What Is the Howey Test??

The Howey test is the test created by the United States Supreme Court for determining whether a transaction qualifies as an “investment contract”, and therefore is considered a security. It comes from a 1946 Supreme Court case, SEC v. W.J. Howey Co. Courts have used it to decide that gold bullion, pay phones, chinchillas, condominium units, prepaid phone cards and a whole slew of things were in fact securities.

The Howey Company sold parcels of citrus groves to prospective investors, who also entered into a service contract with the Howey Company to care for and harvest the citrus trees. In exchange, those who bought the parcels could get a share of the net income from the fruit that was sold. Investors had no right to use the land.

When the Securities and Exchange Commission sued the Howey Company, the Supreme Court held that the Howey Company was in fact selling a security. The real purpose of the scheme, said the Court, was to get a share of the income from the growing and selling of fruit, not to own or occupy the land. Those who bought into the scheme were expecting a profit from the efforts of the Howey Company. The Court described investments as plans to use other people’s money on a promise of profits.

Three-part Test

Later decisions refined the meaning of investment contract.

Courts have settled on a three-part test: (1) an investment of money (2) in a common enterprise (3) with expectation of profit solely through the efforts of others.

The Court of Appeals for the Second Circuit articulated this three-pronged version of the Howey test in Revak v. SEC Realty Corp. in 1994.

The DAO Report

In new, fast-moving markets like crypto, the SEC prosecutes bad behavior before all rules are clarified. Openly fraudulent coins multiplied and drew SEC enforcement actions. But a widespread consensus as to what the SEC might do with tokens of less sinister appearance has been difficult to arrive at. For harder cases, SEC prosecutors went slow and cautiously.

In time, the SEC began an investigation of the DAO. But the SEC declined to prosecute and instead issued a public Section 21(a) report of its findings in July 2017. A report like this makes findings public without a lawsuit, and the SEC sometimes issues one about a new issue or the first public pronouncement of a legal position.

The DAO report began by pointing out that the DAO was never formally incorporated. It was built to automate and ease cryptocurrency dealings. It did not register its tokens as securities. The tokens were being sold to investors as part of a package to provide the funds to build the DAO’s own blockchain (a computerized ledger). Running that system was supposed to produce returns for token holders. The SEC’s DAO report found that the returns depended on founders’ management, so the tokens were securities under Howey.

Applying the Test

At the extremes, applying the test is simple. On one end sits an asset created by a completely automated process, where no public capital is raised. Its value would come from its use or resale demand, not from any human managerial efforts. Bitcoin seems to fit this bill. Its blockchain and algorithm were built without money from future holders, and after launch the system ran by itself; new coins need no work by bitcoin’s creator. The general excitement about its use and the demand for bitcoin to accomplish that use is what gives bitcoin value, along with the hope that others will want to buy it. Therefore, it is not a security under Howey.

Other kinds of tokens are easy to see as security tokens. In some cases, someone launches a coin just to obtain money and the money goes nowhere, which is plain fraud. Perhaps the seller claims to be creating a business but never follows through on that, instead pocketing the cash. This would look a lot like stock or an interest in a legitimate business that someone else would run, and it is clearly a security. The SEC’s complaint in its FLiK case claimed that something like this was going on. The defendants had promised to build a streaming music service based on blockchain technology and sold tokens to raise money for it. The SEC claimed the money raised went toward the promoters’ personal expenses. The SEC filed its complaint in federal court in Georgia in September 2020.

However, none of these extreme cases are the subject of most controversy. Most of the harder cases fall between these two extremes. Two SEC cases have been followed most closely by crypto founders. One is the Kik Interactive case, decided by a federal court in New York in September 2020. The other is the suit the SEC filed against Ripple Labs in December 2020. Both cases center on the need to register a coin offering under securities law. Even the fact that the SEC is willing to bring cases like this sends a message and helps sharpen the law.