The Howey Test — What is a Security?
Continuing our series outlining the regulatory environment for crypto in the United States, we look at the famous Howey Test for determining what is a “security” in the United States. We recommend reading our previous articles outlining the US regulatory environment and the SEC’s role and the CFTC’s role before this one to understand why this is an important question.
Securities under US law — why is it relevant?
As discussed in our previous articles, a crypto token’s legal status as a “security” or not has significant consequences in the United States. In essence, although a token being a “security” is completely legal, it brings with it additional regulatory, disclosure and compliance obligations upon the entity issuing the token (like the obligations imposed by law upon companies issuing shares and selling to the public), in order to protect the retail public. These obligations are cumbersome, expensive and in some cases not practical to comply with at all for a crypto project.
As a result, most crypto projects would prefer that their token not be a security, and will often design it in such a way as to avoid (or try to avoid — it is not necessarily successful) that classification. US-based crypto exchanges (and exchanges elsewhere) will not typically list a token unless they are satisfied that it is not a security (since the exchanges themselves have to comply with certain regulatory obligations in order to list securities, and crypto exchanges do not typically comply with them, as they do not list securities).
The SEC is the agency with enforcement authority and the power to regulate securities issuers (which includes crypto token issuers if they issue securities) and they aggressively litigate against crypto projects that they believe have issued tokens that are securities but are not complying with their legal obligations.
It is important to note however, that the US law on this matter is not clear and there can be significant disagreement on whether a given crypto token is a security or not. The SEC believes that the vast majority of crypto tokens are securities and fall within their jurisdiction, and they litigate on this basis (and crypto projects often reach negotiated settlements with the SEC and pay penalties on that basis, because they often do not have the funds or inclination for lengthy litigation). However, the SEC’s opinion that a token is only an opinion and it is not legally binding unless a court agrees with them.
Nevertheless, no crypto project wants to be involved in uncertain litigation that could define the project’s future for years, and (if sued) will often settle, or frequently block the USA or restrict access to US users to limit their regulatory risk, even if they are confident their token is not a security (for example, this is why the DyDx token airdrop, and many others were not made available to US users).
The Howey Test
One aspect that is frequently overlooked when discussing the Howey Test, is that it is NOT the sole determinant of whether a crypto token is a security under US law. There are many types of securities under US law, each with their own characteristics, and it is important to look at all of them before trying to reach a conclusion on whether a given token is a security.
The Howey Test is the legal test used to determine whether a crypto token is *one particular type of security* called an “investment contract”, because that is the category into which crypto tokens are most likely to fall.
The name is derived from a 1946 case decided by the US Supreme Court called SEC v WJ Howey & Co where the Supreme Court authoritatively laid down the criteria to determine whether something was an investment contract or not:
“…an investment contract, for the purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third part…”
These words set out the 4 criteria that are now called the “Howey Test” — all 4 of these must be satisfied in order to conclude that a crypto token is an “investment contract” and therefore a security:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
While it is beyond the scope of this article to discuss each element of the Howey Test in more detail, it is sufficient to note that there are decades of legal precedent applying the test, and deciding whether a given crypto token satisfies the test is often unclear and not conclusive.
Conclusion
While it is important to be aware of the Howey Test and its relevance, we believe that the vagueness of the test, the existence of other types of security beyond investment contracts, the SEC’s willingness to prosecute against crypto projects, and the general difficulty of attaining legal certainty on the subject means that projects should look not just to understanding their legal position by consulting a qualified US lawyer, but also to technical and other means to reduce regulatory risk. There are never any guarantees of safety, but it is certainly possible to reduce risk and do one’s best to avoid being in breach of legal obligations.
October 2023
— The Compliant Defi Team
www.compliantDefi.org
