What Is the Howey Test?
The Howey Test is four criteria an asset must meet to qualify as an "investment contract." If the asset is an "investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others" it is considered a security. It is then subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.
The test applies to any contract, scheme, or transaction. The Howey Test is important for evaluating blockchain and digital currency projects when developers are fundraising. Certain cryptocurrencies and initial coin offerings (ICOs) may be found to meet the definition of an "investment contract" under the test.
Key Takeaways
- The Howey Test determines what qualifies as an "investment contract," subjecting the asset to U.S. securities laws.
- An investment contract exists if there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."
- The Howey Test is important for blockchain and digital currency projects conducting fundraising efforts with investors and project backers.
- Certain cryptocurrencies and initial coin offerings (ICOs) may be found to meet the definition of an "investment contract" under the Howey Test.
Understanding the Howey Test
The Howey Test is based on a ruling from SEC v. W.J. Howey Co., which reached the Supreme Court in 1946. Howey Company sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey. Company staff would tend to the groves and sell the fruit on behalf of the owners. Both parties shared in the revenue. Most buyers had no experience in agriculture and were not required to tend to the land themselves.
Howey had failed to register the transactions, and the U.S. Securities and Exchange Commission (SEC) intervened. The court's final ruling determined the leaseback arrangements qualified as investment contracts.
The opinion of the Supreme Court stated that "...an investment contract, for the purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third part..." This statement created the four criteria now used as the Howey Test:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
In the case of Howey, the buyers of the Florida citrus groves saw the transactions as valuable primarily because the labor and expertise were provided by others. Buyers only needed to invest capital to access an income stream.
Howey Test and Cryptocurrencies
Digital currencies such as Bitcoin are notoriously difficult to categorize. They are decentralized and, as such, elude regulation in many ways. Nonetheless, the SEC has taken an interest in digital assets and has sought to clarify when their sale meets the definition of an investment contract.
According to the SEC, the "investment of money" test is easily satisfied with the sale of digital assets because fiat money or other digital assets are exchanged with the expectation of profits or gains. Likewise, the "common enterprise" test is also easily met. The commission has repeatedly used the test to pursue legal action against cryptocurrency developers.
Examples of Howey Test on Cryptocurrencies
In July 2023, the Southern District of New York court released a summary judgment regarding the case SEC v Ripple, a blockchain developer with a popular cryptocurrency, XRP. The SEC had filed an action against Ripple in 2020 for an unlawful offer and sale of securities, while Ripple denied the accusations. Both parties petitioned for summary judgments regarding sales to institutional and retail investors.
The court ruled that Ripple and its coin, XRP, did not pass the Howey Test when the cryptocurrency was sold in a secondary sale, such as through an exchange. At the same time, it found that the sale did pass the Howey Test when XRP was offered to or purchased by institutional investors.
The court ruling remains controversial because the crypto industry declared victory while the SEC continued its efforts to regulate cryptocurrency using the Howey Test.
On July 13, 2023, the SEC filed a complaint against Celsius Network Limited for issuing unregistered securities and selling crypto asset securities. It then filed a complaint against Digital World Exchange, BoostedPro, and D.W. Exchange on July 21, 2023, for promoting, offering, and selling exchange tokens and crypto asset securities. It is possible the entities committed these acts, but the SEC clearly hasn't backed down from applying the test to cryptocurrencies.
How Do You Determine If Something Is a Security?
The U.S. Supreme Court uses the Howey Test to determine whether certain transactions qualify as "investment contracts." If transactions qualify as "investment contracts" under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities.
Why Is Bitcoin Not a Security?
In June 2018, the former Chair of the SEC, Jay Clayton, clarified that Bitcoin is not a security: "Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with Bitcoin. That type of currency is not a security," said Clayton.
Bitcoin, which has never sought public funds to develop its technology, doesnot passtheHowey Testused by the SEC to classify securities; however, by Clayton's definition, tokens used in an ICO are securities.
How Does the SEC Define a Security?
Securities are fungible and tradable financial instruments used to raise capital in public and private markets. The public sales of securities are regulated by the SEC.
The definition of a security offering was established by the Supreme Court in a 1946 case called SEC v. W.J. Howey Co.
The Bottom Line
The Howey Test sets out the criteria for what counts as an investment contract, which then determines the laws and regulations that the contract needs to abide by as set out by the SEC. As cryptocurrencies have been an important asset in the last few years, regulators have sought ways to regulate them, often utilizing the Howey Test to make determinations.
