Key points
- For decades, regulators have used the Howey test to determine whether assets are securities.
- Many in the crypto community argue the framework should not be applied to blockchain-based assets.
- Current SEC chair Gary Gensler treats cryptocurrencies as securities.
What is the Howey test?
The Howey test is a set of criteria used to determine whether an asset bears the hallmarks of a security and constitutes an “investment contract.”
The tool can also be applied to projects, commercial deals and other transactions.
According to the Howey test, an investment contract exists when there is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
The SEC believes that some cryptoassets and most ICO may qualify as investment contracts.
Where did the Howey test come from?
The Howey test was developed and first applied in 1946. It arose from an SEC case against Florida firms W.J. Howey Co. and Howey-in-the-Hills Service.
The companies sold plots in a citrus grove to the public. Investors agreed to lease the plots back to the firms. As a result, W.J. Howey Co. could cultivate and harvest crops on land it did not own, handle marketing and share proceeds from sales with stakeholders. Most buyers had no farming experience and did not plan to learn.
The U.S. Supreme Court concluded that the plots were, in substance, an unregistered securities offering. Under the law, the deals bore the characteristics of an investment contract: participants only had to contribute funds to receive a passive income stream.
The SEC v. W.J. Howey Co. case yielded four criteria that became the core of the Howey test:
- An investment of funds (in any form: cash, checks and, later, cryptoassets).
- An investment of capital in a common enterprise.
- Investors’ reasonable expectation of profit.
- Profits derived from the efforts of others.
The approach stuck, and the Howey criteria have since been used to assess whether various assets are securities.
Why does the SEC apply the Howey test to cryptocurrencies?
As the crypto market grew — especially after the initial coin offerings boom of 2017–2018 — regulators worldwide asked whether these new assets were securities. In some cases, the U.S. SEC applies the Howey test for this purpose.
The Securities and Exchange Commission has issued guidance on using this framework for cryptocurrencies and other blockchain-based assets.
“The term ‘security’ includes an ‘investment contract,’ as well as other instruments such as stocks, bonds, and transferable shares [in companies]. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of a security under federal law,” the SEC document says.
One prominent application of the Howey test in crypto was the Telegram token sale. The TON project raised $1.7bn by selling Gram tokens to qualified investors in the U.S. and abroad, but never launched due to a clash with the SEC.
Another example is the SEC’s lawsuit against Ripple, filed in 2020. The regulator accused the company of distributing unregistered securities worth about $1.3bn via the platform’s native tokens.
After years of litigation, the case took a turn that surprised many in crypto. On July 13, 2023, the Southern District of New York held that Ripple’s programmatic sales and other distributions of XRP did not constitute the offer and sale of investment contracts.
In June, the SEC sued the exchange Binance and its CEO Changpeng Zhao, as well as the U.S. company Coinbase. In both cases, the claims concern unregistered token offerings and yield-generating services.
Current SEC chair Gary Gensler is adamant that cryptocurrencies are investment contracts. Therefore, platforms responsible for issuing coins must register with the SEC.
Given America’s sway over the industry, crypto projects have to reckon with the Howey test. Many present their digital assets as governance tokens (governance tokens) because they are used for voting within DAOs. Yet legal uncertainty means many projects — and their assets — could still attract regulatory scrutiny.
Why doesn’t the SEC treat bitcoin as a security?
In June 2018, then-SEC chair Jay Clayton said bitcoin is not an “investment contract.”
“Cryptocurrencies are substitutes for sovereign currencies. Bitcoin may replace the dollar, the euro, the yen. This type of currency is not a security,” he said.
Clayton said tokens can be considered securities because they serve as digital assets, a sphere overseen by the U.S. regulator.
“If I give you money and you create a business and give me the right to a share of the joint equity, then we are talking about securities. The Commission regulates the offering of such securities and trading in them,” he commented.
Also in the summer of 2018, SEC Director of Corporate Finance William Hinman said bitcoin and Ethereum display more of the characteristics of commodities, implying the jurisdiction of the U.S. Commodity Futures Trading Commission (CFTC).
“If a cryptocurrency’s network is sufficiently decentralized, and purchasers are not relying on a third party to manage it, the coin is not a security,” he stressed.
What are the shortcomings of the Howey test?
In practice, a framework from the first half of the last century does not capture the specifics of cryptocurrencies.
SEC Commissioner Hester Peirce has argued as much. She noted that many startups raised funding on the promise of building a network — grounds for classifying issued tokens as “investment contracts” under Howey.
In Peirce’s view, the existence of an investment contract depends not only on the asset but also on the promises associated with it. The two elements are not the same, she said.
“The fact that I sold you an orange grove under an investment contract does not turn it into a security. The orange grove plus promises about how I am going to tend it and bring you profit — that is what constitutes a securities offering,” Peirce explained.
She believes the Howey test alone cannot definitively determine whether a cryptocurrency is an investment contract without examining the distribution process, where such features may appear.