Saturday, September 11, 2021

Howey, Reves, and a Common Law Comedy of Error

So, Coinbase has made a lot of noise recently about the SEC’s warning that its “Lend” product may be a security and thus subject to registration under the securities laws.

Its wounded blog post, not to mention the complaints from the CEO on Twitter, have attracted a good deal of mockery, but I actually want to use this as a jumping off point for a different discussion.

The Lend product, as I understand it, would allow Coinbase to lend certain cryptocurrency held by its clients to other actors; the borrowers will pay an interest rate to Coinbase, which Coinbase will share with clients, resulting in a guaranteed minimum 4% interest payment to the client.  Essentially, Coinbase wants to be a bank, and to treat its clients as depositors, without the bother of banking regulation.  Per Coinbase’s blog post, the SEC is “assessing our Lend product through the prism of decades-old Supreme Court cases called Howey and Reves....  These two cases are from 1946 and 1990.”  Leaving aside the baffled tone (Howey? Reves? What is this sorcery?), and the language designed to make me feel old (I still wear clothes I bought in 1990), what is interesting to me is that the SEC is using both tests

This is an unsettled area when it comes to the definition of a security.  Howey is used to determine whether an instrument is an “investment contract” as that term is used in the definition of a security contained in the Securities Act of 1933 and the Exchange Act of 1934; Reves is used to determine whether a “note” is a security as defined in those Acts.  And it’s not always clear which test applies when.  Technically, a “note” is a definite promise to pay a particular sum.  But in SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court used the Howey test for a sale-and-leaseback arrangement that included a promise to pay $82 per month, rather than the Reves test.  That leaves a fair degree of uncertainty as to how to determine whether new instruments count as “notes” in the first place so that the Reves test is appropriate.  Are the two tests alternatives?  Is one preferable to the other in some situations?  The answer isn’t clear.

And it matters because the tests themselves are similar but not identical.  Both consider whether the product is sold to many people or to a single person; both consider the purposes of the transaction, but Reves is a fuzzy multifactored balancing test whereas Howey requires that all elements be met.

Why is the law like this? 

It’s actually, as far as I can tell, the product of the sometimes dysfunctional development of the common law.  (Something I previously discussed in the context of United Food and Commercial Workers Union v. Zuckerberg.  In that blog post, I talked about a different example of the common law creating an unnecessary multiplicity of tests: Aronson and Rales.  I should add, though, that in that post, I was wrong in predicting what the plaintiffs would do; Zuckerberg is currently pending before the Delaware Supreme Court and the plaintiffs are arguing for a reinterpretation of Aronson that would distinguish it from Rales.).

So, back to securities: In 1946, the Supreme Court had to decide if interests in an orange grove constituted an investment contract/security, and it came up with the four-factored Howey test: investment of money, in a common enterprise, with the expectation of profit, due to the managerial efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

Nearly 30 years later, in 1975, the Supreme Court decided United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975).  In Forman, a New York City co-op was created as part of a program of low income housing.  To get an apartment in the co-op, you had to buy a share of “stock” in the corporation, but the stock itself had none of the features of traditional stock and mainly was used as a security payment for the apartment.  When the residents/stockholders sued, claiming they had been sold securities, the Supreme Court held that the stock was not “stock” as that term was meant in the securities laws, and then further held that it was not even an investment contract under the Howey test.  Why? Among other things, there was no expectation of profit as Howey envisioned.  As the Supreme Court put it:

By profits, the Court has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds. . . .

Lower courts did two things with this.  First, they decided that all instruments allegedly subject to the securities laws – stock, notes, anything else – would get the Howey test.  Second, they read Forman’s concept of profit narrowly, to mean that the expectation of profit had to be something like profits generated specifically from the success of the enterprise.  Fixed rates of return, especially at a market rate, would not count as “profit” because those amounts would be due to the investor regardless of whether the enterprise was a success or failure. 

And then came Reves v. Ernst & Young, 494 U.S. 56 (1990), with the question whether a demand note was a security.  The Eighth Circuit applied Howey and concluded that the fixed rate of return excluded it from the security definition. See Arthur Young & Co. v. Reves, 856 F.2d 52 (8th Cir. 1988) (“the interest rate was fixed by an established market rate. The demand noteholders did not participate in the Co-op's earnings by virtue of their ownership of the demand notes, nor was there any prospect of capital appreciation. Therefore, the demand noteholders did not expect a ‘profit’ as that term is defined in Howey.”)

But debt instruments often have fixed rates of return!!  It’s kind of the point!  If you do this, you end up with a lot of debt instruments being entirely uncovered by the securities laws!

So, off it goes to the Supreme Court.  And the Court – rather than interrogate the lower courts’ interpretation of Forman, see Reves, 494 U.S. at 68 n.4 – decides that notes should have an entirely different test.

Now there are two tests. Howey and Reves.  (Okay, three, if you think of Forman, and subsequently Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), as setting forth a definition of whether something is “stock”).

But we’re not done.  Because in SEC v. Edwards, the Court finally did confront the narrow definition of “profit” that courts were using for Howey. And there, applying Howey, it held that fixed rates of return can in fact be “profits.” 

But if the instrument has a fixed rate of return, there’s going to be a specific payment due at a particular time, and that might make it a note!

The whole point of Reves, I submit, was to get around an unduly narrow interpretation of Howey.  Once that interpretation changed, we’re left with two tests, no clear reason for them, and no clear guidance when one should apply and when it should be the other.

And that’s why the SEC is testing Coinbase’s Lend product – which involves a fixed rate of return – under both Reves and Howey.    

Anyway, here’s Adam Levitin on how Lend comes out under Howey and Reves.

Ann Lipton | Permalink


Nice post. I enjoyed it a lot. And thanks for the pointer to Prof. Levitin's blog as well.

I will say though, I find the mockery of the Coinbase blog post to be a little unfair. You can't really fault their legal department for being unfamiliar with securities law and SEC procedure. It's not like their GC was a federal magistrate judge for many years or anything.

Posted by: kotodama | Sep 12, 2021 9:57:18 AM

You might want to look at the SEC complaint against BitConnect, which offered a very similar crypto lending project ( The Commission relied solely on Howey there. Since the complaint was filed last May it undermines the CoinBase claim that they did not have clarity. I am not sure I would accept CoinBase's claim that the SEC is relying on both tests.

Posted by: Steve Diamond | Sep 17, 2021 1:45:49 PM

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