The Howey Test Explained

July 27, 2023
10 MIN READ
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The Howey test is an array of criteria that an investment must follow for the SEC to classify it as a security and control it accordingly. This categorization is governed by several rules intended to safeguard investors so that you are not just handing out cash without recognizing the dangers or potential hazards that may occur. Unofficial securities are a type of security that is frequently riskier and not governed by the SEC. These securities are out of reach for the ordinary retail trader. Rather, a shareholder must get the certification before investing in these high-risk, unregistered assets. To be accredited, a trader must have a net worth of $1 million or income of $200,000 per year, or $300,000 when joined with a spouse.

What is the Howey test?

The Howey test alludes to the United States Supreme Court's order to assess whether a transaction is considered an "investment contract." It thus becomes a security based on publication and prerequisites for registration according to the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the Howey Test, an investment contract occurs when money is invested in a joint company with an appropriate expectation of benefit from the initiatives of others.

Any deal, plan, or transaction is subject to the test. It is critical for locating traders and project financiers for Bitcoin and digital currency ventures. Under the criteria, specific cryptocurrencies and initial coin offerings (ICOs) can be determined to fit the concept of an "investment contract."

Securities

Security is an economic tool with a financial value that may be offered or exchanged in financial markets. Bonds, exchange-traded funds (EFTs), stocks,  mutual funds, and options are the most prevalent forms of securities.

Securities are usually classified into four distinct categories:

1.     Equity securities

These include securities that reflect a portion of ownership in a corporation, trust, or partnership (similar to capital stock). As an outcome, owners of equity securities can profit from profits in the form of variable capital gains and dividends if they sell the assets.

2.     Debt securities

Corporations can borrow capital from shareholders and reimburse the loan with interest using debt securities. Bonds and promissory statements are instances of debt securities.

3.     Hybrid securities

These types of securities are precisely what their name implies: a blend of debt and equity instruments. A convertible bond, which may be changed into shares of property for the corporation issuing the bond, is a prime instance of a hybrid security.

4.     Derivative securities

These are financial agreements between at least two parties. The cost of the fundamental asset determines its worth.

The concept of the Howey test

The Howey Test is named after the 1946 Supreme Court case SEC v. W.J. Howey Co. Howey corporation sold citrus grove tracts to customers in Florida, who subsequently leased the land back to Howey. Firm employees would take care of the trees and sell the fruit on the proprietors' behalf. The income was split between the two parties. Most consumers had little agricultural knowledge and were not expected to care for the land themselves.

Howey neglected to record the transactions, prompting the Securities and Exchange Commission (SEC) to step in. The court's ultimate judgment ruled that the leaseback arrangements constituted investment contracts. As a result, the Supreme Court set four standards for determining the existence of an investment contract. An investment pact is defined as:

1.     A financial investment

This criterion implies that the respondents in the deal must be putting their finances at risk. This includes both monetary and in-kind investments.

2.     A shared venture

The Supreme Court never specifically clarified the word "common enterprise." Nevertheless, it is still a vital aspect of this assessment.

There are three broad interpretations of "common enterprise." The first strategy, the horizontal approach, is based on the premise that all investors invest their money into the same venture. The second technique, a vertical approach, is defined as an investment in which the achievement of the shareholders is tied to the performance of the party being invested. The last strategy, recognized as the broad vertical approach, describes a typical business as an investment dependent on the skills of an agent or a third party.

3.     With the prospect of generating gains

This test section examines a shareholder's purpose in purchasing an asset. Are they engaged in a trade to make a profit, or are these individuals, for instance, attempting to store affluence? If it is to make a profit, then that security is checked. If it is to accumulate wealth, it will undoubtedly be labeled as something else. A stablecoin, for instance, would be classified as a currency rather than a financial commitment.

4.     To be obtained via the labor of others

This criterion aims to segregate the shareholder from the third party. If the trader has a considerable say in whether or not an investment succeeds, it is probably not.

In the instance of Howey, the purchasers of the Florida citrus fields valued the deals since others gave the work and knowledge. Customers are merely required to invest money to have exposure to a potential revenue flow. The deal was thus classed as an investment pact under what has since been referred to as the Howey Test and therefore had to be documented with the SEC.

Initial coin offering

To comprehend how the Howey Test relates to crypto, you need to know an essential phrase in the controversy between digital currencies and securities: initial coin offering (ICO).

The most concise description is that an ICO is a sort of crowdsourcing. Companies generate tokens that individuals may buy to raise funds for their cryptocurrency initiatives.

The ICO method is outlined as follows. To begin, a firm prepares a white paper, a document outlining the organization's presentation to possible shareholders, and a website devoted to the new coin. After capturing people's attention, the firm requests financial contributions (typically from a well-known cryptocurrency like Bitcoin) for part of the initiative's crypto tokens.

These tokens can be used for various purposes, such as gaining exposure for subsequent products or services or entitling the financier to a portion of the venture's revenues.

In the United States, ICOs are mostly unregulated, meaning anybody with technical knowledge may establish one. However, the absence of laws makes ICOs exceedingly risky, and traders do not have much protection should an ICO fails or is fraudulent.

Cryptocurrencies and the Howey Test

Bitcoin and other digital currencies are extremely hard to classify. They are autonomous, and as a result, they evade regulation in various ways. However, the SEC has expressed concern about digital assets and has worked to define when their sale qualifies as an investment contract.

According to the SEC, the "investment of money" requirement is resadily fulfilled with the transaction of digital assets since fiat money or other digital assets are exchanged. Similarly, the "common enterprise" condition is readily fulfilled. Most of the time, whether a digital asset qualifies as an investment contract is determined by whether there is an expectation of gain to be generated by the initiatives of others.

For instance, buyers of a digital asset may depend on other people's attempts if they depend on the project's sponsors to set up and uphold the digital network (particularly in the initial phases) rather than a distributed population of independent users. The condition is also fulfilled if the project financiers try to maintain the digital asset's price by generating a shortage through token burning. Another option to meet the " attempts of others" condition is for the project's funders to continue to engage in a management capacity.

These are only a few of the instances provided by the SEC. If a project's success depends on its financiers' continuous engagement, the buyer of the linked digital asset is most likely reliant on the " initiatives of others."

The Howey test's effects on digital currencies: Is it a security or not?

The Howey test has significant value for Bitcoin since it establishes an outline for deciding whether a specific cryptocurrency offering may be classed as a security under US law. If a cryptocurrency offering passes the Howey test requirements, it may be classified as a security and governed by federal securities regulations.

This has significant implications for cryptocurrency firms and shareholders, as violations of federal securities regulations may culminate in charges, legal action, and economic harm to the company. Before developing their offers, cryptocurrency entrepreneurs should carefully evaluate the Howey test to ensure adherence to federal securities laws.

Tokens that do not satisfy the Howey test are classified as utility tokens since they give shareholders accessibility to future goods or services or may be redeemed for lower costs. While utility tokens are not generally regarded as securities, the SEC has stated that including a utility token scheme does not always indicate that a project is not subject to securities regulation.

Stablecoins fail the Howey test as well, though for different explanations. These resources have engaged populations that help to keep the coin stable, which meets the fourth criterion. Nonetheless, they fail to fulfill the third condition because these coins are not predicted to gain value.

Finally, the Howey test's consequences for cryptocurrencies will be determined by how authorities apply it in reality and how cryptocurrency businesses structure their offers to adhere to federal securities regulations.

What cryptocurrency businesses should understand about federal securities regulations

To maintain compliance, cryptocurrency enterprises must be conscious of the federal securities legislation in the United States. Here are some crucial points to remember:

·       Cryptocurrencies are subject to securities laws

The Securities and Exchange Commission (SEC) considers specific cryptocurrencies securities. This indicates that bitcoin enterprises must follow federal securities rules, including registration and disclosure requirements.

·       Securities laws may apply to token offerings

If a cryptocurrency corporation offers tokens to the public in exchange for money or additional securities, it may be considered a securities offering. As an outcome, the company would be required to follow securities regulations, which would entail filing the sale with the SEC.

·       Certain expenditures must be disclosed

A cryptocurrency business must outline its financial objectives when soliciting funds through a securities offering. The company must keep shareholders updated on how the funds are spent.

Securities laws may apply to trading platforms: Cryptocurrency trading networks that allow users to buy and sell tokens may be included in securities exchanges. If so, the platform must submit an SEC registration form and follow other securities requirements.

Securities regulations may apply to trading channels: Cryptocurrency trading systems that allow users to buy and sell tokens may be included in securities exchanges. If so, the system must submit a SEC registration form and follow other securities requirements.

·       Compliance violations can result in harsh penalties: Noncompliance may result in severe penalties. A cryptocurrency business may face serious penalties like fines and sanctions if it breaches federal securities rules.

As a result, cryptocurrency enterprises in the United States must be mindful of and conform to federal securities regulations. This involves determining if their tokens are securities, reporting how funds are used, and adhering to certification and transparency regulations.

The benefits and drawbacks of the Howey test

The benefits

·       Investor safety

·       Clarification of regulations

·       More emphasis on Blockchain and developer-specific viewpoints

·       Legitimization of the space

The drawbacks

·       Uncertainty in execution due to the existence of a myriad of crypto varieties

·       Global differences in the "securities label."

·       Innovation has been hindered.

·       Over-regulation danger

Alternative methods

1.    The "Gary plastic" examination

This evaluation, which corresponds to the SEC vs. Gary Plastic Packaging case, determines whether a non-security can be regarded as a security at any moment. Furthermore, the criteria for action involved include marketing and promotions, the presence of familiar trade places, and trader expectations.

2.     The capital risk assessment

This examination form is commonly employed in US courts to establish if an investment is a security. The indicators utilized here comprise the risk quotient connected with the investment, shareholder control over the firm, and capital risks presented by others' efforts.

Conclusion

The Howey test decides what constitutes an "investment contract" and hence depends on US securities regulations. If there is an investment of cash in a usual business with an achievable goal of gains to be generated by the endeavors of others, an investment contract develops. The Howey test is critical for locating entrepreneurs and financiers for blockchain and digital currency ventures. Various cryptocurrencies and initial coin offerings (ICOs) could be deemed to fit the Howey Test's description of an investment contract.