What Is the Howey Test?

What Is the Howey Test?

Let me tell you about the Howey Test—it evaluates whether transactions qualify as 'investment contracts' under U.S. securities laws, with a focus on expecting profits from the efforts of others. You need to know this is crucial for blockchain and cryptocurrency projects, as it impacts how these digital assets get classified and regulated.

Key Takeaways

The Howey Test relies on four criteria to decide if an asset is an 'investment contract' under U.S. securities laws. For an asset to pass the test, it must involve an investment of money in a common enterprise, with an expectation of profit coming from the efforts of others. You should understand that this test is essential for assessing the regulatory status of cryptocurrencies and digital currency projects. Cryptocurrencies often come under review because they can meet these criteria, making them subject to SEC regulations. The SEC has applied the Howey Test to regulate and sometimes prosecute certain cryptocurrency transactions and offerings.

Understanding the Howey Test

The Howey Test comes from a ruling in SEC v. W.J. Howey Co., which went to the Supreme Court in 1946. In that case, Howey Company sold tracts of citrus groves to buyers in Florida, who then leased the land back to Howey. The company's staff handled the groves and sold the fruit for the owners, and both sides shared the revenue. Most buyers lacked experience in agriculture and didn't have to tend the land themselves.

Howey didn't register these transactions, so the SEC stepped in. The court decided that these leaseback deals were investment contracts.

The Supreme Court defined an investment contract as a deal where someone invests money in a common venture, expecting profits mainly from someone else's efforts. This led to the four criteria of the Howey Test: an investment of money, in a common enterprise, with the expectation of profit, to be derived from the efforts of others.

Fast Fact

In the Howey case, the buyers of the Florida citrus groves valued the transactions mainly because the labor and expertise came from others. All they had to do was invest capital to get an income stream.

Applying the Howey Test to Cryptocurrencies

Digital currencies like Bitcoin are hard to categorize—they're decentralized and often slip past regulation. Still, the SEC has shown interest in digital assets and works to clarify when their sale fits the definition of an investment contract.

According to the SEC, the 'investment of money' part is easily met when selling digital assets, since fiat money or other digital assets are exchanged with hopes of profits or gains. The 'common enterprise' test is also straightforward to satisfy. The commission has used this test repeatedly to take legal action against cryptocurrency developers.

Case Studies: Howey Test in Action with Cryptocurrencies

In July 2023, the Southern District of New York court issued a summary judgment in SEC v. Ripple, involving the blockchain developer and its cryptocurrency XRP. The SEC sued Ripple in 2020 for unlawfully offering and selling securities, but Ripple denied it. Both sides sought summary judgments on sales to institutional and retail investors.

The court ruled that Ripple and XRP didn't pass the Howey Test for secondary sales, like through exchanges. However, it did pass when XRP was sold to or bought by institutional investors.

This ruling stirred controversy—the crypto industry saw it as a win, but the SEC continued using the Howey Test for regulation.

On July 13, 2023, the SEC filed a complaint against Celsius Network Limited for issuing unregistered securities and selling crypto asset securities. Then, on July 21, 2023, it filed against Digital World Exchange, BoostedPro, and D.W. Exchange for promoting, offering, and selling exchange tokens and crypto asset securities. These entities might have done this, but it's clear the SEC isn't backing off from applying the test to cryptocurrencies.

How Do You Determine If Something Is a Security?

The U.S. Supreme Court uses the Howey Test to see if certain transactions qualify as 'investment contracts.' If they do under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities.

Why Is Bitcoin Not a Security?

In June 2018, former SEC Chair Jay Clayton stated 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,' he said.

Bitcoin never sought public funds for its technology development, so it doesn't pass the Howey Test that the SEC uses for securities. But by Clayton's view, tokens in an ICO are securities.

How Does the SEC Define a Security?

Securities are fungible and tradable financial instruments for raising capital in public and private markets. The SEC regulates public sales of securities.

The definition came from the Supreme Court in the 1946 case SEC v. W.J. Howey Co.

The Bottom Line

The Howey Test gives a clear framework for spotting investment contracts, which then fall under U.S. securities regulations. This is especially relevant now as regulators turn their attention to cryptocurrencies, using the test to check if digital assets like ICOs count as securities. Recent cases, such as the SEC's actions against Ripple and Celsius Network, highlight the continued push to apply this test to digital currencies. If you're a blockchain developer or investor, you must understand the Howey Test to handle the complex regulatory environment.