How to Determine if a Cryptocurrency is a Security or Not Using the Howey Test
We hear a lot about the Security and Exchange Commission (SEC) in the US potentially regulating ICOs and possibly declaring some coins and tokens securities. We even hear of potential security-laws violations in the past months. However, how do we tell if an asset really is a security? The SEC uses something called the “Howey test”. This article explains what the Howey test is and explores whether ICO tokens qualify under it.
What is a Security?
There are three elements that make an asset a security. First, a security is any investment product that can be exchanged for value. Second, the investment involves some element of risk, and third, it must be tradable. Thus, a security represents an ownership position, a creditor relationship, or rights to ownership as represented in an option. Good examples would be stocks and bonds. In contrast to this are are tangible assets that you own, for example a car or a house.
What is the Howey Test?
The Howey test is used to determine whether things that don’t look like securities can in fact be deemed securities. The name originates from a Supreme Court decision in 1946: SEC v W.J. Howey Co. Howey Co was offering service contracts for producing, harvesting and marketing orange crops in Lake County, Florida. Most of these contracts were sold to tourists who stayed at a hotel that was owned by Howey Co. The company sold land and land plus service contracts to interested visitors.
The Supreme Court was asked if the land purchase plus the service contract created an “investment contract”? The Court eventually said yes and the so-called Howey-test was born. There are three criteria to the test:
1. There is an investment of money
2. The investment comes with an expectation of profit
3. This expectation of profit derives largely from the efforts of others
An example can help make the difference between a security and a tangible asset clear. If you buy a finished house with the expectation of rising real-estate prices, it is a commodity. If you buy a house pre-construction and the developer promises to do work on the house and provide ongoing maintenance post-construction, you have entered an investment contract, a.k.a., a security.
Let’s take another example: a coffee shop gift card. Buying a gift card involves an investment, so criteria one of the Howey test is satisfied. There is also the expectation you are going to get something back for the card, and what you get back is derived from the labor of others (i.e. the employees of the coffee shop). However, the investment does not come with the expectation of profit. Rather, it comes with the expectation of coffee. Since coffee is a tangible good, a gift card would not be a security.
Are Cryptocurrencies Securities?
Now the question is are ICO tokens securities? Let’s apply the Howey test to find out.
There are two types of tokens: security tokens and utility tokens. Security tokens give holders ownership rights in a company. This makes them a clear example of a security according to the Howey test. There is an investment of money with the expectation of profit. This profit is based on the labor of others (i.e. the project being a success and the tokens increasing in value as a result). Thus, security tokens would be considered securities under the law
The question of whether utility tokens are securities might seem harder to answer. Utility tokens represent a unit of account in a network. The more the network grows, the more utility is in the token. As the size of the network grows along with the transaction volumes, this will increase demand for the tokens.
So, are utility tokens securities? There is an investment of money. Thus, the first Howey criteria is satisfied. The expectation of profit is also clearly at play. A utility token may not represent shares in a company but that doesn’t mean it won’t grow in value. The increase in value is based on the ability of a project to attract users and improve the token over time. This may lead to future profit for token holders, which satisfies the second Howey criteria. The profit is also based on the labor of others. Thus, all three criteria of the Howey test are satisfied, making utility tokens securities as well.
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Thank you — Mina Down
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The purpose of ALTCOIN MAGAZINE is to educate the world on crypto and ultimately to bring it to the hands and the minds of the masses. Brought to you by the best writers in the world. This article was written and composed by Mina Down for Altcoin Magazine.
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