The Howey test derives its name from a landmark U.S. Supreme Court case in 1946, SEC v. W.J. Howey Co., that established a blueprint for whether a transaction qualifies as an investment contract. If a trade meets the test, it is a security and falls under the same laws and regulations as stocks. Deals that meet the Howey test are thus subject to disclosure requirements, registration, and other investor protections.
Key Takeaways
- The Howey test is a legal framework provided by the U.S. Supreme Court to determine whether a transaction qualifies as an investment contract and is thus subject to securities regulation.
- The Howey test consists of four criteria: an investment of money, expectation of profits, common enterprise, and reliance on the efforts of others.
- Applying the Howey test to cryptocurrencies is a topic of debate, with arguments both for and against crypto passing the test.
- Because the crypto space is so broad and dynamic, applying the Howey test to crypto assets will likely be conducted on a case-by-case basis.
Whether a specific cryptocurrency or crypto-related investment qualifies under the “Howey test” depends on how it’s sold and what investors expect to gain from it. While some cryptocurrencies may not meet all the criteria, some initial coin offerings (ICOs) and tokens have been found to satisfy the Howey test, making them subject to U.S. securities laws.
By establishing this test, the Supreme Court clarified how to identify securities, capturing a wide range of investments within financial regulation to protect investors. The Howey test has since become a critical component of securities law, used by the Securities and Exchange Commission (SEC) and courts to figure out whether novel assets or financial products should be regulated and treated as securities.
However, the Howey test was conceived during a different era, long before the advent of blockchain technology and the crypto assets it has birthed. Its criteria, discussed below, have for decades drawn the boundaries between securities and other types of assets. Yet, cryptocurrencies present a new, complex scenario that could mean rethinking the Howey framework.
The decentralized, borderless, and often pseudonymous nature of cryptocurrencies and other crypto assets challenge traditional legal classifications, leading to a compelling question: do cryptocurrencies and other crypto-assets pass the Howey test? Alternatively, do they require a change in legal analysis?
These questions are not merely academic. The answers to them have significant implications for both the burgeoning crypto industry and regulatory bodies striving to adapt to the fast-evolving digital asset landscape. The questions also touch on how adaptable existing legal frameworks can be for crypto and other novel and rapidly evolving financial innovations.
An Overview of the Howey Test
The Howey test provided by the Supreme Court has four criteria for determining whether a trade constitutes an investment contract and security. Satisfying each strongly indicates that the product involved is a security, while failure to meet one or more criteria suggests the product or transaction likely falls outside the scope of securities law. Here are the criteria the Court laid out:
- Money is invested: There must be monetary investment involved in the transaction, or at least some consideration passes from one party to another.
- Meets the criterion: Purchasing corporate bonds with funds from your brokerage account.
- Does not meet the criterion: Earning shares in a startup by contributing only time and expertise without putting any money into the business.
- There is an expectation of profits: The investor anticipates financial gains from the investment, typically through the enterprise’s success.
- Meets the criterion: Investing in a real estate venture with the expectation that the property will appreciate in value.
- Does not meet the criterion: Buying a home for personal use as a primary residence without planning to sell it for a profit.
- There is a common enterprise: The investors and the enterprise behind the transaction, asset, or product are bound by a financial relationship, and the fortunes of the investors are tied to the enterprise’s success.
- Meets the criterion: Pooling funds with other investors in a mutual fund managed by a fund manager.
- Does not meet the criterion: A stand-alone contract in which the financial return does not depend on the efforts or success of a wider enterprise, e.g., a lease agreement between a landlord and tenant.
- Success relies on the efforts of others: The success of the investment depends predominantly on the efforts of individuals other than the investor.
- Meets the criterion: Investing in a startup where the financial return depends on the managerial expertise and efforts of the founding team.
- Does not meet the criterion: Buying a piece of art where any potential appreciation in value is not tied to the efforts of others.
Interpreting the Howey Test Criteria
Since the original case, courts have had different interpretations and ways of applying the Howey test, leading to variations in how the criteria are read and applied. Here are some examples:
- What is a common enterprise?: Most courts have applied a “horizontal commonality” view, where a common enterprise exists if investors pool funds in an investment and the profits of each investor correlate with those of the other investors. Other courts have defined a common enterprise in terms of “vertical commonality,” which focuses on the relationship between the efforts of the one promoting the investment opportunity and the investor’s expectation of a return. Essentially, this form of commonality looks at the link between the profits of the promoter profits and those of the investor.
- How strong should the expectation be for profits?: What constitutes an “expectation of profits” has been a point of contention. Some courts require a promise of dividends or increased value, while others might consider other forms of return or even the avoidance of loss.
- How much effort is to be involved from the other party?: The court’s discussion of the profits coming from the efforts of others has also been a point of contention. Most courts have focused on the promoter of the opportunity providing managerial control, while others have asked how essential the promoter’s efforts have been to realizing the returns.
Thus, while the Howey test remains crucial in discerning the line between securities and non-investments, its application has varied based on jurisdiction, the specifics of the case, and changes in the types of financial products being offered.
Examples of What Has and Hasn’t Passed the Howey Test
The original Howey test case involved an arrangement where individuals bought plots of an orange grove and then leased them back to a service company for care and harvesting. The Supreme Court ruled that this arrangement constituted an investment contract, thus passing the Howey test. Here are other examples of assets or transactions that meet the criteria:
- Shares of common stock: Traditional shares of common stock in a company pass the Howey test as they represent an investment in a common enterprise with expectations of profit predominantly from the efforts of others.
- Real estate limited partnerships: Real estate limited partnerships often pass the Howey test since they involve an investment of money, a common enterprise, and an expectation of profits produced by the efforts of others, such as the managing partner.
- Multilevel marketing schemes: In certain multilevel marketing schemes, participants earn money primarily by recruiting others to purchase products or services. The Supreme Court has applied the Howey test and deemed that these schemes constitute an investment contract and hence are a security since individuals were investing money with the expectation of profits, mostly from the recruitment efforts of others.
At the same time, courts have ruled other types of financial products or transactions do not meet the criteria:
- Condominium units: Courts have found that the sale of condominium units, where buyers intend to occupy the unit or have control over its operation, do not pass the Howey test since they don’t entail an expectation of profits from the efforts of others.
- Whiskey warehouse receipts: Historically, whiskey warehouse receipts were used as a form of collateral and were even traded, but their status as securities had been a matter of legal debate. The Supreme Court found that these did not pass the Howey test as there wasn’t a common enterprise, and the profits were not to be derived solely from the efforts of others.
- Merchandise accounts: In cases where individuals bought merchandise accounts that allowed them to buy goods at a discount, courts have found that these arrangements did not pass the Howey test as they lacked the expectation of profits from the effort of others.
Each of these cases illustrates the application of the Howey test in different contexts and how the courts have interpreted the criteria of the test in determining whether a particular arrangement qualifies as a security.
Different Interpretations of the Howey Test for Cryptocurrencies
The applicability of the Howey test to cryptocurrencies has sparked extensive legal analysis and debate. While Bitcoin and some other decentralized cryptocurrencies might fail to meet the “common enterprise” and “reliance on the efforts of others” criteria, the case becomes less clear for crypto assets with more centralized administration. Stablecoins, for instance, arguably depend on the ongoing efforts of their issuing organization to maintain their pegged value. Similarly, the profits for some non-fungible tokens (NFTs) and smart contracts could be seen as relying on the work of the developers or promoters.
Given the diversity of crypto assets, more decentralized cryptocurrencies may avoid classification as securities, while more centralized and profit-driven digital assets are more likely to meet the Howey criteria. Legal experts continue working to guide regulators on how to apply existing securities law to these novel and varied digital financial instruments.
Let’s see how the four criteria of the Howey test might apply in several examples:
Bitcoin
- Investment of money: Individuals purchase Bitcoin with fiat currency or exchange it with other cryptocurrencies.
- Expectation of profits: Many investors buy Bitcoin while anticipating that its value will increase over time.
- Common enterprise: Bitcoin operates on a decentralized network and thus might not be a common enterprise. Each investor’s gain or loss is independent of the others.
- Reliance on the efforts of others: The value of Bitcoin is market-driven and not controlled by a central authority or group.
Bitcoin may not pass the Howey test since it seems to lack a common enterprise and doesn’t rely on the efforts of others.
USD Tether
- Investment of money: Individuals can purchase USD Tether (USDT) with fiat currency or other cryptocurrencies.
- Expectation of profits: USDT is a stablecoin pegged to the U.S. dollar, so there’s no expectation of profit as its value remains stable.
- Common enterprise: The backing and stability of USDT could be seen as a common enterprise with the issuing organization, Tether Ltd.
- Reliance on the efforts of others: The stability of USDT is maintained by Tether Ltd., which can be seen as reliance on the efforts of others.
There might be a stronger case that USDT passes the Howey test due to the reliance on the issuing organization to maintain its value in line with the U.S. dollar.
Non-Fungible Tokens
- Investment of money: Individuals purchase non-fungible tokens (NFTs) with cryptocurrency.
- Expectation of profits: Many buyers purchase NFTs while hoping to resell them at a higher price.
- Common enterprise: NFT transactions are typically independent and not tied to a common enterprise, although some NFTs are created, marketed, and sold through syndicates.
- Reliance on the efforts of others: The value of NFTs is market-driven but can also be influenced by the creator’s efforts in promoting their work.
Certain NFTs might pass the Howey test if derived from a common enterprise.
Smart Contracts
- Investment of money: Individuals interact with smart contracts by sending cryptocurrency to them.
- Expectation of profits: Some smart contracts, like those used on decentralized finance platforms, are taken up with the goal of generating returns for users.
- Common Enterprise: Smart contracts operate on decentralized networks, and there might not be a clear common enterprise.
- Reliance on the efforts of others: While smart contracts execute code automatically, their creation and maintenance on a shared platform often rely on developers.
Smart contracts might pass the Howey test, especially in cases where there is a clear expectation of profit and reliance on the efforts of developers.
These examples are hypothetical simplifications for illustrative purposes only, and the actual classification can be much more nuanced, requiring legal expertise and regulatory guidance.
Recent Developments and Regulatory Actions
The SEC and the Commodity Futures Trading Commission (CFTC) have been at the forefront of the regulatory discussions surrounding cryptocurrencies and the application of the Howey test. The CFTC initiated cases as early as 2015, asserting that virtual currencies should be defined as commodities. Meanwhile, the SEC, under Chairman Gary Gensler, has leaned toward classifying many crypto assets as unregistered securities based on the Howey test, especially when people acquire them with the expectation of profits from the issuer’s efforts to boost the asset’s value by managing, promoting, or improving it.
For instance, in a recent case, the SEC appealed a decision involving Ripple Labs, indicating a continued effort to apply the securities framework to certain crypto assets. The SEC has also used the Howey test to define tokens as securities and determine whether a digital asset is an investment contract.
While regulatory bodies and lawmakers continue to debate whether crypto assets are securities or otherwise, there remains a lack of a definitive legal framework encompassing the multifaceted nature of these digital assets. The application of the Howey test to cryptocurrencies is a topic of ongoing discourse, with various stakeholders presenting differing interpretations and viewpoints.
The Independent Community Bankers of America has recently argued that most crypto assets likely qualify under the Howey test as securities and should be subject to the relevant securities laws and regulations. This indicates a broad acknowledgment within the financial community that the Howey test does apply to at least some cryptocurrencies.
These developments are part of a dynamic regulatory environment in which there are ongoing efforts by federal agencies to define and regulate crypto assets. Nevertheless, as yet, there isn’t consensus on the issue. For example, the SEC is inclined to apply the Howey test to determine that crypto assets count as securities status of crypto assets, which differs from the CFTC’s stance.
Would an Initial Coin Offering (ICO) Pass the Howey Test?
An initial coin offering (ICO) seems likely to pass the Howey test and be considered an offer of securities. An ICO involves investors exchanging fiat currencies or cryptocurrencies for the tokens being offered. This constitutes an investment of money. The promoters of an ICO tout the potential for profit through the increase in value of the tokens over time. Investors clearly expect to profit. Moreover, the investors pool funds in the ICO, which are used to develop the project. This creates a common enterprise between token buyers and the core team or issuing syndicate. Finally, investors depend on the managerial and technical efforts of the project team to execute the project plan and boost the token value.
Since an ICO satisfies all four prongs of the Howey test, it would likely be considered a security offering under U.S. securities law.
What Implications Does The Howey Test Have For Crypto Exchanges?
Applying the Howey test can significantly impact crypto exchanges by determining which tokens are deemed securities. Exchanges would need to follow existing securities laws when listing such tokens, requiring them to register as securities exchanges or ensure they have exemptions.
Are There Alternatives to the Howey Test for Evaluating Cryptocurrencies?
Yes, there have been proposals for alternative frameworks to evaluate cryptocurrencies. For instance, some stakeholders advocate having a more nuanced or updated framework that considers the unique attributes of blockchain technology and digital assets, which they say would provide a more accurate classification.
The Bottom Line
The Howey test, established in 1946, has long been a key means for classifying securities. However, the rise of cryptocurrencies, brought about by blockchain technology, challenges this traditional framework. Cryptocurrencies like Bitcoin, which are decentralized, are a complex case for regulatory bodies. The crypto realm, with its blend of clear-cut and borderline cases, tests the adaptability of the Howey test. Recent cases and ongoing regulatory deliberations highlight the effort to align existing legal frameworks with the evolving landscape of digital assets. These broader discussions reflect not just a legal or regulatory debate but a broader examination of how traditional legal frameworks can adapt to rapid technological advances.
