What is the Howey Test?

In the context of potential government regulation of cryptocurrency and blockchain technology, the billion-dollar question (sometimes literally) about any cryptocurrency coin or token is whether it passes the Howey Test. Given the emerging state of US cryptocurrency regulation, the answer at the time this glossary entry was published has not been officially resolved for all coins and tokens. However, unofficially, the current answer is “it depends.”

Regulatory uncertainty, both in the US and internationally, is one of several barriers to enterprise adoption of Distributed Ledger Technology (DLT). New laws and regulations are inevitable. Some of them pertain to protecting retail investors from scams while others involve the tax implications relating to organizations that keep cryptocurrency in their reserves and the degree to which that cryptocurrency experiences any volatility in value relative to a fiat currency like the US dollar. When enterprises must operate in a highly regulated environment where the laws and regulations are well known, then they also understand what the operating parameters are and where guardrails exist. However, knowing that future laws and regulations are in the works while not knowing the final content of those laws and regulations makes it harder for risk managers to plot a safe course of action.

Not surprisingly, for enterprises that prefer not to wait to adopt DLT and cryptocurrency in order to gain competitive advantage in their markets, the uncertainty is uncomfortable. Thus, it’s advisable to develop some Howey Test fluency, if only to assist in DLT/crypto strategy planning.

Origin of the Howey Test

William John Howey was a citrus grower in Florida. He owned large tracts of cropland and wanted to increase his monetization of this asset. So, Howey founded a service company, Howey-in-the-Hills, Inc., which retained ownership of half of the citrus groves. The other half was divided into parcels and sold via real estate contracts to generate cash. Purchasers, most of whom had no experience in agriculture and were merely speculating for profit, were persuaded to lease their parcels back to Howey-in-the-Hills, which would then manage the land, harvest the crops and share the profits. Unfortunately, Howey did not register these offerings as securities with the US Securities and Exchange Commission (SEC). Consequently, the regulatory body determined that Howey’s contracts and leaseback arrangements were, in fact, unregistered securities, and the case ultimately went before the US Supreme Court.

The fundamental question in the case was whether Howey’s offerings constituted an “investment contract.” In 1946, the Supreme Court concluded: “An investment contract for purposes of the Securities Act of 1933 means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”

The Supreme Court’s smackdown led to what is commonly called the Howey Test. Expressed simply, if something is an investment contract, it’s a security. How do you know if it’s an investment contract? You run it through the Howey Test and see if it meets four essential criteria:

Relevance of the Howey Test to Cryptocurrency

Referring back to the aforementioned billion-dollar question as to whether a given token or coin passes the Howey Test, one of the main reasons for applying the Howey Test to cryptocurrency is to determine if a coin or token should be considered a security or a commodity. If a cryptocurrency passes the Howey Test and is therefore considered by lawmakers and regulators to be a security, that cryptocurrency would not only be subject to different laws and regulations compared a cryptocurrency that was determined to be a commodity, the rules for taxation would likely be different as well. The business officers such as the CFO and corporate attorneys who are in charge of risk management would want to know whether their organization’s cryptocurrencies are considered by lawmakers and regulators to be securities or commodities.

As an example, what if Bitcoin were put to the Howey Test? Let’s see how Blockchain Journal would answer the four provisions:

Another important outcome of the Howey Test pertains to which US government agency has jurisdiction when it comes to writing and enforcing regulations. If the Howey Test is passed and the cryptocurrency in question is determined to be a security, the SEC has jurisdiction. However, if the Howey Test isn’t satisfied and the cryptocurrency is determined to be a commodity, then the US Commodities Futures Trading Commission (CFTC) has jurisdiction.