Howey Test For Crypto? The Supreme Court created the Howey Test to determine whether or not something qualifies as an investment contract. Consequently, under the Securities Act of 1933, it makes it subject to certain regulatory requirements. One important thing to note about this test is that it has nothing to do with securities in the way they are normally used in the financial world. It only applies to certain kinds of investments. This means a company can sell securities without being regulated by the SEC, if it passes the Howey Test. That said, let’s take a look at the Howey Test’s 4 prongs, how the Howey Test applies to cryptocurrencies, and updates on how the Howey Test is being used today.
What Exactly is The Howey Test?
The most important thing to understand about the Howey Test is that it’s a legal definition of how certain transactions are classified. Specifically, the Howey Test is a test for an investment contract. This is relevant for cryptocurrency because the SEC has considered some cryptocurrency offerings as investments. Therefore, the SEC treats them as securities.
The SEC defines an investment contract as any transaction in which someone invests their money in a common enterprise and is led to expect profits solely from the efforts of others.
A key factor in determining whether something counts as an investment contract under the Howey Test is whether investors rely on others to manage or operate their funds for them. Or if they do their own thing, even if it involves investing with others.
The Howey Test: 4 Prongs
The Howey Test came about because of a case in 1946 called SEC v. W.J. Howey Co., which involved land development in Florida. The Supreme Court decided that whether or not a particular scheme counts as an investment contract is based on four factors of the Howey Test:
- There’s an investment of money.
- There’s an expectation of profits from that money.
- Those profits come from a common enterprise that exists solely to make those profits
- Any profit comes solely from speculation or risk rather than work.
The first three parts of Howey Test are easy to understand. The last part—the requirement that profits come solely from risk rather than work—is slightly more difficult.
An investment contract is still an investment contract under Howey if those who invest their money:
- Have a significant effect on how their money is spent.
- Receive any profits generated by someone else’s labor. Because it means they’re being paid for taking a risk, which isn’t allowed under Howey.
Investors who buy cryptos can also be classified as issuers under securities law in certain cases. This is due to their power to manage other people’s money. Consequently, they may be considered subject to securities law liability.
Cases Where The Test Applies
The test was created by the Supreme Court in the 1946 case of SEC v. W.J. Howey Co. In which it was used to determine whether citrus groves were an investment contract subject to securities regulation. They were, as buyers had invested money with a reasonable expectation of profit.
The ruling helped define what constitutes an investment contract under the federal securities laws. Consequently, it’s become one of the keys to deciding whether cryptocurrencies fall into that category.
While most people have heard of the test—it is named after its creator, Judge Louis V. Howey—fewer know how it has been applied over time.
You probably already know that cryptocurrencies, particularly bitcoin, have had a massive boom in popularity over recent years. Wven as early buyers see their holdings soar in value, regulators are warning investors over the risks involved.
Even if cryptocurrencies don’t become worthless, there is still reason to think that regulators will come down hard on cryptocurrencies if and when investors start losing money. Many believe that no cryptocurrency should escape regulation under any circumstances. Others say there is room for individual cases to be judged independently according to how they apply to The Howey Test.
The Howey Test and Cryptocurrencies
In the Strategic Hub for Innovation and Financial Technology, or FinHub, of the SEC, two pieces of guidance were published on April 3, 2019. They provide guidance on whether a blockchain-enabled digital asset will, or will not, be considered a security.
The first letter of guidance (TKJ No-Action Letter) was in response to TurnKey Jet’s request. If based on the opinion of a lawyer that the digital assets are not securities, the subject entity offers and sells securities without registration of the Securities Act of 1933, as amended (Securities Act) and the Securities Exchange Act of 1934, as amended (Exchange Act).
Guidance came in the form of a Framework for Investment Contract Analysis of Digital Assets, intended to serve as an analytical tool to help companies determine whether federal securities laws apply to the purchase of a particular digital asset.
Recent Rulings For Cryptocurrencies
The Securities and Exchange Commission filed a complaint in 2022, alleging that BlockFi Lending LLC (BlockFi) violated federal law. The SEC accused BlockFi of failing to register their offers and sales of its retail crypto lending product. According to the SEC, the company failed to adhere to certain provisions of the Investment Company Act of 1940.
In response to SEC allegations, BlockFi has agreed to pay a $50 million penalty, stop making unregistered offers and sales of their lending product, BlockFi Interest Accounts (BIAs).
Additionally, BlockFi would start complying with the requirements of the Investment Company Act within 60 days from the ruling date. BlockFi’s parent company also announced that it intends to register under the Securities Act of 1933 the offer and sale of a new lending product.
On that same day, BlockFi also agreed to pay an additional $50 million in fines to 32 states to settle similar charges.
BlockFi & SEC Ruling
From March 4, 2019 to the present, BlockFi sold blockchain-backed instruments (BIAs) to the public. A BIA works by making monthly interest payments in the form of cryptocurrency. The Commission found that securitized tokens qualified as securities under applicable law. Consequentl, the company was required to register its offers and sales of the tokens.
Additionally, the Commission found that BlockFi operated for more than 18 months as an unregistered investment company. The reason being: that it issued securities and also held more than 40 percent of its total assets, excluding cash, in investment securities, including loans of crypto assets to institutional borrowers.
The Order states that BlockFi violated federal securities law by issuing false and misleading statements on its website for over two years about the risk of its loan portfolio and its lending activity.
Without confirming or denying the SEC’s findings, BlockFi has agreed to a cease-and-desist order forbidding it from violating the antifraud provisions of the Securities Act and the registration provisions of the Investment Company Act. BlockFi also agrees to cease selling or promoting BIAs in the United States.
The Howey Test & Ripple Labs’ XRP
In 2021, Ripple moved to have the SEC respond to interrogatories by naming the SEC’s reasoning on the applicability of the Howey Test to virtually all of Ripple’s transactions in XRP over the last 8 years. Although Judge Netburn insisted, the SEC refused to cooperate, deeming it baseless.
According to the defendants, providing factual support to how their case aligns with the Howey Test is absolutely basic information and essential to the defense.
The complaint goes on to request the information the firm is looking for through interrogatories. One interrogatory deals with whether or not someone who buys XRP expects to earn a profit from the purchase.
Ripple wished to push the SEC to provide more information on whether ETH and BTC are securities. The company argued that it is a part of the factual basis. The SEC claimed this information is not relevant to the case. However, the court rejected that argument, claiming it’s very relevant to Ripple’s argument of fair motion.
Ripple wanted to know from the SEC whether the firm’s efforts contributed to any impact on the price of XRP.
Should The Howey Test Be Used For Cryptocurrencies?
The Howey Test determines whether an asset is a security or not. Currently, most ICOs do not pass The Howey Test. If more stringent regulations are placed on cryptocurrencies, then there is a very real possibility the SEC and regulators may deem many cryptos to be securities. The implications of doing so would be huge for both investors and creators in the blockchain ecosystem.
Coinbase Global (NASDAQ: COIN) CEO Brian Armstrong went on a podcast and actually spoke about the SEC.
Armstrong mentioned that it would not make sense to use the same regulation for every cryptocurrency. Some of which could be considered a commodity and others a security. Stablecoins may be classified as a currency.
He gave the example that there needs to be a separate set of regulations and regulatory bodies for commodities, securities, and currencies.
With regards to commodities, they are overseen by the Commodities Futures Trading Commission (CFTC). With securities being overseen by the SEC, and with currencies being overseen by the Treasury. These products may not cover cryptocurrencies, and therefore neither will they be regulated.
The SEC, in the past, has commented on the uncertainties about cryptocurrencies. They also noted this at various instances. For example, Hester Pierce’s dissent, Gary Gensler’s remarks on the regulation of cryptocurrencies, and the Ripple lawsuit.
Closing Remarks: The Howey Test and Cryptocurrencies
If a transaction represents an investment of money, there is an expectation of profit through some effort of others, or due to passive involvement in that activity, it’s likely considered a security. The SEC has its own classification system for assets that it applies to determine whether something qualifies as a security.
There are both supporters and adversaries of the use of the Howey Test. Regardless of your opinion on how well it’s applied, it’s important to be aware of what qualifies as a security in today’s crypto world.
Some may argue that there are cryptocurrencies that have nothing to do with securities. Others see them as hidden securities. In turn, they fear there could potentially bring unwanted attention from regulators if they fail to comply with regulations surrounding securities offerings. The Howey Test is still used, and it should not be ignored, whether you’re a cryptocurrency or blockchain company, or an investor. We’ll see if the Howey Test will be applicable to cryptocurrencies very soon.
