What is the Howey Test? How Does it Affect Cryptocurrency?

If you are about to invest in a new venture where the concept is attractive and returns are great, the only issue is whether the project could be considered a security. It is essential to determine whether the venture is a security because this defines how the investment is regulated and taxed, as well as the risk you are undertaking. The Howey Test helps you clarify whether it is a security or not. In this article, we’ll talk about the criteria of the test and how it affects cryptocurrency. 

What is the Howey Test?

The Howey Test is a legal standard established by the U.S. Supreme Court to determine whether a transaction qualifies as an investment contract. The test consists of four different criteria that the asset must satisfy to be considered an investment contract. If the asset satisfies all the conditions, it will be treated as securities and will fall under the Securities Act of 1933 and the Securities Exchange Act of 1934. The Howey Test mainly looks at the substance rather than the form of the investment.      

The test originated from the landmark case in 1946, SEC vs W.J. Howey. In this case, the SEC brought the Howey Company to the U.S. District Court, arguing that the sale of citrus grove land combined with service contracts constituted a security offering. However, Howey’s failure to register these transactions as securities violated the Securities Act of 1933. The SEC’s injunction to stop the sale of lands and service contracts was denied as the court ruled in favor of Howey. 

The SEC was persistent in its efforts and later appealed the case to the U.S. Supreme Court, which ruled in favor of the SEC. It determined that the transactions did constitute an investment contract under the Securities Act of 1933, leading to the establishment of the Howey Test. The Supreme Court stated that, 

For purposes of the Securities Act, an investment contract (undefined by the 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 party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

What are Securities?

Securities are financial instruments with monetary value that can be traded or used to raise funds in the financial markets. Various securities, including options, bonds, and stocks, are available in the market. The securities are divided into four types, and they are:

• Equity Securities: These securities refer to ownership in a company or trust. When investors buy these securities in the form of stocks or shares, they own a part of the company. It allows them to benefit from earnings through dividends. If investors accumulate a significant number of shares, they can become board members and participate in crucial decision-making processes.       
• Debt Securities: This allows corporations or governments to borrow money from investors through bonds. The borrowed money must be repaid with interest and have a maturity or renewal date.
• Hybrid Securities: It combines both equity and debt securities, offering the features of both asset classes. They provide fixed or floating interest rates like debt securities and, like convertible bonds, have the potential for appreciation or conversion into stocks.  
• Derivative Securities: These type of securities derive their value from the underlying assets like currency, stocks, or commodities. They include futures and options and can be used for speculative purposes. 

What Are the Criteria for the Howey Test?

The Supreme Court divided the Howey test into four criteria to determine if an asset falls under investment contracts and securities. Only when the asset satisfies all the requirements does it have the qualification to be called an investment contract. If it fails even one of the criteria, the asset doesn’t qualify to fall under the scope of securities.  

Investment of money

It refers to the investment of funds or other assets into a transaction with the idea of earning profits. The transaction typically involves cash and other forms of value like goods or services. The main idea behind this is that the investor is putting something of value at risk with the expectation of earning returns.     

A common enterprise

In this, the investors and the enterprise responsible for managing the asset or transaction are linked together, typically involving pooling funds or resources into a single venture. Here, the investment success is interdependent, meaning the investor’s financial outcome is tied to the enterprise’s success. Furthermore, there are several different versions of what constitutes a common enterprise because the courts have yet to define the term “common enterprise” clearly.  

• Horizontal Approach: In this approach, investors pool their resources into a single investment, which means their returns are tied to the overall success of the investment. 
• Vertical Approach: Here, the investor and promoters’ profits are linked, meaning the promoter shares the venture’s profits or losses with the investor. It aligns the promoter’s interests with the investor’s. 
• Broad Vertical Approach: In this approach, the investor’s profits are entirely dependent on the success of the promotor’s experience. The promotor does not share the profits or losses with the investors, but their returns are closely tied to the promotor’s efforts.  

Expectations about profits

It refers to the investors’ anticipation of profits through dividends, interest, appreciations, or other means when buying an asset. For example, investors may invest in real estate with the hopes that it will rise in value over time.  

Success derived based on the efforts of Others 

It focuses on whether the investment’s success relies on the efforts of the promotors or other individuals rather than the efforts of investors. To qualify under this criteria, the investors’ returns should be based on the actions of the founding team or other parties.    

How Does Howey Test Affect Cryptocurrency?

The Howey Test helps determine whether a cryptocurrency falls within the bounds of securities. If it is, then that cryptocurrency must comply with the rules and regulations of the Securities and Exchange Commission (SEC). 

Let’s take Bitcoin as an example; BTC satisfies the first but not the second and third criteria, meaning Bitcoin doesn’t pass the Howey Test. However, Bitcoin and other cryptocurrencies like Ethereum fall under the Commodity Futures Trading Commission (CFTC) because they are regulated as commodities. 

However, determining whether an initial coin offering (ICO) falls under securities law is entirely different. According to the SEC, the first and second criteria are usually satisfied, and the main issue is with the third and fourth (expectation of profits and if that profit is derived from the effort of others) because it is difficult to prove these tests.        

Conclusion

Howey Test is crucial in determining whether transactions, including those involving cryptocurrencies, qualify as securities. For cryptocurrencies, the implications of being classified as security are significant, as it subjects them to strict regulatory oversight by the SEC. While cryptocurrencies like Bitcoin generally do not meet all the criteria of the Howey Test and are thus regulated as commodities by the CFTC, the same cannot be said for many Initial Coin Offerings (ICOs). As the cryptocurrency landscape evolves, understanding the application of the Howey Test remains crucial for investors, developers, and regulators to navigate the complexities of digital assets and securities law.