DEFINITION of 'Howey Test'

The Securities Act of 1933 and the Securities Exchange Act of 1934 dictate much of the U.S. government's approach to financial regulation, even nearly 100 years after they were established. Under these acts, transactions which qualify as "investment contracts" are considered securities, meaning that they are also subject to specific requirements related to disclosure and registration.

Predictably, this has a significant impact on how the financial world views and interacts with those securities, so it is necessary to have a consistent and thorough way of determining whether a transaction is, in fact, an example of an "investment contract." The Howey Test is the standard methodology, put in place by the U.S. Supreme Court, to make that determination.

BREAKING DOWN 'Howey Test'

Put simply, the Howey Test asks whether the value of a transaction for one of its participants is dependent upon the other's work. Specifically, the Howey Test determines that a transaction represents an investment contract if "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," 

The Howey Test refers to a 1946 case which reached the Supreme Court, SEC v. W.J. Howey Co., a lawsuit involving the Howey Company of Florida. This company was a citrus farm which operated on a large swath of land in the southern portion of the state.

When the company decided to lease out half of its large property in order to "finance an additional development," the question of whether or not the land itself could be seen as a security came into play. Purchasers of the Howey land, who themselves had none of the "knowledge, skill, and equipment necessary for the care and cultivation of citrus trees," were speculators. They purchased the land based on the assumption that it would generate a profit for them as a result of the efforts of someone else.

Howey Co. ran afoul of the law when it failed to register the transactions. The U.S. Securities and Exchange Commission (SEC) responded with an injunction to block the sale of the land, and the case was eventually appealed, finally arriving in the U.S Supreme Court.

The opinion of the Court in the Howey case indicated that "the transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land...they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise."

In the case of Howey Co., the investors in the Florida land saw the transaction as valuable only because of the work that others would perform on the land. By the standards of the Howey Test, this classifies the transaction as an investment contract. Thus, the transaction needed to be registered, and the Howey Co. was found to have violated the law by failing to do that.

Howey Test Being Applied to Crypto Market

The Howey Test has remained a notable determiner of regulatory oversight for many decades. In the past few years, it has been called into question, most frequently in conjunction with discussions about cryptocurrencies and blockchain technology.

As investor activity in the cryptocurrency space has grown, the SEC has become increasingly interested in defining cryptocurrencies. (See also: Issuing an ICO? Don't Skip This Step, Says the SEC.)

Digital currencies like bitcoin are notoriously difficult to categorize in this way; they are decentralized and designed to evade regulation in many ways. Nonetheless, investors who have moved quickly to buy up the latest digital currency in the hopes of turning a profit are undoubtedly engaging in behavior that could be characterized as speculation.

From the perspective of the Howey Test, the operative question in this case is whether or not cryptocurrency investors are participating in a speculative enterprise, and if so, if the profits those investors are hoping for are entirely dependent upon the work of a third party.

If the SEC determines that a particular cryptocurrency token is classified as a security, that brings about a host of implications for that cryptocurrency. Effectively, it means the SEC can determine whether or not the token can be sold to U.S. investors legally or not; it also compels U.S. investors to register their token holdings with the SEC.

There are parallels between the cryptocurrency world and the original Howey Co. situation, but there are also many differences. Critically, cryptocurrencies are autonomous and distributed networks that are designed to be decentralized. Classifying a cryptocurrency as a security likely goes sharply against the goals of the creators of that digital currency.

However, considering how significant the cryptocurrency space has become, the SEC has a growing interest in monitoring and overseeing cryptocurrency transactions in a way that it sees as appropriate. Regardless of the ultimate regulatory decision, it is sure to have a significant impact on the virtual currency world and investors in that space.

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