As the popularity of cryptocurrencies soars, civil suits are working their way through federal courts, which are showing more of their cards in determining whether cryptocurrency projects can be considered securities. To determine whether a cryptocurrency meets the legal definition of a security under federal law, courts apply the Howey Test. This article scrutinizes this well-established legal analysis and brings you the details.
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What The Fuss is All About
The Howey Test determines what investment or asset qualifies to be considered under the U.S. securities laws. According to these laws, there’s an investment contract in situations where there exists an investment of money towards a common enterprise, and there’s a realistic expectation that profits would result from the efforts of others.
Without any solid form of crypto regulation, the Howey test becomes integral to blockchain and cryptocurrency projects, especially if they plan to conduct fundraising efforts among investors and project supporters. Numerous crypto projects planning to conduct Initial Coin Offerings (ICOs) may unknowingly find themselves meeting the definition of “investment contracts” under the Howey Test.
Understanding the Howey Test
The Howey Test was created by the U.S. Supreme Court to determine what transactions qualify as “investment contracts”. It can be considered securities subject to definite disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. The U.S. Supreme Court had in 1964 heard a case (SEC vs. Howey) where the U.S. Securities and Exchange Commission (SEC) sued two Florida-based corporate defendants, claiming they broke the law by failing to file a securities registration statement for real estate contracts for tracts of land with citrus groves.
The Supreme Court found the defendants’ agreements were a form of security and developed the landmark Howey Test.
Per the judgment, a transaction is an investment contract if it satisfies the following four criteria:
- Investment of money: People will have invested cash, property or any other helpful asset.
- Common enterprise: Several investors will have pooled their funds, and success will depend on the work of others. A third party or promoter will manage the investment in a shared enterprise.
- The expectation of profits: Investors will look forward to making money from the labor of others, with this component examining whether or not there’s an expectation for an ROI.
- Efforts of others: The third party’s or promoter’s efforts will play a significant role in most revenues, meaning that the project’s success will depend on someone else’s knowledge, talents or efforts rather than the investor’s.
Application in the Crypto Space
Since the Howey Test has been used as an oversight tool for many decades to determine regulatory compliance, we will find out how the Test is applied in the cryptocurrency market to decide which tokens serve as securities. Regarding token classification in the crypto sphere, there are two types: security and utility tokens.
- Security Tokens: They offer ownership rights, and users expect a profit from the investment based on other people’s labour. The result is the project succeeds, and the token’s value increases. Some benefits of security tokens include lower issuance fees, superior market efficiency and fractionalization of more significant assets.
- Utility Tokens: They represent a unit of account and are added to the token as the network grows. The token’s demand grows in tandem with the network’s growth alongside transaction volumes.
A cryptocurrency like Bitcoin may not pass the Howey Test because while it meets the first criteria, it fails on the second and third elements as there’s no promoter, common enterprise or investors pooling their resources, and there are no efforts of others. However, cryptocurrency projects that involve ICOs seeking public funds to develop their technology are a different case altogether. Tokens that don’t pass the Howey Test are classified as utility, user, or app tokens.
However, according to the SEC, a utility token isn’t automatically excluded from being a security simply because it has a token framework, leading to many crypto-related cases involving the Howey Test. Due to the ongoing confusion, the SEC has previously argued that some tokens traded on Coinbase are securities and should, therefore, be regulated by the watchdog, while the SEC vs. Ripple has been in the headlines for a while now.
Impact on Crypto Market
So far, The SEC has singled out some 68 cryptocurrency projects as securities. The impact of the Howey Test on the cryptocurrency market is noteworthy because any such crypto project that qualifies as a security under the law becomes subject to federal law. This becomes particularly noteworthy for investors and crypto-based businesses since breaking related rules would potentially attract legal action, penalties, and reputational harm to companies. This, therefore, makes it mandatory for companies to carefully consider their offerings to avoid being at loggerheads with the authorities.
Challenges and Criticisms
Despite its importance, pundits have argued that the Howey Test needs to be narrower and capture transactions that go beyond the scope of traditional securities like art or real estate investments. Moreover, they argue that the requirements of the Howey Test aren’t straightforward, leaving a vacuum and room for interpretation.
According to players in the crypto industry, the Howey Test is vague when dealing with the question of determining whether investing in an asset involves a common enterprise. Most importantly, there’s a general feeling that the Test is outdated and unsuitable to address the modern financial landscape involving assets like cryptocurrencies and blockchain projects. The emergence of new technologies and financial products demands the development of new tests and regulatory frameworks to address investor protection.
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The truth is that attempting to apply the existing framework to emerging financial technologies like cryptocurrency projects can be challenging for several reasons. First, the crypto sphere is dynamic and is evolving rapidly, and regulators are playing catch up as they try to acquire talent to learn the requisite skills. Secondly, monitoring the cryptocurrency market can become tricky owing to the unavailability of data, as thousands of actors are not subject to regular disclosure and reporting requirements.
While different national authorities and international regulatory organizations are burning the midnight oil to amend their laws or introduce new legislation that covers crypto assets, the International Monetary Fund (IMF) proposes a well-coordinated global response that will fill the existing regulatory gaps arising from cross-border and cross-sector issuance to ensure a level playing field. The IMF recommends introducing a comprehensive regulatory approach covering all actors and aspects of the cryptocurrency ecosystem. The international body believes a global regulatory framework would bring order to the entire market, help instill consumer confidence, and provide a safe space to promote innovation.
Recent Developments and Future Outlook
While no specific law directly addresses the circumstances under which a cryptocurrency project becomes a security, the SEC has consistently applied the Howey Test and its four elements on digital assets. However, the applicability of the Howey Test on crypto purchases has faced serious criticism from numerous industry participants, government officials, litigants and at least one former SEC commissioner, all of whom have questioned the Test’s appropriateness for secondary-market transactions.
Critics generally agree about distinguishing between investment contract transactions, which could be securities offerings, and underlying investment contracts, which don’t qualify as securities. At a time when even SEC officials agree that when tokens are sufficiently tokenized, and purchasers no longer expect someone else to perform entrepreneurial or managerial efforts, they may no longer represent an investment contract; there may be sufficient reason to reconsider the Howey Test’s place in cryptocurrency projects.
To Sum Things Up
As the evolution of the financial landscape continues at such a fast pace and the Howey Test remains the sole securities regulation tool, especially in the United States, there’s a need for the development of a new regulatory framework that will keep pace with the crypto industry trends and guarantee investor protection.
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Since the authorities are still playing catch up on matters of crypto regulation, cryptocurrency businesses must remain aware of the existing federal securities laws and comply with them. This involves a clear understanding of whether the tokens they deal with are considered securities so they can comply with the existing registration and disclosure requirements.
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