Howey Test: What it means for Digital Assets and Cryptocurrencies?

Howey Test has become an integral element in the US Securities Law. If you are familiar with the cryptocurrency market, chances are that you would have heard of this particular test. When Bitcoin became popular, many of us began wondering about the legal implications of such a groundbreaking concept. As cryptocurrencies gained an increasing number of investors, many more questions arose. 

Are there any regulations that need to be considered?

Should cryptocurrencies be considered as securities or do they fall under the asset class? 

Most of us would say that a digital asset must be evaluated for certain characteristics in order to be considered as a security under the federal securities law. To make this process faster and easier, the United States Securities and Exchange Commission [SEC] came up with the test. The aim of this article is to provide a deeper insight into the Howey Test and its applications in the cryptocurrency market.  

What Is the Howey Test?

At this point, you have probably come to the conclusion that the Howey Test is some kind of evaluation that is performed on cryptocurrencies. This assumption would be completely right, but there is a lot more to it. However, before delving into the exact definition, it would be helpful to take a look at the term “securities” and what it entails. 

A security is often defined as a tradable financial asset. The section 2(a)(1) of the Securities Act of 1933 states that transactions which qualify as “investment contracts” are considered as securities like promissory notes, books, bonds and stocks. 

In order to gauge whether a cryptocurrency should be considered a security or not, we employ the Howey Test. According to the test, if an asset needs to be considered as a security, it needs to meet four primary criteria- it should involve an investment of money, operate with a profit expectation, be tied to a common enterprise, and the profits, in question, should be generated by a third party. We will take a deeper look into these conditions in the following sections. 

In essence, W.J. Howey Co. states that 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 Supreme Court has stated that the cryptocurrencies which pass the Howey Test can be considered as securities that must adhere to securities regulations under the Securities Act of 1933 and the Securities Exchange Act of 1934.

Origin of the Howey Test

It is evident that the Howey Test has made it much easier for the financial industry to get a better grasp on the regulations associated with cryptocurrencies.

But how did the test even come into being?

Strangely enough, the test finds its roots way back in a lawsuit dating back to 1946. The case in question was taken to the Supreme Court and involved the Howey Company of Florida. The company in the case was a citrus farm which was based in a sizable portion of land in South Florida. In order to acquire additional funding for development purposes, the company had decided to lease out half of its property. Most of the purchasers of this land were not Florida residents or farmers. Instead, they were business and professional individuals with barely any experience in agriculture. This means that they bought the land thinking that they would be able to gain a profit from the efforts of a third party. 

Unfortunately, the company did not register any of its transactions, which resulted in them being slapped with an injunction from the SEC. 

In this case, the people investing in the land being sold by the company depended on the work that others would perform for profit. If we take the Howey Test into account, this classifies the transaction as an investment contract. Therefore, the transaction needed to be registered, and the Howey Co. was found to have violated the law by failing to do that.

What is the need for security regulations in crypto-based financial transactions? 

In the U.S.A, many state governments have implemented laws or regulations associated with cryptocurrencies. Till date, there are usually two approaches that can be seen. Some states promote the technology by passing favorable laws, often by exempting cryptocurrencies from state securities laws and/or money transmission statutes. For example, Wyoming, recently passed a bill exempting cryptocurrencies from property taxation. The second approach would be to improve trading efficiency and understanding of the cryptocurrency market. Either way, regulations are an important part of crypto-based financial transactions. Some of the main reasons for promoting security regulations in this space include-

• Promotes security of virtual asset ownership: Regulations will provide an effective control layer for virtual asset custodians and owners. They will be able to freeze irregular transmittals in transit, reverse malicious transmittals, detect suspicious activity etc.
• Improves efficiency of trading: A regulated crypto market makes it easier for users to set up universal profiles without KYC requirements. They will also be more comfortable with their wallet custodians. 
• Better valuation on the worth of a cryptocurrency: Cryptocurrencies will be better evaluated according to their merits and will be subject to purer supply and demand economic forces.
• Makes it easier for financial institutions to invest: Regulations allow financial organizations to understand the landscape and risks associated with cryptocurrency, which makes them more confident about investing.

What are the main elements that represent the Howey Test?

The test involves a few primary elements that contribute towards its foundation. They can be understood as follows- 

• Investment of money

The first condition that must be satisfied under the Howey Test would be the sale of a digital asset, which can be purchased or acquired in exchange for value in the form of fiat currency, another digital asset, or other types of consideration. In a crypto based transaction, purchasers would pay for a token or coin with cryptocurrency, this involving an investment of funds. 

• A common enterprise

Having a common enterprise is another distinct element of an investment contract. The tests used to determine a common enterprise in the US varies according to the judicial court. 

• Expectations of profit

Generally, the primary issue in evaluating a digital asset under the test is whether a buyer is expecting to gain a profit out of the transaction. However, acquiring a profit is just one aspect of a security.  

• Work effort from a third party

Under the test, the purchaser is expected to gain a profit from the efforts put in by a third party and not themselves.

How does the Howey Test regulate cryptocurrencies?

Cryptocurrencies have been garnering notable interest from investors, which has led the SEC to put up clear cut definitions associated with the field. However, some digital currencies are difficult to categorize. This is because they are decentralized and are particularly developed to evade regulation as much as possible. However, the Howey Test helps regulate cryptocurrencies and digital assets to a certain extent. 

In case the SEC decides that a certain cryptocurrency token comes under the category of a security, this will bring about numerous implications for that cryptocurrency. In other words, it implies that the SEC will be able to decide whether a particular token can be put on sale for U.S. investors legally or not. Additionally, it also ensures that U.S. investors register their token holdings with the SEC.

The SEC has filed cases against various projects for violating securities laws. Paragon Coin Inc. and Airfox were two companies that were caught and fined $250,000 each by the SEC. These companies were not charged with fraud but were given a deal in which they could bring their ICO under SEC oversight and offer refunds to investors.

Possible impact on digital assets in the crypto market

Since the launch of the cryptocurrency era, ICO campaigns have raised millions of dollars. Such blockchain projects have primarily received funding from investors who are hoping to gain profit. Generally, an ICO investor acquires ICO tokens that are designed for fundraising after transferring a renowned cryptocurrency like Bitcoin. Since it is difficult to tell whether these investments are legally monetary in nature, there is a lack of clarity on whether ICOs are selling securities or not.

To make matters worse, several projects are being launched under the guise of “utility tokens”. This means that the coins being sold to investors have a primary function in the performance of their project, instead of it being a completely speculative investment. 

The SEC has stated these projects may constitute security offerings despite the utility token framework. This can make a huge impact in the crypto space as any project that is found to be selling securities could be liable for prosecution and subject to retroactive legal action pending upcoming legislation. 

At the end of the day, cryptocurrencies were designed to be autonomous and decentralized. Some may say that classifying cryptocurrencies as securities goes against everything it stands for. Despite this, it is important to note that regulating the industry comes with its own set of undeniable advantages.