1. Introduction

In the wake of Ethereum’s transition to a proof-of-stake consensus mechanism (“the Merge”), various commentators have suggested that Ethereum’s new staking model could result in its native token Ether (ETH) being deemed a security under U.S. securities laws.¹ Some have taken the extreme position that the token in any proof-of-stake system is likely to be a security.

However, these arguments stretch the interpretation of the Howey test beyond recognition and fail to recognize that the fundamental purpose of securities laws is to address information asymmetries that are not present in this context.

As explained below, Ethereum’s adoption of a proof-of-stake consensus mechanism does not make ETH (or even staked ETH) an investment contract, and such a finding would result in a nonsensical application of securities laws.

2. Securities Laws Primer

U.S. securities laws require issuers to register any offers or sales of securities with the SEC, unless an exemption is available.² Registration entails mandatory disclosure that ensures material information is shared with investors to allow for informed decision-making, prevent information asymmetries, and avoid agency problems.

The Securities Act of 1933 enumerates the types of instruments that constitute a “security,” which include an “investment contract.”³ As defined by the Supreme Court’s seminal opinion in Howey, an “investment contract” entails (1) an investment of money; (2) in a common enterprise; (3) with the reasonable expectation of profits; (4) derived solely from the efforts of others.⁴ In order to meet this definition, a contract, scheme, or transaction must satisfy each of the four prongs.

In decisions interpreting “investment contract,” the Court has rejected a literal construction of the statute, adopting instead a flexible interpretation that focuses on the “economic realities” of the relationship between the promoter and investors.⁵ In various instances, the Court has applied the economic reality concept to limit the scope of “investment contracts” and the application of securities laws if the underlying economic relationship between the parties is not one of investor and promoter.⁶

3. Application of Howey to Proof-of-Stake Ethereum

Ethereum’s adoption of a proof-of-stake consensus mechanism has led various commentators to suggest that ETH, or more specifically the act of staking ETH, could meet the definition of an investment contract under Howey.⁷ The argument takes the following structure: staking ETH as a validator meets the Howey test because a validator is (1) “investing money” by locking up 32 ETH to stake, (2) in a “common enterprise” comprised of the various parties participating in the validation process, (3) with the expectation of receiving profits in the form of staking rewards, (4) that are derived from the efforts of other validators or other parties participating in the validation process.⁸

Putting aside whether a validator depositing ETH into a smart contract would qualify as an “investment of money,”⁹ the argument that Ethereum’s adoption of proof-of-stake results in ETH being deemed an investment contract fundamentally misinterprets the second and fourth prongs of Howey, and the failure of either prong is fatal. The conclusion would also result in an absurd and unnecessary application of securities laws because there is no issuer or promoter with privileged access to information who could or should be forced to make disclosures.

3a. Proof-of-stake does not entail a “common enterprise”

3ai. Legal Standard

As the Supreme Court stated in Howey, an essential component of an investment contract is a “common enterprise.”¹⁰ While some courts have held that a common enterprise exists only when there is “horizontal commonality,”¹¹ others have found “vertical commonality” sufficient to meet this prong of Howey.¹² As explained below, staking ETH entails neither horizontal nor vertical commonality and thus fails to meet the common enterprise prong of Howey.

3aii. There is no “horizontal commonality” among validators

Horizontal commonality is present when each individual investor’s fortunes are tied to the fortunes of other investors by the “pooling of assets, usually combined with the pro-rata distribution of profits.”¹³ “Pooling” in turn requires an issuer or promoter to commingle investors’ funds and use them toward a common enterprise.¹⁴ In other words, courts have stressed that horizontal commonality requires the expected profits of an investor to be tied to other investors “by entrepreneurial efforts of a promoter.”¹⁵ Horizontal commonality therefore requires investors to give up any individualized claims to profits, in return for a participatory and pro-rata interest in the ensuing profits distributed by the promoter.¹⁶

Some have mistakenly argued that staking ETH implies horizontal commonality because validators deposit ETH into a single smart contract address, which allegedly entails a “pooling of assets”,¹⁷ or alternatively that horizontal commonality is allegedly found because there is a perceived “cooperation” amongst validators.¹⁸ As shown below, these arguments are conclusory, and misunderstand the mechanics of staking in Ethereum.

To become a validator on the Ethereum network, one is required to deposit 32 ETH to a smart contract address (known as the “Deposit Contract”).¹⁹ However, the deposit of ETH to the Deposit Contract is not “pooling” since that ETH is never under the discretionary control of a promoter who can use it to drive value to a common enterprise. Instead, the purpose of staked ETH is to create an incentive mechanism that secures the network; it ensures that validators have some skin in the game so that they can be penalized or “slashed” for behaving dishonestly. Further, while each validator’s ETH is deposited in the Deposit Contract, it is not commingled and remains distinguishable. Each validator will also have the ability to withdraw its staked ETH once that functionality is implemented in a later network upgrade.

Individual validators also do not have participatory rights to any pro-rata distribution of profits generated by an enterprise. As explained further below, rewards vary for different validators and are determined primarily based on each validator’s individual efforts; their fortunes do not rise and fall together based on the entrepreneurial efforts of any promoter.²⁰ Therefore, in analyzing the economic realities of a staking transaction, a court should find an absence of horizontal commonality.²¹

3aiii. There is no “vertical commonality” among validators

Some courts have held that the common enterprise prong of Howey can also be satisfied through vertical commonality, which focuses "on the relationship between the promoter and the body of investors."²² However, staking ETH does not entail vertical commonality simply because there is no promoter.

In general, the Ethereum network does not rely on any key party for its success or operation; it is “sufficiently decentralized.”²³ To ensure decentralization, Ethereum’s consensus mechanism allows validators to operate self-sufficiently without reliance on any third party. Validators come to the network freely and voluntarily, and they can choose to stop participating at their discretion. Validators can perform their role in the network without depending on anyone else. If they perform their role properly based on the rules of the network, they will receive a reward based on those rules and not on the efforts of a promoter.

Focusing specifically on the economic realities of a staking transaction, it is clear that there is no promoter on which validators rely. Since vertical commonality requires that “the fortunes of investors” are “tied to the fortunes of the promoter[,]”²⁴ the absence of a promoter ends the inquiry.

3b. Staking ETH does not satisfy the “efforts of others” prong of Howey

3bi. Legal Standard

According to the Supreme Court’s original formulation in Howey, one of the requirements for an investment contract is that investors expect profits “solely from the efforts of the promoter or a third party.”²⁵ This standard has been watered down by the appellate courts, which have read out “solely” and focused instead on whether the efforts of promoters are “undeniably significant”²⁶ and “essential managerial efforts which affect the failure or success of the enterprise.”²⁷ According to the SEC’s guidance, these efforts are typically characterized by “expertise and decision-making that impact the success of the business or enterprise through the application of skill and judgment.”²⁸

Inversely, courts have focused on whether the investor had the “ability to control the profitability of his [own] investment.”²⁹ The greater the degree to which an investor relies on their own efforts for their profit, the weaker the justification to characterize the underlying transaction as an investment contract under Howey. In these cases, applying securities laws or disclosure requirements is unnecessary because there is no separation of ownership and control.³⁰ Courts have further outlined several factors (known as the “Schaden factors”) to test an investor’s “ability to control”³¹ (listed in order of importance): (1) the investors’ access to information, (2) the investors’ contractual powers, (3) the investors’ contribution or time and effort, (4) the adequacy of financing, (5) the nature of the business risks, and (6) the level of speculation.

3bii. Application to Proof-of-Stake Ethereum

Some have argued that Ethereum’s transition from proof-of-work to proof-of-stake was also a transition from a competitive to a more “cooperative” mechanism³² since the validation process in proof-of-stake requires multiple parties. According to this view, when staking ETH, each validator is reasonably expecting to derive staking rewards by relying on the efforts of other validators.³³

This argument has been supported by the low-level implementation detail that, under Ethereum’s unique proof-of-stake protocol, validators are sorted into committees.³⁴ However, there are multiple other proof-of-stake protocols that do not segregate validators into committees.³⁵

More significantly, this argument misunderstands the mechanics of validator rewards in Ethereum’s proof-of-stake implementation and dilutes Howey’s original standard requiring reliance “solely on the efforts of others” to an unprecedented degree. As we explain below, Ethereum’s validators cooperate no more than miners in the pre-Merge proof-of-work network and do not expect rewards from significant managerial efforts of other validators, but instead expect rewards primarily from their own efforts and funds. To understand why this is the case, it is helpful to have a base level understanding of the rewards validators can earn in Ethereum’s proof-of-stake network.

3bii1. Validator rewards in Ethereum’s proof-of-stake network

There are many factors that enter into the calculation of rewards for validators. Under Ethereum’s proof-of-stake implementation, validators receive rewards every epoch (6.4 minutes) that are calculated as multiples of a “base reward.”³⁶ The base reward is itself determined by the number of active validators on the network (the “total active stake”) and dynamically adjusted to incentivise a validator set of a desired size.³⁷ The total amount of stake in the network is arguably the most impactful factor dictating rewards earned for validating transactions.³⁸

Validators can earn a multiple of the base reward for attesting (or accurately voting) on (i) the correct source; (ii) the correct target; (iii) the correct head (collectively the “accuracy rewards”) of a block; and (iv) for having their attestation (their vote) included in a block (the “inclusion reward”). The inclusion reward is also split between the attesters and the validators that is chosen at random to produce a block.³⁹

According to researchers, assuming a fixed base reward over time, the profits of a single validator are predominantly determined by the balance of ETH the validator has deposited in the network, which is capped at 32 ETH.⁴⁰ Attesting with a higher balance results in larger rewards and penalties, and vice versa.⁴¹ On a finite timescale, a significant portion of validation rewards will also be determined by the random opportunities a validator receives to propose a block.⁴²

3bii2. Validators expect to earn staking rewards from their own actions, not from the “efforts of others”

Analyzing the economic realities of staking ETH, a court should find that it does not meet the “efforts of others” prong of Howey. Staking rewards are primarily determined by a validator’s individual efforts and not dependent on any managerial efforts of a third party. As explained above, a validator’s rewards are largely determined by the amount of ETH they have staked and the random opportunities they receive to propose a block, both of which are idiosyncratic to the individual staker and do not depend on any third party.

In other words, validators retain the ability to control the profitability of their investment. Applying the Schaden test,”⁴³ a validator’s control is evidenced first by a lack of information asymmetries; rewards are distributed based on open-source protocol and transactions recorded on a public blockchain. The rewards are also determined based on the validator’s contribution of time and effort, as validators must maximize their up-time and remain connected to the network to avoid being slashed.

While a validator is sometimes incentivized to have other validators join the network (e.g., when it would result in an increase to the base reward), and depends on the actions of other validators to maximize rewards (e.g., the requirement for an attestation to be propagated), a validator is never relying on “entrepreneurial” or “managerial” efforts requiring skill and judgment as required by Howey.

4. Conclusion

As shown above, analyzing the economic realities of staking ETH on Ethereum’s proof-of-stake network, a court should find that staking fail to satisfy the Howey test because there is no “common enterprise” and validators are never relying on the “efforts of others”. While not the focus of this paper, there are also questions about whether depositing ETH to stake would qualify as an “investment of money.” And again, failure to meet any of the four Howey prongs would entail that the transaction is not an investment contract and therefore not a securities transaction.

But beyond the legal analysis, applying the stringent requirements mandated by U.S. securities laws to staking would result in an ill-fitted and absurd application of the law. As we have noted, a raison d'être of securities regulation is to ameliorate information asymmetries that exist between promoters and investors through disclosure. Deeming the staking of ETH to be an investment contract would therefore entail imposing disclosure obligations on an “issuer” or “promoter.”

As we stated above, no identifiable issuer or promoter exists when staking ETH. But if we accept the premise that validators play the role of a promoter or issuer, the clear unreasonableness of attending registration, reporting, and disclosure requirements becomes clear. Would securities laws mandate validators to provide each other with disclosure? What material information would validators be required to disclose? How would this help alleviate any information asymmetries, and how would it serve the public interest? The impracticality of answering these questions illustrates the flawed logic of applying securities laws to validators in the first place: they don’t pose the risks that disclosures are meant to address.

Authors

• Rodrigo Seira is Crypto Counsel at Paradigm.
• Amy Aixi Zhang is Policy Counsel at Paradigm.
• Jake Chervinsky is Head of Policy at the Blockchain Association, Advisor at Variant Fund, and Board Member at DeFi Education Fund.

Disclosure

This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Circumstances vary, and one should consult their own advisers and attorneys for advice. Certain information contained herein has been obtained from third-party sources. While taken from sources believed to be reliable, the authors have not independently verified such information and make no representations about the current or enduring accuracy of the information or its appropriateness for a given situation. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services.

Footnotes

1. See, e.g., Paul Kiernan and Vicky Ge Huang, “Ether’s New ‘Staking’ Model Could Draw SEC Attention,” Wall Street Journal (Sept. 15, 2022), available here. ↩

2. Securities Act of 1933 §5(a). ↩

3. Securities Act of 1933 §2(a)(1). ↩

4. SEC vs. W.J. Howey Co., 328 U.S. at 301 (1946) ↩

5. See, e.g., SEC vs. W.J. Howey Co., 328 U.S. at 299 (1946) (defining the term “investment contract” to encompass “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 to use the money of other on the promise of profits”). ↩

6. See, e.g., United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975) (holding that when viewed “in terms of their substance (the economic realities of the transaction)” shares of stock in a housing cooperative were not securities) and International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979) (holding that interests in a noncontributory, compulsory pension plan are not an investment contract and, hence, not a security) ↩

7. See, e.g., Paul Kiernan and Vicky Ge Huang, “Ether’s New ‘Staking’ Model Could Draw SEC Attention,” Wall Street Journal (Sept. 15, 2022), available here. ↩

8. See, e.g., Adam Levitin, Twitter (Jul. 23, 2022), available here. (“Something no one is talking about: after the Merge, there's will be a strong case that Ether will be a security. The token in any proof of stake system is likely to be a security.”) ↩

9. While the SEC has argued that the first prong requiring an “investment of money” is typically satisfied (see Framework for “Investment Contract Analysis of Digital Assets” (modified Apr. 3, 2019), available here), the Supreme Court’s opinion in Howey evinces a narrower interpretation of “investment contract” that should not apply to the staking of ETH. While the Court notes that an “investment contract” is a flexible term that can apply to a variety of contracts, transactions and schemes, its purpose is to capture those “who seek the use of the money of others on the promise of profits.” When staking ETH, no investor is giving capital to any promoter or issuer because no promoter or issuer exists to use the money, or promise any profits. ↩

10. SEC vs. W.J. Howey Co., 328 U.S. 293 (1946). Despite the Supreme Court’s clear language in Howey, the SEC has taken the position that "common enterprise" is not a distinct element of the term "investment contract." ↩

11. See, e.g., Salcer v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 682 F.2d 459 (3rd Cir. 1982); Milnarik v. M.S. Commodities, Inc., 457 F.2d 274 (7th Cir. 1972). ↩

12. See, e.g., Mechigian v. Art Capital Corp., 612 F. Supp. 1421, 1427 (S.D.N.Y. 1985); Dooner v. NMI Limited, 725 F. Supp. 153, 159 (S.D.N.Y. 1989) ↩

13. Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (2d Cir. 1994). See also “‘[H]orizontal commonality requires a sharing or pooling of funds.’” Id. (quoting Hart v. Pulte Homes of Michigan Corp., 735 F.2d 1001, 1004 (6th Cir. 1984)); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016, 1019 (7th Cir. 1994) (A “pooling of profits” is also “essential to horizontal commonality.”) ↩

14. See, e.g., Howey, 328 U.S. at 300 (“The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise.”) ↩

15. See, e.g., Hart v. Pulte Homes of Michigan Corp., 735 F.2d 1001, 1004 (6th Cir. 1984) (noting horizontal commonality requires “the fortunes of individual purchasers [to be] ‘inextricably intertwined’ by contractual or financial arrangements.”); Curran v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 622 F.2d 216, 224 (6th Cir. 1980), aff’d on other grounds, 456 U.S. 353 (1982) (“no horizontal common enterprise can exist unless there...exists between [the investors] themselves some relationship which ties the fortunes of each investor to the success of the overall venture.”) (emphasis added). ↩

16. See, e.g., Hocking v. Dubois, 885 F.2d 1449, 1459 (9th Cir. 1989) (en banc) (horizontal commonality requires investors to “give up any claim to profits or losses attributable to their particular investments in return for a pro rata share of the profits of the enterprise”). ↩

17. Adam Levitin, Twitter (Jul. 23, 2022), available here (“The common enterprise element is also readily met with staking: the whole validation system requires multiple parties. That's the pooling (i.e., the more demanding interpretation of common enterprise--horizontal commonality). 4/”) ↩

18. Adam Levitin, Twitter (Sept. 16, 2022), available here (“(2) Common enterprise: in PoS, the validators have to work cooperatively with other validators. A single node has to work with 127 others in a committee in ETH. That's different than in PoW, where miners are competing, not cooperating. 3/”) ↩

19. See Etherscan, “Contract 0x00000000219ab540356cBB839Cbe05303d7705Fa” (last visited Oct. 5, 2022), available here. See also, Ethereum, “Deposit Contract” (last visited Sept. 25, 2022), available here. ↩

20. See, e.g., Revak, 18 F.3d at 88 (holding that condominium owners using same rental agency had not pooled their funds because “rents and expenses attributable to each unit were not shared” among all owners.) ↩

21. Id. ↩

22. Id. at 81, 87-88. ↩

23. See generally, Marc Boiron, “Sufficient Decentralization: A Playbook for web3 Builders and Lawyers,” available here. ↩

24. Revak, 18 F.3d at 88. ↩

25. 328 U.S. at 298 (emphasis added). ↩

26. Maritan v. Birmingham Props., 875 F.2d 1451, 1457 (10th Cir. 1989) ↩

27. SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973) (emphasis added); see also, SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974). ↩

28. SEC Strategic Hub for Innovation and Financial Technology, “Framework for ‘Investment Contract’ Analysis of Digital Assets,” (April 3, 2019), available here. (emphasis added) ↩

29. See also Steinhardt Group, Inc. v. Citicorp, 126 F.3d 144, 152 (3rd Cir. 1997) (holding that due to limited partner’s “pervasive control over its investment in the limited partnership,” no investment contract is present); see also, Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003) (interests in limited liability company deemed not an investment contract do to investor’s active managerial input). ↩

30. But see, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017) (although DAO token holders had certain voting rights, they nonetheless reasonably relied on the managerial efforts of others); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 n.15 (5th Cir. 1974) ("nominal or limited responsibilities to the [investor] does not negate the existence of an investment contract.") ↩

31. Foxfield v. Robben 967 F.3d 1082 (10th Cir. 2020), articulating the “ability to control” Schaden factors test set forth in Avenue Capital Management II, L.P. v. Schaden, 843 F.3d 876 (10th Cir. 2016). ↩

32. Adam Levitin, Twitter (Jul. 23, 2022), available here. (“The key is the switch from competition to cooperation in PoW to PoS. There's lots of good things about that, but it has a securities regulation impact.”) ↩

33. Adam Levitin, Twitter (Sept. 16, 2022), available here.(“(3) Expectation of profit from the efforts of others: in PoS the validators make or lose money based on successful (timely) validation. That requires the efforts of others in the committee. 4/”) ↩

34. Vitalik Buterin et al, “Combining GHOST and Casper,” (May 20, 2020), available here. (“Committees: the validators are partitioned into committees in each epoch, with one committee per slot. In each slot, one validator from the designated committee proposes a block. Then, all the members of that committee will attest to what they see as the head of the chain (which is hopefully the block just proposed) with the fork-choice rule HLMD GHOST (a slight variation of LMD GHOST).”) ↩

35. Id. ↩

36. Pintail, “Beacon Chain Validator Rewards,” (last seen Sept. 23, 2022), available here. ↩

37. “If there aren’t many validators, the protocol needs to offer a high return, to encourage more validators to join. However if there is already a large number of validators, the protocol can afford to pay less, and save on issuance. The function which does this for the beacon chain is an inverse square root — that is, the level of the reward is divided by the square root of currently validating Ether (the reasoning for choosing an inverse square root relationship is explained in Vitalik Buterin’s design rationale document).” Id. ↩

38. Ethereum Launchpad, “Validator FAQs,” (last visited Oct. 5, 2022), available here. ↩

39. “For every slot (a slot is 12 seconds — there are 32 slots in an epoch), one validator, chosen at random, is responsible for producing a block. The block is made up of beacon chain attestations submitted by the other validators, and the block producer is rewarded with a proportion of all the inclusion rewards from attestations in the block.” Pintail, “Beacon Chain Validator Rewards,” (last seen Sept. 23, 2022), available here. ↩

40. Pintail, “Beacon Chain Validator Rewards.” ↩

41. Ethereum Launchpad, “Validator FAQs.” ↩

42. Pintail, “Beacon Chain Validator Rewards.” ↩

43. Foxfield v. Robben 967 F.3d 1082 (10th Cir. 2020), articulating the “ability to control” Schaden test set forth in Avenue Capital Management II, L.P. v. Schaden, 843 F.3d 876 (10th Cir. 2016). ↩