State-level securities laws — AKA “blue sky” laws — have been adopted by all 50 states plus Washington DC, Guam, Puerto Rico and the US Virgin Islands. As noted in this Wilmer Hale alert, these laws both regulate securities “left unregulated” by federal authorities (e.g., “securities only offered and sold within one state or offered by state or local governments”) and give states overlapping enforcement authority to prevent and punish securities fraud. The alert describes how state enforcement activity has — and is likely to continue to — “respond to perceived federal enforcement gaps” — i.e., possibly to act on crypto in ways the federal government is not.

Not surprising, perhaps, but here’s the key. Several states (the alert has a map) have adopted the more expansive “risk capital” test as either an alternative or complement to the Howey and Reves tests used to determine whether federal securities laws apply to a given financial instrument.

One of the most prominent applications of this test comes from the 1961 case Silver Hills Country Club v. Sobieski, decided by the Supreme Court of California. In Silver Hills, Justice Roger Traynor applied the risk capital test to conclude that memberships sold to develop a country club constituted securities—the memberships involved an investment of money in an enterprise for profit, which subjects the investor’s money to the risks of the enterprise, and the investor has no managerial control over the enterprise.

Some states have adopted this test by common law, and others by statute/regulation. For example:

The Supreme Court of Oregon has also adopted the risk capital test [and] a federal district court in Oregon has applied Oregon law to determine that a security exists under Oregon state law—but not federal law—where an individual bought into a franchising scheme. 

Oregon is notable because it “provides a modern example of state attorneys general applying the broader risk capital test to treat newer instruments as securities” – i.e., its enforcement action against Coinbase. Oregon’s attorney general has shared his position in no uncertain terms: “[S]tates must fill the enforcement vacuum being left by federal regulators who are giving up under the new administration and abandoning these important cases.”

What does this mean for crypto and corporate issuers? That this may not be a one-off, and “the current polarized political environment” may “exacerbate the impact of the Howey/risk capital distinction.”

Given the Trump Administration’s pro-crypto and wider deregulatory policy agenda, Democratic state attorneys general and securities regulators may use state securities enforcement powers to act as a counterweight and/or to advance their own political priorities. Financial industry firms, exchanges, issuers and others should consider the potential impact of the Howey/risk capital distinction as they face what may be a more fractured securities regulatory environment in coming years.

– Meredith Ervine