After the collapse of FTX and a summer of crypto failures (Terra Luna, Celsius, Three Arrows), the Securities and Exchange Commission (SEC) will want to act quickly and treat more digital assets as “securities.”  But which ones?  In a new article, I attempt an answer by re-interpreting the Howey test for determining what is an “investment contract” and thus a security.

The first crypto entrepreneurs – such as Satoshi Nakamoto (Bitcoin) and Vitalik Buterin (Ethereum) – look like the angel investors who have long funded traditional startups.  They engage in “for-profit philanthropy,” investing financial capital in startups but also contributing value-added services.  Unfortunately, as a result of both market and legal changes over the last decade, angels now resemble money-driven venture capitalists more than for-profit philanthropists.

For-profit philanthropy has reappeared in crypto, however.  Like angel investors, Nakamoto, Buterin, and others have invested substantial time and money creating something that people could build on: blockchain networks.  My article contends that a crypto entrepreneur’s classification as an “angel” – based on contributions to the crypto ecosystem of blockchain technology in addition to profits – informs whether the digital assets created by that entrepreneur are securities under the Howey test.

While an angel sits on one shoulder, however, a devil may sit on the other.  For every crypto angel who contributes to blockchain innovation and crypto generally, there is a scammer who damages the system and violates its core principle of decentralization.

Crypto devils may have started out as scammers, running traditional Ponzi schemes under cover of the blockchain.  For example, Bulgaria’s OneCoin never had a functioning blockchain and was sold using the same method (multi-level marketing) as Tupperware.  FTX and Terra Luna are more complicated cases and may involve crypto creators who began as angels but became devils along the way.  These “fallen angels” pose unique classification issues.

Finally, my article turns to how courts and the SEC should respond.  The Howey test can be reinterpreted to focus on an entrepreneur’s angel or devilish behavior.  Doing so changes the inquiry in two key ways.

First, instead of asking whether investors expected a return on their crypto investment, the test should now ask whether they were led by a devil to expect those returns.  In other words, did the crypto creator market his token by focusing on potential riches instead of the technology?  Second, when asking whether an investor’s expectation of returns depended on the efforts of others – the key inquiry so far in determining whether a digital asset is a security – we must determine whether the relevant time is before or after an initial coin offering (ICO).  That is, are we talking about developing the blockchain protocol initially or after it is established?  If we focus on angels and devils, we know the answer:  Angels set up decentralized networks designed to run autonomously after launch – perhaps with a grace period to become truly decentralized – while devils retain control and continue to determine the network’s success.  The focus on angels and devils leads us to the right answer on when the important efforts of others must occur to meet Howey.

The ultimate payoff: Under the Howey test as re-interpreted, an angel’s token should be a commodity regulated by the CFTC, legal to sell without SEC registration.  A devil’s token, on the other hand, would be a security and thus subject to SEC registration and enforcement actions for noncompliance.  This will strike the proper balance of allowing the SEC to protect investors from scams while allowing legitimate digital assets to be sold under the lighter-touch CFTC commodities regulation.

This post comes to us from Darian Ibrahim, the Tazewell Taylor Professor of Law at William & Mary Law School. It is based on his new article, “Angels and Devils: The Early Crypto Entrepreneurs,” available here..