In a recent decision in SEC v. Payward, Inc. (d/b/a “Kraken”), Judge Orrick of the Northern District of California denied Kraken's motion to dismiss the SEC's suit against it. In its complaint, the SEC alleges that Kraken acts as an unregistered broker-dealer, exchange, and clearing agency for "crypto asset securities." Judge Orrick ruled that the SEC plausibly alleged that at least some of the cryptocurrency transactions that Kraken facilitates constitute investment contracts and are subject to securities laws. The SEC's claims will thus move forward to the discovery phase.

The decision's analysis of the Howey test is more interesting than its outcome denying Kraken's motion. To determine if something is an "investment contract" and thus a "security" under the Securities Act of 1933 and Securities Exchange Act of 1934, the Howey test defines an "investment contract" as "an investment of money in a common enterprise with profits to come solely from the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). How that test applies to cryptocurrency has been a sticking point for the last decade between the SEC and the crypto industry. In his order, Judge Orrick clarified that the Howey test should be applied on a transaction-by-transaction basis rather than on an asset-by-asset basis. In other words, whether it's an investment contract could not be uniformly applied across a crypto asset writ large, but rather depended on the unique facts of each transaction. In a footnote, the judge cautioned the SEC to "be careful going forward to maintain this distinction" because if it tries to argue that individual tokens are themselves securities, its argument cannot proceed. This raises the level of difficulty for the SEC if it has to show the unique circumstances behind each Kraken transaction, and is a good reminder for the entire industry as it wrestles with the correct terminology for these issues.

The court also pointed out that this appears to be the first case where a court has considered secondary market sales of crypto assets; here, the SEC's allegations involve tokens issued by a third party that are transacted on Kraken. But the court held that the Howey test must be applied to the transactions as they occurred on the secondary market, and that representations made at the primary market transactions can carry forward into the secondary market. The determinative factor of this analysis is "not the nature of the platform upon which the asset is transacted, but rather the reasonable expectations of the individual initiating the transaction."

Some other takeaways: (1) On whether there was a "common enterprise" under Howey, the court ruled that the SEC plausibly alleged vertical commonality between the investors who used Kraken to purchase crypto assets and the promoters whose job it was to promote those assets, particularly where the promoters held a significant amount of the asset they are promoting; and (2) The court rejected Kraken's invocation of the “major questions doctrine” and its argument that the SEC had granted itself transformative authority without Congress's approval, in part because the crypto industry has a relatively small foothold in the US economy and in part because the SEC's attempt to regulate this new financial instrument was not beyond its authority.

How this case progresses will no doubt impact both the SEC and crypto industry from both a litigation strategy and broader policy perspective.