What Is the Howey Test?
The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an "investment contract," and therefore would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. Under the Howey Test, 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 test applies to any contract, scheme, or transaction. The Howey Test is important for situating blockchain and digital currency projects 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 test.
- The Howey Test determines what qualifies as an "investment contract" and would therefore be subject 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 situating blockchain and digital currency projects 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 refers to 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.
In doing so, the Supreme Court established four criteria to determine whether an investment contract exists. An investment contract is:
- 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. This classified the transaction as an investment contract under what is now known as the Howey Test, and therefore it needed to be registered with the SEC.
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 digitals assets are being exchanged. Likewise, the "common enterprise" test is also easily met.
In most cases, whether a digital asset qualifies as an investment contract largely turns on whether there is an "expectation of profit to be derived from the efforts of others."
For example, the purchasers of a digital asset may be relying on the efforts of others if they depend on the project's backers to develop and maintain the digital network (especially in the early stages), rather than these tasks being performed by a dispersed community of unaffiliated users. The test is also met if the project's backers take steps to support the price of the digital asset, such as by creating scarcity through token burning. Another way the "efforts of others" test is met is if the project's backers continue to act in a managerial role.
These are but a handful of examples outlined by the SEC. If the success of a project depends on the ongoing participation of its backers, the purchaser of the associated digital asset is likely relying on the "efforts of others."
The amount raised via ICOs in Q1 of 2018. In Q1 of 2019, this amount was $118 million, 58 times less than during the same period in 2018.
A host of implications are raised if the SEC determines a cryptocurrency token is a security. Effectively, it means the SEC can determine whether or not a token can be sold to U.S. investors and compels the project to register with the SEC.
A significant application of the Howey Test came in 2017 when the SEC ruled that the sale of DAO tokens in exchange for Ether violated federal securities law. Instead of taking enforcement action, the SEC warned that securities laws applied to token sales—effectively firing a warning shot at the cryptocurrency industry.
Because of the Howey Test, most ICOs that take place today are likely to be off-limits to U.S investors. In 2018, then-SEC Chair Jay Clayton said every ICO he'd seen could be classified as a security.
Howey Test FAQs
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.
The Howey Test attempts to determine 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." If so, the transaction is subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.
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, does not pass the Howey Test used 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. In its judgment, the court derives the definition of a security based on four criteria:
- The existence of an investment contract
- The formation of a common enterprise
- A promise of profits by the issuer
- The use of a third party to promote the offering