Putting the Howey Test to the Test

The Howey Test is the method used by US regulators to establish whether an investment qualifies as a security. It emerged from a U.S. Supreme Court decision from 1976, but is now being challenged in its application to cryptocurrencies.

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The question of whether cryptoassets are commodities or securities has deep implications. Broadly speaking, regardless of the jurisdiction, securities and commodities are supervised by different agencies and entail different obligations. These obligations range from registering an investment product to complying with disclosure and transparency obligations. Compliance would have rendered crypto too slow and expensive, and probably only a fraction of projects would have been able to launch if regulation had been stricter. Regulators worldwide have understood that imposing greater compliance standards would have hampered innovation or pushed it away to other jurisdictions.

The resulting lack of clarity is now a risk for many projects. Regulators refuse to provide strong definitions but, in the meantime, enforce the old laws without clear explanations. The Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) prosecuted individuals and organizations in 2022 for violating securities or commodities laws, despite never having defined the boundaries of their application to crypto.

In 1946 the SEC brought a civil enforcement action against W.J. Howey Co. alleging that they were offering and selling unregistered securities in the form of contracts for the purchase of land in a citrus grove.

For the last 76 years, the Howey Test has been the rule of thumb used by authorities to evaluate whether an investment contract could be considered a security. It was developed by the U.S. Supreme Court in the case SEC v. W.J. Howey Co. (1946) and has been used by courts and regulatory agencies, including the U.S. Securities and Exchange Commission (SEC), to evaluate the status of various financial instruments, including stocks, bonds, and more recently, cryptocurrencies.

The test consists of four factors:

1. It is an investment of money
2. There is an expectation of profits from the investment
3. The investment of money is in a common enterprise
4. Any profit comes from the efforts of a promoter or third party

If an investment meets all four of these criteria, it is considered a security and is subject to the regulatory requirements that apply to securities. If an investment does not meet all four criteria, it is not considered a security and may not be subject to the same regulatory requirements.

The Howey test has been used to evaluate the status of cryptocurrencies in the United States, and some courts and regulatory agencies have applied the test to determine whether certain cryptocurrencies should be treated as securities. However, the application of the Howey test to cryptocurrencies has been somewhat inconsistent, and there is ongoing debate about how it should be applied in this context.

There have been calls for the Howey test to be revised or updated to better address the unique features of cryptocurrencies and other digital assets. Some have come from within (Commissioner Hester Peirce has been an outspoken proponent of updates), and some from outside of the SEC (lately, Coinbase has produced its outline for a new approach). Some possible improvements to the Howey test that have been suggested in order to adapt to the crypto space include:

1. Clarifying the definition of “investment of money”: The Howey test requires that there be an “investment of money” in order for a transaction to be considered an investment contract. This element has been interpreted in various ways by courts, and some have argued that it should be revised to better reflect the nature of cryptocurrency transactions, which may involve the exchange of cryptocurrency rather than traditional currency.
2. Clarifying the concept of “expectation of profits”. Tokens can have main purposes different from generating profits such as governance or incentives.
3. Clarifying the definition of “common enterprise”: The Howey test requires that there be a “common enterprise” in order for a transaction to be considered an investment contract. This element has been interpreted in various ways by courts, and some have argued that it should be revised to better reflect the decentralized nature of many cryptocurrency projects.

Regulators have not produced solid opinions on the nature of cryptoassets. Their opinions are scattered across informal media quotes and the fine print of their actions. So far, most people in the industry have decided to live by the “ask for forgiveness, not for permission” mantra. Time will tell how costly asking for forgiveness can be.