What is the Howey test?
The Howey test is a legal test used in the United States to determine whether a transaction qualifies as an investment contract and is therefore considered a security under federal law. The test was established by the US Supreme Court in SEC v. WJ Howey Co. (1946) and has since been used in many cases to determine whether various financial arrangements and offers constitute securities.
According to Howey’s test, the transaction must involve an investment of funds in a group enterprise with the expectation that all profits will derive from the group’s efforts. A transaction is considered a security if it meets these requirements, in which case it is subject to federal securities laws and regulations.
Understanding the criteria for a security
The test includes three key criteria that must be met for a transaction to qualify as a security, as outlined below:
The first criterion is financial investment, which means that the participants of the transaction must risk their own money. This includes both financial and in-kind investments.
The second requirement is a shared enterprise, meaning that the investors’ financial success is somehow linked. This can be demonstrated by providing evidence of the pooling of investors’ resources or that they rely on a third party to manage their investments.
The third criterion is the expectation of profits only from the efforts of others, which means that investors rely on someone else to generate a return on their investment. This could include, for example, profits generated by a third-party manager or profits generated by the efforts of a particular group or organization.
Chance? On the same day as the Ethereum merger, SEC Chairman Gary Gensler said proof-of-stake cryptocurrencies could be considered securities under the Howey test. https://t.co/D24G9edoc7
— Cointelegraph (@Cointelegraph) September 16, 2022
Implications of the Howey Test for Cryptocurrency: Is It a Security or Not?
Implications of the Howey test for cryptocurrency are significant because the test provides a framework for determining whether a particular cryptocurrency offering should be classified as a security under US law. If a cryptocurrency offering meets the criteria set forth in the Howey test, it may be considered a security and subject to federal securities laws.
This has important implications for crypto businesses and investors, as violations of federal securities laws can lead to penalties, legal action, and reputational damage. To ensure compliance with federal securities laws, cryptocurrency companies should carefully consider the Howey test before creating their offerings.
Related: Cryptocurrencies and Securities: A New Interpretation of the US Howey Test Takes Place
Tokens that fail the Howey test are considered utility tokens which give investors access to a future product or service or can be exchanged for preferential fees. While utility tokens are not typically considered securities, the SEC has suggested that the presence of a utility token does not necessarily mean that a project is not classified as a security.
The implications of the Howey test for cryptocurrencies will ultimately depend on how regulators choose to apply the test in practice and how cryptocurrency companies choose to structure their offerings to comply with federal securities law.
Compliance with Federal Securities Laws: What Cryptocurrency Companies Need to Know
Cryptocurrency companies must be aware of United States federal securities laws to ensure compliance. Here are some key things to keep in mind:
- Securities laws apply to cryptocurrencies: The Securities and Exchange Commission considers several cryptocurrencies to be securities. This means that cryptocurrency businesses must comply with federal securities laws, including registration and disclosure requirements.
- Token offerings may be subject to securities laws: They may be considered a securities offering if a cryptocurrency company sells tokens to the general public in exchange for cash or other assets. As a result, the business would have to comply with securities rules, which would include registering the offering with the SEC.
- Use of funds must be disclosed: A cryptocurrency company must disclose its financial goals when getting money through a securities offering. The business must also inform investors about how the money is being used.
- Trading Platforms May Be Subject to Securities Laws: Securities exchanges may include cryptocurrency trading platforms that allow users to buy and sell tokens. If so, the platform would have to file a registration form with the SEC and comply with other securities regulations.
- Penalties for non-compliance can be severe: Substantial penalties can be imposed for non-compliance: A cryptocurrency company can face serious consequences such as fines and legal action if it violates federal securities regulations.
Therefore, cryptocurrency companies must be aware of and comply with United States federal securities laws. This includes understanding whether their tokens are considered securities, disclosing the use of funds, and meeting registration and disclosure requirements.