Howey Test: Regulation and Securities

By Kate Ashford · May 05, 2021 · 6 minute read

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Howey Test: Regulation and Securities

While few outside the securities industry may have heard of the Howey Test, it’s regularly used to test whether what you’re investing in is considered a security by law, according to the U.S. Securities and Exchange Commission (SEC).

The Howey Test is an important step in protecting investors. Once an investment is deemed a security, it must follow a process—and undergo increased scrutiny—that ultimately helps regulate the sale of such investments.

Most recently, the howey test has been discussed in conversations around cryptocurrency and digital assets, in determining whether this new digital asset class can be considered a security.

What Is the Howey Test?

The Howey Test determines whether a financial transaction qualifies as an investment contract. If it does, the transaction is subject to U.S. securities laws. Essentially, the Howey Test maintains that 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 name of the test refers to the U.S. Supreme Court case SEC v. W.J. Howey Co., which was heard by the Supreme Court in 1946. It involved the Howey Company, which sold tracts of orange groves to buyers in Florida, which the buyers leased back to Howey. Company staff would tend to the groves and sell the fruit for the owners, with Howey and the land owners sharing the revenue.

Because the Howey Company didn’t register the transactions as securities in an investment contract, the SEC got involved. In SEC vs. Howey, the Supreme Court ruling determined that the leaseback arrangements qualified as investment contracts, and as such were subject to U.S. securities laws.

What Is a Security?

Under Section 2(a)(1) of the Securities Act of 1933, transactions that qualify as investment contracts are referred to as securities (as are promissory notes, books, bonds, and stocks).

In order to register a security, a company must provide:

•  A description of the issuing organization’s properties and business purpose
•  A description of the offered security
•  The offering company’s management details
•  Financial statements of the company, certified by independent accountants

Recommended: Bonds vs. Stocks: What’s the Difference?

What Is the Criteria for Meeting the Howey Test?

Through its ruling in SEC vs. Howey, the Supreme Court established four criteria that decide whether an investment contract exists—in other words, whether it meets the Howey Test. An investment contract meets requirements if:

1. There is an investment of money…
2. In a common enterprise…
3. With a reasonable expectation of profits…
4. To be derived from the efforts of others.

If the investor has a critical influence on how the investment is managed, then it is not a security. In other words, if the buyers of the Howey orange grove plots had been working the land and selling the oranges themselves, the transactions would not be investment contracts.

But the buyers of the orange grove plots in Florida viewed the contracts as valuable in large part because other people took care of the work and know-how—buyers just had to put their money into the deal. Hence, the transactions were investment contracts in the eyes of the SEC.

The upshot: Such transactions must be registered with the SEC.

Does Crypto Pass the Howey Test?

What does a citrus grove contract have to do with modern investing? Plenty, as it turns out. The sale of most digital assets via initial coin offers (ICOs) are likely to be considered securities under the Howey Test, according to the SEC.

Digital currencies like Bitcoin or Ethereum have been hard to categorize because they’re so decentralized, and that makes it hard for them to be regulated. And many companies have sold digital currencies with very little regulatory oversight. But the SEC is actively seeking to make it clear when, exactly, their sale meets the definition of an investment contract.

Digital asset sales easily check the “investment of money” box, per the SEC, because there is an exchange of value, regardless of the type of value being exchanged. The SEC also believes the sales are a “common enterprise,” because the fortunes of purchasers have been linked to each other or to the success of the seller’s efforts.

So, what about the other criteria of the Howey Test? Is there an “expectation of profit to be derived from the efforts of others”?

So far, the SEC has stated that if promoters or sponsors provide critical managerial efforts that influence the success of the enterprise, and if investors reasonably expect to profit from those efforts, then that box is checked as well.

In 2017, the SEC warned coin issuers that securities laws applied to token sales, putting the cryptocurrency industry on notice that the Howey Test applies to their business, even if they’d hoped to escape it.

While there are some cryptocurrency rules and regulations in place, most companies selling virtual currencies are not yet required to comply with securities laws, which, among other things, require companies to disclose information about their operations before collecting money from American investors.

Recommended: 2021 Crypto Guide: What to Know for New Crypto Investors

Other Rulings Related to Securities

There are a number of other cases that have also affected securities law.

United Housing Foundation v. Forman

In this case, residents of a cooperative housing project were required to purchase shares of stock for each room they wanted, along with paying monthly rent. They sued the developer for sale of unregistered securities. But the court ruled that even though the shares were called “stock,” the economic realities were that people were paying money to acquire a residential apartment and would not have reasonably believed that they were investing for profit. Hence, securities law did not apply.

The Family Resemblance Test

This test, which came about from the Supreme Court case of Reves v. Ernst & Young, resolves that issuers of a note may show that the note should not be considered a security by proving that the note has a “family resemblance” to other investments that are not securities.

Blue Sky Laws

State-specific securities registration requirements are often called “Blue Sky Laws.” For instance, California uses something known as the “risk capital test” to determine if something is a security. Following the court’s findings in Silver Hills Country Club v. Sobieski, this test focuses on whether funds are being raised for a business venture or enterprise, whether the public at large can participate, whether investors are powerless to affect the success of the enterprise, and whether investor money is substantially at risk.

The Takeaway

Under the Howey Test, an investment can include a provision of capital, cash, assets, goods, services, and a promissory note. When it comes to crypto, since the buyers of token or coins pay for them with cryptocurrency, there is an investment of funds in exchange for the token or coin.

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