The Howey test is a legal standard utilized in the United States to determine whether a transaction qualifies as an investment contract and is therefore considered a security under federal law. In SEC v. W.J. Howey Co. (1946), the U.S. Supreme Court established the test, which has subsequently been used in various cases to determine whether a range of financial arrangements and offerings are classified as securities, subject to federal securities laws and regulations.
According to the Howey test, a transaction must involve an investment of funds in a common enterprise, with profits generated solely from the efforts of others, in order to qualify as a security. If these conditions are met, the transaction is subject to federal securities laws and regulations.
The test involves three key criteria that must be satisfied in order for a transaction to be considered a security. The first requirement is a financial investment, which means that individuals participating in the transaction must be risking their own money, either through financial investments or investments in kind.
The second criterion is a common enterprise, which indicates that the financial success of investors is somehow linked. This can be demonstrated by showing that investors are pooling their resources or relying on a third party to manage their investments.
The third and final criterion is an expectation of profits generated solely from the efforts of others. This means that investors are relying on someone else to generate a return on their investment, whether through profits generated by a third-party manager or profits generated by a particular group or organization.
The Howey test’s impact on cryptocurrency is significant, as it offers a guideline for determining whether a particular cryptocurrency offering should be classified as a security under U.S. law. If a cryptocurrency offering meets the Howey test criteria, it may be considered a security and subject to federal securities laws, which can lead to penalties, legal action, and harm to the business’s reputation if not complied with.
To ensure compliance with federal securities laws, cryptocurrency companies must carefully consider the Howey test before creating their offerings. Tokens that fail the Howey test are classified as utility tokens, which provide investors with access to a future product or service or can be redeemed for discounted fees. While utility tokens are generally not considered securities, the Securities and Exchange Commission (SEC) has suggested that the presence of a utility token framework does not necessarily exempt a project from being classified as a security.
Ultimately, the impact of the Howey test on cryptocurrency depends on how regulators apply the test in practice and how cryptocurrency companies structure their offerings to comply with federal securities law.