The Howey Test’s Relevance with Crypto

There has been much debate amongst both the public and regulatory government agencies as to whether or not digital assets are securities.

When it comes to investing in digital assets, though, it’s not so important what you as an individual investor believes is true, but rather, what the law dictates. Before investing in cryptocurrencies or other digital assets, it’s critical to know if U.S. federal securities laws apply. 

If a company you invest in fails to comply with federal securities laws, it could spell danger for your investment. One way private companies using Rule 506(c) can ensure they are meeting the necessary requirements is by verifying investors have an accredited investor status certificate. Learn how to verify accredited investors to stay in good standing with the SEC.

With digital assets, in particular, it can be difficult to know whether or not securities laws apply. The Howey test is what courts use to separate assets that are securities from those that are not.

What Is The Howey Test?

The Howey test is a way to determine if something is considered an investment contract and, thus, a security.

According to The U.S. Supreme Court, an investment contract exists if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

The Supreme Court established this framework in 1946 in a case called SEC v. W.J. Howey Co., when it ruled that leaseback arrangements made between the Howey Company and buyers of their citrus groves qualified as investment contracts.

The law applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities — if it qualifies as an “investment contract,” it is subject to U.S. federal securities laws.

How Is It Used

Courts use the Howey test to determine whether unique arrangements, such as digital assets, are securities and, thus, subject to federal securities laws.

The Howey test is used to determine if a transaction is an investment contract by seeing if it meets the four criteria set forth by the Supreme Court in the Howey case. These four criteria are: (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profit, (4) to be derived from the effort of others.

If a transaction passes the Howey test, it is considered an investment contract and must be registered with the SEC.

What It Means for Crypto

Again, the Howey test applies to “any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities,” including cryptocurrency transactions.

While there is still much debate over whether or not certain digital assets are securities, some do qualify as investment contracts according to the Howey test.

Almost all digital assets are (1) an investment of money (2) in a common enterprise (3) with an expectation of profit. The question is whether or not that profit is to be derived from the efforts of others.

In many cases, though, it is. Take participating in an Initial Coin Offering (ICO), for instance. The investor would reasonably expect that the issuer of the coin would continue to make efforts that support the market or price of that coin. In this case, this transaction would qualify as an investment contract.

According to the SEC, when a promoter, sponsor, or another third-party provides essential managerial efforts that affect the success of the enterprise and investors reasonably expect to derive profit from those efforts, the fourth criterion of the Howey test is met.

The SEC provides numerous other examples of cases where digital assets qualify as investment contracts. As an investor, it’s critical to be aware that investments in digital assets may be considered securities and subject to registration requirements.