Classification as a security is an omnipresent concern for issuers of digital assets. When offering or selling securities in the United States, securities must either be registered or exempt from registration. The registration process is onerous and outside the capabilities of most (if not all) web3 projects, and exemptions from registration typically require certain provisions that are not ideal for the iterative development process (including lockup provisions and limitations on transferability).

When determining whether a given digital asset is a security, issuers must determine whether it constitutes an “investment contract.” This analysis was provided by the Supreme Court in the case of SEC v. However (the Howey Test). Howey asks whether an asset involves: (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profit, (4) from the efforts of others. If a digital asset meets all four of these prongs, then it is likely to be considered an investment contract and, in turn, a security for purposes of U.S. securities laws. 

For years, securities regulators and market participants have engaged in a back-and-forth on this topic, arguing whether or not a constant parade of digital assets either satisfy or fail to satisfy Howey. Although the SEC has issued guidance for determining when a digital asset is an investment contract, there is still broad uncertainty.

Facing an action from the Texas State Securities Board, crypto exchange FTX will begin delisting certain assets from its platform that its legal team deems securities. CEO Sam Bankman-Fried has stated the legal team will review its offerings for compliance with the Howey Test and case law. If the asset fails any of the four prongs of Howey, the exchange will label the asset a commodity (absent previous negative guidance).

This news highlights the fact that, absent clear regulatory guidance and infrastructure, market participants (including digital asset exchanges) must take conservative positions when analyzing the assets associated with their respective projects and protocols. An overly conservative posture may serve to further cool an already downturned market for digital assets, especially those that are either (a) at higher likelihood to being classified as securities, and (2) digital assets that, despite being initially classified as securities, have subsequent legitimate utility and consumptive use. 

Developers, issuers, and exchanges should take a proactive posture when structuring (or restructuring) their digital assets. Failure to do so could lead to short and long-term consequences, including delisting, enforcement action, or an inability to launch a particular project or protocol.

Tanner Dowdy also contributed to this article.