving more than 90% support (i.e., 78% vs. 75%) is also higher than last year.

Investors are now able to vote on the compensation of the top executives in a public company, which includes the CEO, CFO and at least another three highly paid executives.

 

Bolster Independence for Compensation Committee

The compensation committee balances investor expectations along with a company’s financials to form employee retention strategies. In recent years, however, the role has evolved. Two-thirds of surveyed companies have expanded the role of their committee by expanding the charter or the name as well as the charter, according to the Center On Executive Compensation.

Institutional investors are driving change with more focus on the environment, talent and diversity and inclusion. New topics like human capital metrics, safety and wellbeing, culture and employee engagement are now falling under the compensation committee’s purview.

Strengthening independence requirements for committee members is more important than ever.

 

Added Disclosure on Conflicts for Consultants

Compensation consultants can serve as an invaluable resource for up-to-date pay rates, ongoing compensation trends and incentives to foster employee performance.

The Dodd-Frank Act requires more disclosure about the portion of compensation consultants and any potential conflicts. Stock exchanges must have listing standards that create greater independence for all compensation committee members, including consultants.

For example, exchanges must consider the source of all compensation to the director and whether the director is affiliated with the issuer via a subsidiary or affiliate.

 

Oversight of CEO/Rank Employee Ratio

The Dodd-Frank Act requires public companies to disclose the CEO pay ratio, which compares a CEO’s compensation to pay for median employees.

In 2021, CEOs were paid 399 times as much as a typical worker—a 1,460% increase since 1978. The shift in executive compensation to stock-related investments, which represents roughly 80% of the gains over the decades, is cited as one of the driving forces by the Economic Policy Institute.

Even though the SEC strongly encourages companies to follow generally accepted accounting principles (GAAP) metrics to ensure integrity, companies are only required to provide the CEO pay ratio without context or a long discussion, which can be found, however, in the compensation and analysis parts of a proxy statement.

 

Disclose Pay Versus Performance

Last summer, the SEC adopted amendments to require companies to disclose information that links executive compensation and financial performance.

For the five more recent fiscal years, the amendments require companies to provide a table of executive compensation and financial performance measures, including total shareholder return, as well as the total shareholder return of companies in the registrant’s peer group, its net income and a financial performance metric of the company’s own selection. Companies are also required to provide a list of three to seven financial performance measures that they deem important for connecting executive compensation and company performance.

 

Mandate Recovery Policies for Restatements

The SEC requires companies to implement policies to recover awarded, incentive-based compensation resulting from an accounting restatement from past and existing executive officers, no matter the level of involvement. As a result, stock exchanges must have listing standards that require companies to adopt a written “clawback” policy, which they will disclose as an exhibit in Form 10-K and on the cover of annual reports.

All types and sizes of restatements can trigger a clawback, including ones that materially impact the financial statements in the current year and ones that don’t from prior fiscal periods.

Companies must recover the compensation that is erroneously awarded and received by an executive in the three years preceding the date of the restatement.

 

Disclose Hedging

A company must disclose the ability of employees, officers and directors who can use equity securities granted as compensation to hedge. The company must comply by disclosing the practices in full or providing an accurate summary. If the company doesn’t have any hedging policies, then it must disclose that hedging is permitted.

Companies should review their current hedging policies with an attorney and consider updating or streamlining the document. Does your current policy cover the correct category of employees or enough detail about transactions?

Review these items carefully with an attorney to make sure pay is aligned with the Dodd-Frank Act.

(Joseph M. Pastore III is chairman of Pastore, a law firm that helps corporate and financial services clients find creative solutions to complex legal challenges. He can be reached at 203.658.8455 or jpastore@pastore.net.)

 

Is the SEC kicking Crypto when it is down?

Coinbase Global Inc. (“Coinbase”) is facing an SEC probe into whether it improperly allowed trading of digital assets that should have been registered as securities. Although there have been several court rulings and position statements by the SEC regarding digital assets, it has not halted the trading on crypto exchanges. While the SEC scrutiny of Coinbase has increased since the platform expanded the number of tokens, in which it offers trading, no meaningful regulatory action has occurred with respect to Coinbase.

The drumbeat in Washington for US regulators to do more to oversee crypto has grown louder as digital currencies have tumbled from all-time highs, erasing hundreds of billions of dollars in market value. SEC Chair Gary Gensler has homed in on trading platforms and argued that the SEC should do more to protect “retail investors”.

To determine if a digital asset is a security, the SEC applies a legal test from the 1946 U.S. Supreme Court decision. Generally, the SEC considers monies under its purview if the funding is made with the intention of profiting from the efforts of the issuer. The SEC Commissioner has suggested publically that “many” cryptocurrencies come under the definition. The SEC has not indicated which “coins” are “securities”, and instead has allowed exchanges to decide for themselves.

In the absence of clear guidance this regulatory approach, seems like a game of “gotcha”. Crypto is a young industry and it deserves clear and accurate rules so that its participants can navigate the path forward. The SEC should either test its approach in court, and perhaps it is with Coinbase, or stand down. Ultimately, the U.S. Supreme Court will likely decide the question of how to determine whether crypto coins or tokens are securities. Either way, crypto can thrive if its coins generate enough investor interest, but the rules for regulation and investor protection should be made clear at this point.