What is the Howey test and how does it relate to cryptocurrencies?

Main

• Regulators have been using the Howey test for decades to determine whether an asset is classified as a security.
• Many members of the crypto community are convinced that this scheme cannot be applied to blockchain assets.
• current head SEC Gary Gensler classifies cryptocurrencies as securities.

What is the Howie test?

The Howey Test is a list of criteria to help determine whether an asset has the characteristics of a security and is an “investment contract”.

The tool can also be applied to projects, commercial transactions and other transactions.

According to the Howey test, an investment contract exists if there is “an investment of money in a common enterprise with a reasonable expectation of a return to be made from the efforts of others.”

The SEC is convinced that some crypto assets and most ICO may qualify as investment contracts.

Where did the Howie test come from?

The Howie test was developed and first used in practice in 1946. The reason for its creation was the SEC proceedings with WJ Howey Co. and Howey-in-the-Hills Service from Florida.

The companies sold citrus plantation plots to the public. Investors have agreed with representatives of firms on the lease of plots. As a result, WJ Howey Co. there was an opportunity to grow and harvest on foreign lands, engage in marketing and share profits from sales with stakeholders. At the same time, most buyers did not have experience in agriculture and did not plan to master this activity.

The U.S. Supreme Court concluded that the lots sold were, in fact, an offer of unregistered securities. In accordance with the law, the transactions had signs of an investment contract – the participants only needed to invest in order to receive a source of passive income.

Based on the case SEC vs WJ Howey Co. four criteria appeared, which became the main components of the Howey test:

1. Investing funds (in any form: cash, checks, and subsequently crypto assets).
2. Investment in a joint venture.
3. Reasonable expectations of profit from investors.
4. Income earned through the efforts of others.

The approach caught on, and since then, the Howey test criteria have been used to determine whether various assets belong to securities.

Why is the SEC applying the Howey test to cryptocurrencies?

With the development of the cryptocurrency market, and especially after the boom in initial coin offerings of 2017-2018, regulators around the world have wondered if new assets have the properties of securities. To this end, in some cases, the US SEC applies the Howey test.

The US Securities and Exchange Commission has released guidance on using the aforementioned framework for cryptocurrencies and other blockchain-based assets.

“The term ‘security’ includes ‘investment contract’ as well as other instruments such as stocks, bonds and transferable shares. [в капитале компаний]. A digital asset must be analyzed to determine whether it has the characteristics of any product that meets the definition of a security under federal law,” the SEC document says.

One of the brightest examples of the application of the Howey test in the context of the crypto industry is the Telegram token sale case. The TON project raised $1.7 billion through the sale of Gram coins to qualified investors in the US and beyond, but never launched due to a conflict with the US Securities and Exchange Commission.

Another example is the SEC lawsuit against Ripple filed in 2020. The regulator accused the company of distributing about $1.3 billion worth of unregistered securities in the form of platform native tokens.

However, the case that lasted for several years took an unexpected turn for many participants in the crypto community. On July 13, 2023, the Court of the Southern District of New York concluded that program sales and other distributions of the XRP token from Ripple do not constitute the offer and implementation of investment contracts.

In June, the SEC sued the Binance exchange and its CEO Changpeng Zhao, as well as the American company Coinbase. In both cases, the claims relate to unregistered offers of tokens and services for generating passive income.

The current head of the Commission, Gary Gensler, firmly believes that cryptocurrencies are investment contracts. Therefore, platforms responsible for issuing coins need to register with the SEC.

The US-focused crypto industry has to reckon with the Howie test. Many projects position the issued digital assets as governance tokens (governance tokens), since they are used in voting within the DAO. However, due to legal uncertainty, many projects and, accordingly, assets may attract the attention of regulators.

Why doesn’t the SEC classify bitcoin as a security?

In June 2018, then-SEC head Jay Clayton stated that bitcoin is not an “investment contract”.

“Cryptocurrencies are substitutes for sovereign money. Bitcoin can replace the dollar, euro, yen. This type of currency is not a security,” he said.

According to Clayton, tokens can be classified as securities, as they serve as digital assets and the US financial regulator controls this area.

“If I give you money, and you create an enterprise and transfer the right to a share of the joint capital to me, then we are talking about securities. The Commission regulates the offerings of such securities and their trading,” he commented.

Also in the summer of 2018, William Hinman, director of corporate finance at the SEC, said that bitcoin and Ethereum have more commodity characteristics, which suggests the competence of the US Commodity Futures Trading Commission (CFTC).

“If the cryptocurrency network is sufficiently decentralized, and buyers do not rely on a third party for management, the coin is not a security,” the official emphasized.

What’s wrong with the Howie test?

Practice has shown that the scheme of the first half of the last century does not take into account the specific features of cryptocurrencies.

SEC Commissioner Hester Pierce is also convinced of this. She stressed that many start-ups raised funding on the promise of building a network. This created grounds for recognizing the issued tokens as “investment contracts” according to the Howey test.

According to Pierce, the existence of an investment contract depends not only on the asset, but also on the promises associated with it. These two components are not related to each other, she noted.

“The fact that I sold you an orange grove as part of an investment contract does not turn it into a security. An orange grove plus promises about how I’m going to take care of it and bring you profit – this is an offer of securities, ”explained Pierce.

The SEC representative is sure that the Howey test itself does not give an unambiguous answer to the question of whether a cryptocurrency corresponds to the status of an investment contract, in isolation from the process of their placement, in which such signs can be found.