The “Howey Test” is the framework established by the US Supreme Court to determine whether a transaction qualifies as an investment contract and is therefore considered an investment contract. security.
The age of cryptocurrencies and the blockchain has created tons of legal conundrums for regulators, specifically the SEC, which regulates securities. Start-ups have found pioneering ways to use cryptocurrencies as a means of financing through Initial Coin Offerings (ICO)but this can cause legal headaches when securities are not properly registered.
The SEC relies heavily on the Howey test to determine whether a crypto company or product is subject to SEC law.
Howey Quiz Questions: Does Your ICO Qualify As A Security?
The 1946 US Supreme Court case SEC vs. Howey Co. debated whether a leasing contract between the Howey Co. and the landowners was an investment contract. Howey Co. leased and tended citrus groves and agreed to share the resulting income with landowners.
Howey Co. failed to register these transactions with the SEC, leading to their meeting in court. The final ruling of the Supreme Court decided that the leaseback agreements qualified as investment contracts and should be comply with SEC law. As a result, the Supreme Court created the 4-Point Howey Test to define values.
These are the 4 points of the Howey Test:
- A party invests money
- in a joint company
- With the expectation of profit
- Based on the efforts of a third party.
Many of today’s crypto tokens involve investments of money (via token sales) into a joint venture, with the expectation of profit based on the efforts of a third party, such as the centralized company behind a crypto project. As such, it is difficult to launch an ICO that does not raise securities concerns.
Furthermore, in 2017, the SEC declared that the tokens of a popular crypto community, the DAOThey were values. The decision established a regulatory expectation that most ICOs are subject to the Securities Act of 1933.
In addition to ICOs, the SEC has been targeting crypto lending products in recent years.
Howey test and cryptocurrency regulation
The SEC has had trouble classifying digital currencies like Bitcoin, Ethereum, and the thousands of altcoins that now exist. Many cryptocurrencies, tokens and exchanges have avoided SEC sanctionsbut the Commission’s pursuit of crypto regulation has intensified with increased adoption of cryptocurrencies.
In 2019, the SEC ruled that Bitcoin, the world’s most popular and valuable cryptocurrency, fails the Howey test.
According to the ruling, Bitcoin checks only the first box in the framework, which states that there must be an investment of money. However, because there is no central company that controls Bitcoin, the SEC ruled that it does not meet other points of Howey’s test: investors are not pooling their funds in a “joint venture” and the value of Bitcoin does not depend from a third party (i.e. developers creating a product).
However, other blockchain-based offerings are unlikely to receive the same treatment from the SEC.
In 2020, the SEC defendant Ripple Labs about its XRP token, claiming that the token is an unregistered security.
In many cases, companies settle with the SEC and apply for registration. However, in this highly publicized case, Ripple claimed that its XRP token does not pass the Howey test and therefore does not qualify as a security. Ripple challenged the SEC and requested that the agency reveal its process for conducting the Howey test. To date, the case remains unresolved in court.
Talk to an ICO Lawyer
Despite its age, the Howey test remains one of the SEC’s most important tools for regulating cryptocurrencies and protecting investors. Our team has been involved in the blockchain and cryptocurrency industries since they emerged. We work with businesses and individuals on everything from crypto tax positioning to SEC compliance.
And remember, most ICO tokens are probably securities, not all of them. Factors like jurisdiction and business structure matter. call us for more information on how to set up your crypto project and comply with the law.