A few years ago, a group of friends persuaded me to join them in buying a cask of whisky. It was a fun day out. We headed to the distillery, a new one in the English countryside making a name for itself disrupting Scottish domination of the market, and took turns filling a 200 litre American oak barrel. The up-front cost was a few thousand pounds, which may not seem like much, but there was a catch.

First, whisky is not whisky until it has sat in a barrel for three years. We agreed to wait ten, which means those few thousand pounds would be tied up for a long time without a return. 

Second, significant additional costs would be incurred before we could ever drink the whisky. At the end of the ageing process, we’d need to bottle it and label it, and pay excise duties and taxes. Assuming we maintained the whisky at cask strength, our barrel would yield around 260 bottles (there is a bit of evaporation along the way – the ‘angel’s share’ as it is known). At £8.50 per bottle to package it, plus excise duty of £31.64 per litre of alcohol (both of which are higher now than when we laid down the barrel) we’d have to stump up an additional £7,300 or so, after tax, before we could savour a dram.

But the benefits! All-in, we would be locking in a delightful whisky at a price of around £40 per bottle. The spirit (as whisky is known before it becomes whisky) has a light, fruity character highly rated by critics; the flavoursome notes delivered by the first-fill ex-Bourbon barrel promise to transform it into an exciting single malt. If it retails at £100 a bottle, we’ve got ourselves a bargain.

Along the way, we are welcome to visit our cask at the distillery’s bonded warehouse and once a year we are entitled to draw a 100ml sample to taste. If we can’t afford the outlay at the end of the contract, the distillery offers an interesting deal: It will pay all the duties and do all the bottling for us in exchange for two-thirds of the product. So there’s an option to sell at the end, albeit at a below-market rate. 

The conditions of ownership are strict. Although we can share the cask, the distillery requires a single one of us to act as legal owner. That’s because it’s selling a product, not shares. It’s an important point; in the past, similar structures have fallen foul of the United States Securities and Exchange Commission (SEC) – there’s a fine line between owning whisky and owning some abstraction of whisky and the distinction has legal ramifications. 

In 1971, officials at the Securities and Exchange Commission came across a series of adverts placed in newspapers across Rhode Island, Massachusetts and Florida. “Exceptional Capital Growth Is Possible When You Buy Scotch Whisky Reserves By The Barrel,” they read. The ads were placed by Maurice Lundy of Rhode Island whose business sold warehouse receipts on whisky to interested investors. “The principle of whisky lying in bond in Scotland is that the older the whisky the more the price appreciates,” his marketing materials proclaimed.

Although investors could in theory take delivery of the scotch, an SEC investigation concluded that “the steps required for the taking of physical possession of such whisky represented by said receipts are both difficult and unprofitable.” Only one investor had ever inquired as to the possibility of taking possession of the whisky and none had ever gone through with it.

In the eyes of the SEC, Lundy wasn’t selling whisky, he was selling whisky securities. And because he hadn’t registered his whisky securities, he was in violation of a whole set of rules that govern the issuance of securities. Lundy countered, of course, attempting to frame his receipts as anything but securities. But the US District Court in Rhode Island came down in favour of the SEC. 

In doing so, it reached back to an earlier case heard by the Supreme Court in 1946. The case, SEC v. W.J. Howey Co., established a “test” of whether something is a security and therefore whether it falls within the purview of securities regulation (emphasis added):

The test of whether there is an “investment contract” under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or non speculative, or whether there is a sale of property with or without intrinsic value.

The test derived from an investment contract as funky as a whisky receipt.

William John Howey was a successful real estate developer based in Florida. In 1914, he began buying land in Lake County for $8 to $10 an acre which he cleared and planted with citrus trees. Howey kept some of the citrus groves for his own use and sold off the rest.

By the early 1940s, his company was able to sell land planted with two year old trees for $750 an acre. But as part of the sale, it would offer to lease back the land via a service contract which gave the company the right to work the land and market the produce. Attracted by the promise of returns of 10% a year for ten years and the hospitality they enjoyed at a company-owned resort hotel, investors piled in: around 85% of the acreage sold was leased back. In theory, buyers could have farmed the citrus groves themselves, but most lacked the agricultural skills to do so. 

As in its whisky case later, the SEC contended that the service contracts constituted securities and, as no registration statement had been filed, Howey’s company was in violation of securities laws. This one went all the way up to the Supreme Court with the SEC coming out victorious. 

Over the years, other esoteric assets have been scrutinised under the Howey test. In the late 1960s, Colorado-based Continental Marketing Corporation sold live beavers to buyers across America. Over a short period of time, the company made over two hundred sales in sixteen states, grossing over a million dollars. By itself, weird but not untoward.

“Manifestly, the simple sale and delivery of live beavers do not, when viewed in isolation, constitute the sale of a security under the Act,” records the case the SEC brought against Continental Marketing Corporation in 1967. 

But buyers were given a choice. They could care for their own animals, with each pair of beavers requiring a private swimming pool, patio, den and nesting box together with the services of a veterinarian, dental technician and breeding specialist. Or, at a cost of $6 per month per animal, they could place their beavers with a professional rancher connected with the company. Every single customer chose the latter. It was this that piqued the interest of the SEC. It seems that buyers were motivated less by a fondness for beavers and more by “an opportunity to share in the profits of the breeding stock stage…the most lucrative stage in the development of the beaver industry.”

Applying the Howey test, the District Court in Utah sided with the SEC. “Investment by members of the public was a profit-making venture in a common enterprise, the success of which was inescapably tied to the efforts of the ranchers and the other defendants and not to the efforts of the investors.”

Buying beavers became less fashionable after Continental Marketing Corporation lost its case; buying whisky, however, remained popular. Even after the US District Court of Rhode Island held whisky interests to be securities, the SEC noted “a substantial rise in the number of sales of whisky interests in this country.” It cautioned people who were solicited to invest in such securities to insist on a prospectus first.

The authority of the SEC derives from the Securities Act of 1933, sometimes referred to as the “truth in securities” law. The objective of the law is to protect investors by imposing a certain level of disclosure on issuers and outlawing deceit and misrepresentation. To accomplish this, the SEC requires all securities to be registered. Hence the need for a Howey test – it’s not always obvious what a security is.

Fifty years later, the SEC is waging the same war. The front isn’t whisky, citrus groves or beavers this time; rather, it’s crypto. Commissioners of the SEC have long held the view that crypto assets are securities. Current chair Gary Gensler said in a speech last year, “My predecessor Jay Clayton said it, and I will reiterate it: Without prejudging any one token, most crypto tokens are investment contracts under the Howey Test.” 

Over the past several years, the SEC has gone after individual crypto projects. In total, it has accused 54 crypto assets of being securities. But there are around 25,500 crypto assets in existence, so even though the focus has been on large ones – covering around 10% of the market – it’s a painful process.

This week, the SEC changed course. In separate cases against crypto exchanges Binance and Coinbase, it added 16 more digital assets to its list of likely securities but rather than going after them, it went after the exchanges that provide a venue for them to trade. “The crypto assets it [Coinbase] has made available for trading…have included crypto asset securities, thus bringing Coinbase’s operations squarely within the purview of the securities laws.” By not registering as an exchange or broker, Coinbase is deemed in violation of such laws. 

Coinbase was always cognisant of the risk. When it registered its own securities ahead of a Nasdaq listing two years ago, its disclosures stated:

We have policies and procedures to analyze whether each crypto asset that we seek to facilitate trading on our platform could be deemed to be a “security” under applicable laws… Regardless of our conclusions, we could be subject to legal or regulatory action in the event the SEC, a foreign regulatory authority, or a court were to determine that a supported crypto asset…is a “security” under applicable laws. 

[W]e could be subject to judicial or administrative sanctions for failing to offer or sell the crypto asset in compliance with the registration requirements, or for acting as a broker, dealer, or national securities exchange without appropriate registration. Such an action could result in injunctions, cease and desist orders, as well as civil monetary penalties, fines, and disgorgement, criminal liability, and reputational harm.

But then they also stated that “many of our employees and service providers are accustomed to working at tech companies which generally do not maintain the same compliance customs and rules as financial services firms. This can lead to high risk of confusion…” So who knows?

If it loses its case, it’s bad news for Coinbase. In the first quarter of this year, 46% of the company’s transaction revenues came from crypto assets other than Bitcoin and Ethereum (Gary Gensler recognises that Bitcoin is not a security), equivalent to 22% of total revenues.

In addition, The SEC targets the company’s “staking” program, in which investors’ crypto assets are transferred to and pooled by Coinbase and subsequently “staked” (or committed) in exchange for rewards, which Coinbase distributes pro-rata to investors after paying itself a commission. The SEC deems the staking program to be an offer of securities – another violation. In the first quarter, 10% of the company’s total revenues came from staking. In combination, 32% of Coinbase revenues are at risk, which could be closer to two-thirds of earnings given the higher margins on these revenue lines. 

Coinbase could always register with the SEC of course, but it’s not easy. Few crypto firms have been successful. So it’s fighting: 

Coinbase’s position is that the Howey test does not apply to secondary market trading. “Howey is inapposite to the secondary market trading of digital assets,” it declares. It seems a bit of a stretch to suppose that once something is a security it’s not always a security, but I’m no lawyer. And as for the SEC’s claim that staking constitutes an offering of securities, Coinbase argues that the program fails to meet the threshold of the Howey test along each of its dimensions: investment of money, common enterprise, and profits coming solely from the efforts of others.

As Howey did all those years ago, Coinbase has threatened to take this case all the way to the Supreme Court. But another case may set a precedent. In December 2020, the SEC filed an action against Ripple Labs, alleging that it raised over $1.38 billion through an unregistered securities offering of its digital asset XRP. Ripple was launched in 2012 as a system to facilitate cross-border financial transactions – “a replacement for SWIFT” – and XRP is the token it uses for payments. The company maintains that XRP is not a security and has said it will spend $200 million on its defence. 

As in its Coinbase case, the SEC leans heavily on Howey. It notes that although the Howey case was a long time ago, the Supreme Court made clear that the definition of whether an instrument is an investment contract and therefore a security is a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” 

Ripple’s claim is that XRP doesn’t pass the test. It takes each of its dimensions in turn:

For the SEC to prevail in its opposition, the Court would have to endorse the SEC’s theory that there can be an “investment contract” without any contract, without any investor rights, and without any issuer obligations. It would have to endorse the SEC’s theory that there can be a “common enterprise” even if the SEC can not say what the enterprise is or prove any of the elements that define such enterprises. And it would have to endorse the SEC’s theory that purchasers could reasonably have expected profits from Ripple’s efforts even though Ripple never promised to make any efforts, even though it expressly disavowed any obligation to do so, and even though profits were overwhelmingly due not to Ripple’s efforts, but to market forces. 

…The SEC’s position boils down to a view that any time someone buys an asset hoping to make money, and the seller’s interests are even partly aligned with the buyer’s, it is a security subject to registration. That is not the law, even if the seller uses the sales proceeds to run its business. If Congress wants to expand the securities laws that way, it can do so; but this Court should not.

The future of crypto in America may yet be decided by Congress, but failing that it will be up to the courts to determine whether a 75+ year old test is as pertinent today as it was when it was devised. Coinbase is ready for the fight. “I’m optimistic, and I think we hope we’re doing a service for the industry and for America here,” said CEO Brian Armstrong this week.

The only question for me is whether my whisky will be ready in time to toast the winner...