The Howey Test was created by the United States Supreme Court to determine if an investment was subject to the securities laws, most notable the Securities Act of 1933 and the Securities Exchange Act of 1934.
It is an important step in protecting investors. Once an investment is deemed a security, it must follow a process that ultimately helps regulate the sale of such investments. There is also increased scrutiny regarding the security.
Background
The Howey Test refers to SEC v. W.J. Howey Co., which reached the Supreme Court in 1946. Howey Company sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey. Company staff would tend to the groves and sell the fruit on behalf of the owners. Both parties shared in the revenue. Most buyers had no experience in agriculture and were not required to tend to the land themselves.
Howey had failed to register the transactions and the U.S. Securities and Exchange Commission (SEC) intervened. The court's final ruling determined the leaseback arrangements qualified as investment contracts.
In the case of Howey, the buyers of the Florida citrus groves saw the transactions as valuable primarily because the labor and expertise were provided by others. Buyers only needed to invest capital to access an income stream. This classified the transaction as an investment contract under what is now known as the Howey Test, and therefore it needed to be registered with the SEC.
Ultimately the Court came up with 4 parameters used to determine if an offering falls under the Securities Acts.
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
There is also another idea that is used, whether the outcome of the investment is beyond the investors' control.
If an asset meets the criteria of the Howey Test, it is considered a security. This requires registration with the Securities and Exchange Commission (SEC).
Cryptocurrency
There is a great deal of disagreement whether digital assets are securities. Cryptocurrency is a recent development that doesn't fit nicely into existing securities law. The challenge is that governments are slow to adopt legislation that would clarify the new industry.
The theoretical decentralized nature of cryptocurrency and blockchain could make it difficult to regulate. There is also the fact that not all crypto assets are the same.
Non-fungible tokens (NFTs) are one category where a problem could arise. The NFT bubble of 2020-2021 shows there can be a speculative nature to these assets. One issue is that speculation is not a given. The buying of a NFT can be akin to any purchase within the software ecosystem.
NFTs have the potential to be tied to assets in both the digital and physical world. The issuing of a token does not necessarily mean a completely new asset was created. We could see a new form of ownership emerging.
Most of the actions of the SEC pertaining to cryptocurrency stemmed from the initial coin offering (ICO) craze in 2017 and 2018. This was a period were money was raised through the sale of the tokens, most through websites. None of these were registered with the agency causing civil lawsuits in many instances. The ongoing case with Ripple is still unresolved.
The SEC is clear that it considers these to be securities as per the Howey Test.
Stablecoins present another problem when trying to determine if there is a security involved. The idea behind these tokens is to mimic traditional currency. This means the primary function is as a medium of exchange. The expectation of profit is not necessarily present as it is meant to be used for payments.
It remains to be seen how this is all resolved. There will likely be some cryptocurrency that ends up being a security others falling outside of it. The laws that are drawn up by different governments will go a long way to determine how these assets are treated.