What is the Howey Test?

Regulatory

What is the Howey Test?

The popularity of initial coin offerings (ICOs) has brought the Howey Test back into the spotlight. The test, which was first outlined in a 1946 Supreme Court ruling, is one of the most important factors — if not the most important —  in determining the status of a token offering. Classification as a security token makes issuers of such tokens liable for additional responsibilities, such as maintaining a white list of accredited investors and filing regular disclosures with the SEC.

The origin of the namesake

In 1945, businessman William John Howey attempted to sell parcels of land, constituting approximately half of an orange grove estate he owned in Florida, to investors. He also owned W.J. Howey Co., which made the sale. Howey offered the option for investors to lease the land back to Howey-in-the-Hills Co., a maintenance and service company also owned by him, which would be responsible for taking care of the land and marketing its product. Investors would not receive ownership or equity in the company from the arrangement. The idea was to have a source of recurring profits for investors through the efforts of the service company.

Investors could choose other companies to lease their share of the land, but Howey marketed his own agency heavily in the promotional material and also pointed out the benefits and convenience of keeping the land in his stable of companies. He also promised profits to those who invested in the venture in marketing materials.

The SEC got wind of Howey’s venture and filed a suit against it, seeking an injunction against an unrestricted sale of securities. But Howey argued that he was selling real estate and not securities. He claimed that he did not offer share certificates or equity in his companies in the venture and, therefore, the sale was not one of securities. The case went all the way to the Supreme Court, which delivered a judgement defining the four prongs used to determine whether a given offering is a security or not.

The Supreme Court’s decision

In its ruling, the Supreme Court stated that “form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” In other words, the economic reality of Howey’s business proposition was that it promised profits to investors from their funding of the venture. The court used this reasoning to derive the four criteria used to determine whether a given offering is a sale of a security or not.

The four criteria are: The existence of an investment contract, the formation of a common enterprise, an expectation of profits by investors and the efforts of a third party or promoter to generate said profits.

Why ICO investors should care about the Howey Test

The Howey Test is among the most important determinants of a token’s status, but the SEC has not provided clarity or guidelines on how it intends to apply the test to evaluate token offerings. It has cited the test on numerous occasions in discussions about initial coin offerings. For example, SEC commissioner William Hinman dissected the test in a speech last year to clear Ethereum’s Ether of security status, claiming the cryptocurrency’s network had become sufficiently decentralized to be exempt

Similarly, the federal agency has used the test to seek out injunctions or halt offerings that it suspects are breaking existing securities laws. The SEC halted online restaurant network Munchee’s offering, among numerous others, because the founder had promoted it as a profit-making venture to investors.  

An absence of clarity on applications of the Howey Test from the SEC introduces a massive regulatory risk for entrepreneurs. It leaves open the possibility that the SEC could swoop down on offerings even after they have raised a substantial amount. Consider the closure of Basis — a much-hyped stablecoin project which attracted funding from a bevy of venture capitalists: The startup raised $133 million from investors before it was forced to shut down after negotiations with the SEC regarding the status of Basiscoin.

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