The Howey Test: Is Your Crypto Token a Security?

November 3, 2022

The “Howey Test” is the framework set by the U.S. Supreme Court to determine whether a transaction qualifies as an investment contract and therefore be considered a security.

The cryptocurrency and blockchain era has created tons of legal puzzles for regulators—specifically the SEC, which regulates securities. Startup companies have found pioneering ways to use crypto as a means of funding through Initial Coin Offerings (ICOs), 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 Test Questions: Does Your ICO Qualify As A Security?

The 1946 U.S. Supreme Court case SEC vs. Howey Co. debated whether a leaseback agreement between Howey Co. and landowners was an investment contract. Howey Co. leased and tended to citrus groves and agreed to share resulting revenue with landowners.

Howey Co. failed to register these transactions with the SEC, leading to their meeting in court. The Supreme Court’s final ruling decided the leaseback agreements did qualify as investment contracts and must comply with SEC law. As a result, the Supreme Court created the 4-point Howey Test to define securities.

These are the 4 points of the Howey Test:

  • A party invests money
  • In a common enterprise
  • With the expectation of profiting
  • Based on the efforts of a third party

Many of today’s crypto tokens involve investments of money (through token sales) in a joint enterprise, 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’s difficult to launch an ICO that doesn’t create securities concerns.

Moreover, in 2017, the SEC declared that the tokens of a popular crypto community, The DAO, were securities. 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 the Regulation of Cryptocurrency

The SEC has struggled to categorize digital currencies such as Bitcoin, Ethereum, and the thousands of altcoins that now exist. Many cryptocurrencies, tokens, and exchanges have avoided penalties from the SEC, but the Commission’s pursuit of cryptocurrency regulation has ramped up with increased crypto adoption.

In 2019, the SEC ruled that Bitcoin, the most popular and highest valued cryptocurrency globally, does not pass the Howey Test.

According to the ruling, Bitcoin checks only the first box of the framework, which states there must be an investment of money. However, because there is no central company controlling Bitcoin, the SEC ruled that it doesn’t meet other points of the Howey Test: Investors are not pooling their funds into a “joint enterprise,” and the value of Bitcoin does not depend on 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 sued Ripple Labs over its XRP token, claiming that the token is an unregistered security.

In many cases, companies agree to a settlement with the SEC and pursue registration. However, in this highly publicized case, Ripple claimed that its XRP token does not pass the Howey Test and thus does not qualify as a security. Ripple challenged the SEC and requested that the agency unveil its process for conducting the Howey Test. To date, the case remains unresolved before the court.

Speak to an ICO Lawyer

Despite its age, the Howey Test is still one of the SEC’s most important instruments for regulating cryptocurrency and protecting investors. Our team has been involved in the blockchain and cryptocurrency industries since they emerged. We work with companies and individuals on everything from crypto tax positioning to SEC compliance.

And remember, most ICO tokens are likely securities—not all. Factors like jurisdiction and business structure matter. Give us a call to learn more about how to set up your crypto project and comply with the law!

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