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The Howey Test is a critical concept in the worlds of cryptocurrency and finance. It is a legal test used to establish whether or not a transaction is an investment contract. In other words, the Howey Test assists in determining whether a transaction is a security or not.
The Howey Test, which was established in the famous 1946 Supreme Court case SEC v. Howey, is used by the Securities and Exchange Commission (SEC) to evaluate whether an arrangement qualifies as a “security” under federal law. Since then, the Howey Test has become a de facto standard for deciding whether a wide range of investments, activities, and transactions are securities.
The main objective of Howey Test is to ensure that investors are protected from fraudulent investments and properly regulate the investment instruments.
What is Security?
Investopedia defines “security” as a fungible, negotiable financial instrument that holds some type of monetary value.
A security contract is an investment agreement between two or more parties. It reflects a claim on the issuer’s assets and is typically supported by some type of collateral.
There are primarily three types of securities:
Equity—> Provides ownership rights to holders
Debt—> Borrowed money that needs to be repaid
Hybrids—> Combination of debt and equity ( Preference shares, Convertible bonds, etc.)
Different Features of Securities that Meet the Howey Test Requirements
The court observed in the Howey vs. SEC case (1946), that the Plaintiff’s sale of land and agricultural services comprises an “investment contract” while there was no involvement of a stock or bond.
This judgment established the four-prong Howey Test. It clearly defines that an investment can be regulated as a security if:
- There must be an investment of money
- The investment of money must be in a common enterprise
- There must be an expectation of profits from the investment
- Any profit must be derived from the efforts of a promoter or third party
The Howey test formalized the way for classification as a security which means any type of investment offering can be regarded as a security and its identification depends solely on the nature of the transaction.
Guidelines for Crypto Projects to Pass Compliance Checks
The Howey Test is an important tool for crypto projects to ensure they are compliant with the law. It is a test used by the US SEC to determine whether or not a particular asset is a security. In order to ensure compliance checks, the project must comply with certain regulations. Here are the general guidelines for crypto projects to follow:
1. On the high level, there must not an investment of money without registration and disclosure requirements
But we do know that crypto projects like Ethereum raised millions of dollars. Then, why was it an exemption?
As per this paper, SEC on this matter stated that if a blockchain project is sufficiently decentralized, the crypto asset associated with the project will not be regarded or represent an “investment contract” under the Howey test.
Interpretation of this statement indicates that if a project is not sufficiently decentralized, it may fall under the purview of the Howey test. So, community enablement is the key to raising money via token, without it being regarded as a security.
2. There must not be an expectation of profits
The project must not offer tokens to investors with the reasonable expectation of profits from their investment. Ethereum is a community-run technology and the tokens have the core utility of managing the economics of the on-chain operations.
3. The profits must be generated from the efforts of others
Providing money to someone to build their project/business and enjoying the profits from it would consider the tokens as security.
4. It cannot be a speculative business
To pass the Howey Test compliance checks, the project must not be purely speculative and must have some sort of inherent value.
By adhering to these recommendations, crypto projects can make sure they are in compliance with all relevant laws and regulations and can pass Howey Test compliance checks.
Conclusion
The Howey test is crucial for any cryptocurrency project since it might have significant legal repercussions if the project is determined to be a security, as in the current SEC action against Ripple.
Crypto projects may make sure that they are in conformity with the law and steer well clear of any potential concerns by having proper understanding of the Howey Test and its implementation.
By knowing how it works and how it can be applied in various instances, crypto projects can ensure that they are functioning within the bounds of the law and avoiding any potential complications down the road.
