What Is the Howey Test?
The Howey Test determines whether something is an "investment contract" and thus falls under the jurisdiction of U.S. securities laws. An investment contract exists when money is invested in a joint project with the expectation of earning profits from the efforts of others. The Howey Test is crucial in helping investors, and project supporters understand the implications of blockchain and digital currency projects. According to the Howey Test, specific cryptocurrencies and initial coin offerings (ICOs) could be considered an "investment contract."
The Howey Test is a significant part of securities regulation, established by a prominent U.S. Supreme Court case. This test serves as a litmus test for discerning whether a transaction qualifies as an "investment contract," consequently subjecting it to the disclosure and registration requirements outlined in the Securities Act of 1933 and the Securities Exchange Act of 1934. Its application extends to various contracts, schemes, and transactions, holding substantial importance in assessing blockchain and digital currency ventures involving investors and project supporters. It is worth noting that certain cryptocurrencies and initial coin offerings might meet the criteria of an "investment contract" as defined by the Howey Test.
What Is the Howey Test?
In a significant legal case that reached the Supreme Court in 1946, SEC v. W.J. Howey Co., the concept of the Howey Test was introduced. The Howey Company, based in Florida, engaged in the sale of citrus grove tracts to buyers, who would subsequently lease the land back to Howey. The company's staff would then handle the groves and sell the fruit, with both parties sharing in the generated revenue. Notably, the buyers, largely lacking agricultural experience, were not required to tend to the land.
However, the Howey Company neglected to register these transactions, leading to intervention by the U.S. Securities and Exchange Commission (SEC). Ultimately, the Supreme Court ruled that the leaseback arrangements constituted investment contracts. This pivotal ruling set forth four criteria to ascertain the existence of an investment contract, which are as follows:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
Applying these criteria to the Howey case, the buyers of the Florida citrus groves perceived the transactions as valuable primarily due to the labor and expertise provided by others. Their role was solely to invest capital to access an income stream. This classification deemed the transaction an investment contract, as per the now-famous Howey Test, thereby necessitating registration with the SEC.
Categorizing Digital Assets: The Howey Test and Cryptocurrencies
Determining the regulatory status of digital currencies can be a challenging task. With their decentralized nature, they often elude conventional regulations. Nevertheless, the Securities and Exchange Commission has shown interest in digital assets and aims to clarify when their sale falls under the definition of an investment contract.
The SEC highlights that the "investment of money" test is readily fulfilled in the sale of digital assets, as they involve the exchange of fiat money or other digital assets. Similarly, meeting the "common enterprise" test is also straightforward.
However, the crucial factor in determining whether a digital asset qualifies as an investment contract lies in an "expectation of profit to be derived from the efforts of others." If buyers depend on the project's supporters to build and sustain the digital network, especially in its initial phases, instead of a dispersed user base, then the requirement is fulfilled. The test can be satisfied if the supporters of the project take action to boost the value of the digital asset, for example, by implementing token burning to create scarcity. Additionally, if the project's backers retain a managerial role, the "efforts of others," test is satisfied.
These examples represent a subset of scenarios outlined by the SEC. If a project's success relies on continuous participation from its backers, purchasers of the associated digital asset are likely dependent on the "efforts of others."
Furthermore, it is noteworthy that the initial coin offering (ICO) market saw a substantial decline. In Q1 of 2018, ICOs raised a staggering $6.9 billion. However, in Q1 of 2019, the amount plummeted to $118 million, marking a significant 58-fold decrease from the previous year's figure.
Is Bitcoin a Security?
In June 2018, the former SEC Chair, Jay Clayton, provided a clear stance, stating that Bitcoin should not be classified as a security. He emphasized that cryptocurrencies, specifically those aiming to replace sovereign currencies like the dollar, euro, or yen with bitcoin, do not fall under the security category.
As Bitcoin has never sought public funding for its technological development, it does not meet the SEC's Howey Test for securities classification. Nevertheless, according to Clayton's definition, tokens utilized in initial coin offerings are considered securities.
The Howey Test determines if a transaction qualifies as an "investment contract" under U.S. securities laws. It consists of four criteria: investment of money, common enterprise, expectation of profit, and profits derived from the efforts of others. The test helps investors and project supporters understand blockchain and digital currency projects. Certain cryptocurrencies and ICOs may meet the test's definition of an "investment contract." Bitcoin is not classified as a security, while ICO tokens generally are. The Howey Test provides crucial guidance for navigating securities regulations and digital assets.