The Howey Test: Securities and Cryptocurrencies
Author: Sidney Williams
Date of Publication: 05/12/2022
The Howey Test
The Howey Test is a legal test to assess whether certain transactions are investment contracts. If a transaction is an investment contract, it can be considered a security by the SEC. In fact it is subject to specific disclosure and registration obligations under federal securities laws.
The test got its name after the 1946 Supreme Court decision in SEC v. W. J. Howey Co., 328 U.S. 293 (1946). So, in this the Court defined an investment contract. Since then, courts throughout the United States have employed the Howey Test. This aimed to evaluate whether a specific transaction qualifies as an investment contract. If so, it would then be handled as a security.
In fact, the Securities and Exchange Commission (SEC) has long used the Howey test. In its most basic form, the Howey test requires that a transaction involve the following:
an investment of money
in a common enterprise
with an expectation of profits predominantly from the efforts of others
Cryptocurrencies, digital or virtual tokens that use cryptography for security, have garnered much attention recently for their potential to take on fiat currencies. Their legal classification, however, has been unclear. For example, in the United States, the Securities and Exchange Commission (SEC) has been struggling to determine whether cryptocurrencies are securities. On June 14 in 2018, the SEC finally released its long-awaited report on The DAO, a decentralised autonomous organisation that had raised over $150 million in a token sale. The SEC’s report stated that cryptocurrencies can be securities and that The DAO was an illegal security offering.
Actually, the digital asset space is emerging and constantly changing. A digital asset is a unit of value created and managed by its creators that may be exchanged on an online marketplace. As a result, they are subject to the same rules as conventional securities. However, in many places, the legitimacy of digital assets is still being contested. Digital assets are frequently regarded as securities. This is primarily due to the fact that digital assets are frequently used to raise finance for a company. According to the Securities and Exchange Commission (SEC), digital assets may constitute securities. As a result, digital assets could be subject to federal securities regulations.
Moreover, regulatory agencies are struggling to adapt to the rise in digital assets. These agencies must answer the question of whether digital assets should be seen as securities. Yet the majority of digital assets are currently not registered with the SEC, which raises the question of whether the SEC has the authority to regulate digital assets.
One company that the SEC has been investigating is Ripple, the company behind the cryptocurrency XRP. Ripple is facing a lawsuit from the SEC which alleges that it violated securities laws by selling $1.3 billion worth of XRP tokens. The SEC is seeking to determine whether Ripple’s XRP token is a security. So, the outcome of this case will likely have a significant impact on the cryptocurrency industry as a whole.
Furthermore, the SEC settles the majority of its lawsuits rather than going to trial. Individual cryptocurrency enterprises must comply with SEC orders and pay penalties in order to be released. Ripple, unlike many others, went all the way and participated in a legal brawl.
Ripple has particularly referenced some of the SEC members' connections to other crypto platforms, specifically Ethereum. While there is no proof of these connections at this time, the commission gave Ethereum a pass on securities legislation. They claim that it operates in a decentralised manner while using XRP. This seems very fishy.
As a result, Ripple perceived the SEC as prejudiced in its application of the security concept to virtual currencies such as XRP. However, Ripple's lawyers stated that the SEC never warned or notified the company. Also, Ripple wasn’t advised that XRP could be categorised as a security, according to the US regulator.
It is still unclear who will end up winning. For now, the assumption is that the final date will be somewhere in March 2023. The thing that matters is that the results will affect the crypto market in one way or the other. Therefore, for the benefit of the whole crypto industry, it is important for Ripple to get away with a win.