The digital currency marketplace has expanded since bitcoin first made headlines in 2009. With Facebook announcing its ambitious Libra Project earlier this year,[1] a renewed focus on the regulatory framework and classification of various digital currencies is again at the forefront. Essential to this conversation is whether a digital currency should be viewed as a “security” and subject to U.S. Securities and Exchange Commission (SEC) applicable rules.
The SEC recently issued a non-binding advisory letter meant to guide potential digital currency issuers in determining whether U.S. federal securities laws will apply to their offering.[2] Central to this analysis is the determination whether the digital currency to be issued is an “investment contract,” thereby making it a security. The SEC believes the four-pronged “Howey test” is key to making this determination. The Howey test focuses on the circumstances surrounding the digital currency and how the digital currency is offered, sold, or resold on a secondary market.[3] The test states: “an investment contract for purposes of the Securities Act means a contract, transaction, or scheme whereby a person 1) invests his money in 2) a common enterprise and is led to 3) expect profits 4) solely from the efforts of the promotor or a third party…”[4]
In applying the Howey Test to Facebook’s Libra, the initial offering of the Libra will likely validate the test and may be considered a security. In analyzing each prong, we have contrasted the Libra offering with bitcoin as it is helpful to show how the Libra varies from the standard digital cryptocurrency.
1) Investment
This prong should be easily satisfied when looking at Facebook’s model for funding Libra. An investment is the outlay of money for income or profit.[5] Facebook has almost 30 investors and hopes to reach 100 before its launch in 2020.[6] Each investor has invested sizable capital to help start the digital currency and will receive income from the Libra Reserve in the form of interest on the securities held in the Libra Reserve.[7] The Libra token will only be distributed to users after the token has been funded and developed via a pre-sale, which appears most similar to the investment of money. We can contrast Facebook’s funding method with the creation – or “mining” – of a bitcoin, which is done through an unlimited number of individuals with no direct investment in the digital currency outside of computing power.[8]
2) Common Enterprise
The common enterprise prong hinges on if the success of the investor’s capital is sufficiently dependent on the efforts of the promoter of the investment.[9] When applying this analysis to a digital currency, the level of decentralization of the digital currency’s transaction network is the determinative factor.[10] The degree of decentralization is subjectively measured by the number of transaction validator nodes[11] and the barrier to becoming a validator node. Libra will be a highly centralized transaction network. Validator nodes will be solely operated by members of the Libra Association which is composed of investors in the Libra Project.[12] The Association is also solely responsible for creating, destroying, and managing the number of tokens in circulation making all users transacting in Libra highly dependent on the Libra Association.[13] Contrast this with bitcoin, where anyone can become a validator node with a modest investment in computer equipment, the number of tokens has been capped within the blockchain’s code and cannot be altered, and there is no selective governing authority overseeing bitcoin’s administration. The centralized structure of Libra likely satisfies this prong of the test.
3) Expectation of Profit
Existing digital currencies used for monetary transactions have exhibited highly speculative value and many purchasers buy and sell the tokens to profit from the volatile value swings. While the Libra’s value will be backed by an actively managed reserve of low-volatility assets, the value of the Libra will fluctuate based on the underlying assets of the reserve and can be purchased with the expectation of profit from selling later.[14] This prong is easily satisfied.
4) Efforts of Promoter
The fourth prong of the test centers on whether buyers rely on a specific third party who is the substantial cause of an increase in the buyer’s profit.[15] Due to bitcoin’s decentralized structure, no user substantially relies on the effort of a discernable third-party in the execution of a transaction.[16] However, a user transacting in Libra will substantially rely on the Libra Association members in completing the transaction and will reasonably rely on the Libra Association’s management in the reserve to maintain a stable value. The Libra Association is promoting, creating, destroying, and guaranteeing the liquidity of Libra tokens. Therefore, a user transacting in Libra will be substantially relying on the Libra Association to effectively manage and increase the value of the digital currency.
The initial offering of Libra will likely validate the Howey test and may be considered a security subject to U.S. federal securities law. It is also important to note that Facebook concluded its Libra whitepaper by stating a medium-term objective of increasing decentralization.[17] If successful, this decentralization could change Libra’s classification under existing law if a more developed regulatory scheme for digital assets is not achieved beforehand. However, with Facebook targeting Libra’s initial coin offering for the first half of 2020, a greater examination of applicable securities law to digital assets is warranted.
[1] Josh Constine, Facebook Announces Libra Cryptocurrency: All You Need to Know, TechCrunch (Oct. 15, 2019, 8:49 PM), https://techcrunch.com/2019/06/18/facebook-libra/.
[2] Available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
[3] Id.
[4] Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).
[5] Investment, Barron’s Financial Guides: Dictionary of Finance and Investment Terms (7th ed. 2006).
[6] Libra Association, An Introduction to Libra 4 (2019).
[7] Id. at 7; See also Elizabeth Lopatto, Libra, Explained, The Verge (Jul. 9, 2019, 3:20 PM), https://www.theverge.com/2019/6/26/18716326/facebook-libra-cryptocurrency-blockchain-irs-starbucks.
[8] Peter Van Valkenburgh, Framework for Securities Regulation of Cryptocurrencies: Version 2, Coin Center (Jul. 9, 2019, 3:32 PM), https://coincenter.org/entry/framework-for-securities-regulation-of-cryptocurrencies.
[9] Id.
[10] Id.
[11] Validator Nodes – a validator node is a computer running the specific software of a cryptocurrency with hardware capable of completing the complex mathematical problem presented to the node by a crypto-transaction. When the node completes the mathematical problem, the crypto-transaction is attached to the blockchain and the node is rewarded with a quantity of cryptocurrency.
[12] Libra Association, An Introduction to Libra 8 (2019).
[13] Id.
[14] Id.
[15] Peter Van Valkenburgh, Framework for Securities Regulation of Cryptocurrencies: Version 2, Coin Center (Jul. 9, 2019, 3:32 PM), https://coincenter.org/entry/framework-for-securities-regulation-of-cryptocurrencies.
[16] Id.
[17] Libra Association, An Introduction to Libra 9 (2019).
