What is the Howey Test for Securities?

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  • The Howey Test for securities has been used by the Securities and Exchange Commission since 1946
  • The test is supposed to allow the SEC to judge whether an asset or commodity is a security or not
  • What is the test and how does it work?

The Howey Test is the standard test used by the Securities and Exchange Commission (SEC) for deciding whether an asset should be deemed a security or not. Much to the resentment of many in the space, cryptocurrencies are also judged by this standard, leading to calls for a separate test for digital assets to be created, as the existing test is believed to be unsuitable. But, what exactly is the Howey test, and why might it not be suitable for cryptocurrencies?

SEC v. Howey

The Howey test is named after W. J. Howey Company and Howey-in-the-Hills Service, the two companies involved in a landmark 1946 case, SEC v. Howey. These companies owned large tracts of citrus acreage in Lake County, Florida, half of which they offered to the public in order to help them finance “additional development”. Purchasers of the Howey land, most of whom had none of the “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees”, were seen as speculators who had purchased the land based on the belief that it would turn a profit for them as a result of the endeavors of others in the cultivating of the land. The defendants argued that they were just selling land. Calling on the Securities Act of 1933 and the Securities Exchange Act of 1934, the U.S. Supreme Court ruled that:

…the transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land…they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise.

The court decided that because the land would generate revenue, and because it would only be profitable due to someone else’s work on it, the two Howey companies were in fact selling securities, and were penalized as such. This case gave us the Howey test, and the four criteria which must be met for a transaction to be considered a security:

  1. There is an investment of money
  2. There is an expectation of profits
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

How does the Howey Test Apply to Crypto?

The collapse of the Ethereum DAO in 2016 drew the SEC’s attention to cryptocurrencies, and they came out fighting. The SEC stipulated that regardless of the medium or the mechanism of the transaction (e.g. a blockchain-based smart contract), the expectations of DAO contributors was to make money from the enterprise, and the fact that they were not the ones doing the work to get this money ticked another box. It was no surprise therefore that the SEC ruled that the DAO had been offering unregistered securities. Since then, a large number of tokens have either been classed as securities or have been suspected of being them.

The waters get a little blurred with utility tokens as it could be argued that investors at ICO stage are buying the token with the intention of using it on the platform rather than profit from it, but the fact is that in 99% of ICO purchases are made with the intention of making money. There is nothing inherently wrong with this attitude, but it falls foul of SEC rules when the ICO mentions potential profit in any way or has no platform ready at the time of the ICO for the tokens to be used on.

Is Change in the Air?

Many cryptocurrency proponents have argued that the Howey test does not fit well with digital assets, as they straddle the four prongs of the test and therefore cannot be judged in the same way. Many security token offerings (STOs) have been massively delayed or failed to get off the ground at all because they were not able to get regulatory clarification, leading to many simply blocking investors from countries that have such laws in place from contributing. In an attempt to change this, two congressmen tabled the Token Taxonomy Act in 2019, which seeks to separate digital assets from existing securities and instead legally define ‘digital tokens’, arguing that an 85-year-old test cannot possibly suit such a complex, contemporary asset such as cryptocurrencies.

Kin founder Ted Livingston took a different approach and challenged the SEC to a date in court in 2019 to let the justice system decide whether ICOs are securities. They accepted and Livingston lost, adding little to no clarity on the issue. With the SEC seemingly unmoved by arguments that the Howey Test is out of date for the modern world, we could be stuck with it for some time to come.