What do Bitcoins have in common with Florida oranges?
This isn’t the setup to terrible joke, it’s an introduction to the Howey Test, a legal tool developed by the Supreme Court in 1946 to identify investment contracts and securities. The relevance of nine old men arguing about oranges during the gold standard may seem trivial, but for budding cryptocurrency businesses, your understanding of the Howey Test can make or break your currency or exchange.
An Initial Coin Offering (ICO) occurs when a new cryptocurrency is offered for sale to the public, similar to an initial public offering (IPO) in the stock market. According to regulators, the issuance of some cryptocurrencies constitutes the issuance of securities, while in other cases it does not. Classification as a security brings significant regulation and burdensome reporting requirements. Unfortunately, there is no straightforward answer whether any individual cryptocurrency is a security; every cryptocurrency token/coin has its own unique attributes. To answer this question, we must turn to the Howey Test.
History of the Howey Test Case
The Howey Test was created by the Supreme Court in a landmark 1946 case, SEC v. Howey Co., and, while it was about orange farming, it provides a basis for regulating blockchain tokens. This case is the leading case on the definition of an investment contract: “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
The Howey Company, a vast citrus farm in Florida’s southern Lake County, leased half of its property to finance more development. The company, in selling several hundred acres of land to businessmen who were interested in the future expectations of profits, began a specific enterprise between two entities. There was now one party that provides the work, the farming, and another that supplies the capital, via a lease contract. The businessmen became the nominal landowners, regardless of any farming abilities. The Howey Company offered buyers the option of leasing any purchased land back to them, for skilled labor on the land and marketing of the fruit. Since most buyers did not have agricultural skills, they promptly leased the land back to the company. The service contract granted full right of possession to the company and the investor would get an account for the produce yielded by the parcel they invested in, but the fruit was marketed exclusively by the company.
The issue was that in the service contracts and leasing the land back to the Howey Company, the land became an instrument of investment, entering the territory of investment contracts. Although the Howey Company utilized various agencies of interstate commerce, it did not register the contracts and securities with the SEC. The SEC brought action seeking an injunction against the use of interstate commerce on the grounds that Howey established sales of unregistered securities, violating § 5(a) of Securities Act of 1933. The key issue in the Howey case is: “Is the term security referencing any document(s) that provide evidence of a monetary investment in a common enterprise whose profits come only through the labors of others?”
The court determined that as defined by § 2(a)(1) of the Act, a “security” includes the documents traded for investment or conjecture, having substance over form, regulating the type of a specific document or agreement. In essence, Howey proposed an agreement to invest money and obtain a portion of the profits of a large-scale citrus farm operation; therefore the documents in this case are representative of shares in the company. The court found that it was obvious that investors were buying into the agreement in order to receive a larger payout in the future, without having to do any work; this mirrors the sale of stock.
Resulting from this case, the Supreme Court developed its test for determining whether certain transactions are investment contracts, and therefore subject to the securities registration requirements. The determining contingency is whether “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” When the value of one’s transaction centers on another’s work, a security has been sold.
Under the Howey Test, a transaction is an investment contract if:
- It is an investment of money (can also be investments of assets other than money);
- There is an expectation of profits from the investment;
- The investment of money is in a common enterprise; and
- Any profit comes from the effort of a promoter or third party
Although it is not precisely defined, most federal courts define the term “common enterprise” as one that is horizontal, meaning investors pool their money or assets together in an investment project. Point four involves whether any profit that comes from the investment is largely outside of the investor’s control. If the investor’s personal actions have sincere influence on whether an investment will be profitable, then the investment is likely not a security. Courts will look at the economic realities behind an investment scheme, rather than just the name and form, to make the determination if it is a security.
An investment opportunity that is open to many people, where investors have little to no control or management of investment money or assets, is very likely to be classified as a security. An investment that is made available to a small number of close friends or associates, where these investors have significant influence over how the investment is managed, is very likely not going to fall into the classification a security.
In a nutshell, after the recent SEC report, investing money (including cryptocurrencies) in a token with an expectation of profit, that comes directly from the managerial efforts of other people, leads to a cryptocurrency being classified as a security and will be required to be regulated as such. Newcomers to market must be vigilant, as the SEC report was a caution to the industry and market participants. The SEC has turned its focus to the new participants in this market, with The Howey Test as the starting point criteria. The Howey Test is a key component of any legal diligence on cryptocurrency. In evaluating blockchain companies that issue their own cryptocurrencies, check the characteristics against the Howey Test.