The Howey test: How a 70-year-old case can influence the future of crypto?

Author: Abdul Kareem Dabbashi

Cryptocurrencies are simply a form of digital currencies that use encryption techniques in order to secure and document financial transactions. They gained a lot of popularity in recent years and many people are entertaining the possibility that they can be a potential alternative to fiat money. However, cryptocurrencies have sparked heated debates and divided opinions, and governments with their various regulatory agencies are struggling to come up with clear guidelines that facilitates how to deal with this technology.

In this piece, we delve into a historic case from the heart of America in the mid-20th century, predating the invention of any digital encryption, and how this case gave birth to a test that will continue to play a crucial role in determining the fate of cryptocurrencies after decades.

The reasoning behind the name of the test goes back to 1946, when the Securities and Exchange Commission (SEC) filed a lawsuit against W.J.HOWEY Corporation and the service company Howey-in-the-hills.

The SEC holds the crucial responsibility of overseeing and regulating the sale of various securities to American citizens. Its objective is to enforce compliance with US laws and regulations, and safeguard the interests of investors who may possess limited information on instances of manipulation and fraud.

The Story of Howey

Howey Companies was one of the firms that owned vast tracts of land cultivated with citrus trees in Florida. Some of these lands were put up for sale, but as an additional option, the company offered to lease back the lands from buyers with a contract for cultivating, marketing and remitting the net proceeds to the investors without requiring any effort from them.

The SEC noticed the services of Howey companies and filed a lawsuit against them in the Supreme Court, alleging that the activities of these companies are considered to be an “investment contract”, which can be defined as a legal agreement between two parties whereby one party provides funds to the other in exchange for the opportunity to receive a profit or yield, and thus is classified as a type of securities (which also includes stocks, bonds, and cash instruments) and requires the approval and regulation by the SEC.

From orange to crypto

In the Howey case, the SEC argued that most clients were not buying land for the sole purpose of owning the fields, which is a commodity (like real estate and gold), and it is regulated by the CFTC, but rather they were buying 1) an investment 2) in a common enterprise where the 3 ) expectations to make profits 4) relies on the efforts of a Promoter or any third party.

The case took place eight years after William Howey’s death, and while its fallout was in favor of the SEC by a Supreme Court decision, it was insignificant in comparison to the true outcome. The four-numbered prongs mentioned above formed the basis for the Howey Test, which has been used frequently to determine what a financial asset is. So, despite losing the case, our friend Howey was honored by having an important test named after him!

Now let’s dive into the test prongs and how they correspond with each other:

An investment of money

This means that the person providing money expects to get something back in return, he uses the money to buy an asset or a financial liability. For example, when you buy stocks in a specific company, you are basically giving the company money in exchange for your acquisition of the share.

In a common enterprise

That is, the investment takes place in an enterprise that includes several parties that consider themselves to be one entity, sharing the investors’ money, profits and losses. Although the term “common enterprise” was never explicitly defined by the Supreme Courts, there is a common three-prong test to determine its qualification:

  1. The employees must be working on the same project
  2. To work on similar or common activities
  3. To be exposed to the same risks

With expectations of a profit

This part of the test looks at an investor’s motivation for buying an asset. Are they carrying out a deal with the intention of making a profit? or are they, for example, trying to store wealth?

To be derived from the efforts of others

This prong is set to separate investors from the third party. If the investor had a considerable influence over the success of the investment, the likelihood of it classifying as investment is highly reduced.

It’s a strange phenomenon, to say the least, when a cryptocurrency project goes out of its way to dodge the Howey Test. Despite the fact that passing any test in general should be a triumphant accomplishment in the eyes of many, crypto projects and their communities have put up a formidable fight in order to fail it. And if all the prongs of the Howey Test are indeed met, then the SEC will be happy to step in and add their regulation to the mix. But the million-dollar question remains: Why go to such lengths to avoid the regulation process?

Here are some reasons that can help you understand why so many cryptocurrency projects try to avoid being regulated by the SEC:

Cost: The registration process with the Securities and Exchange Commission can be both financially costly and time-consuming, which hinders the progress of well-known cryptocurrency projects and does not fit the budget of emerging projects.

Regulation: Cryptocurrencies may hesitate to register with the SEC due to the regulatory requirements that come with being classified as securities. These requirements can include additional financial disclosure obligations and restrictions, as well as many limitations on how these currencies can be traded and promoted.

Ambiguity: The regulatory approach towards cryptocurrencies today is not well-defined, causing some projects to hold off on registering with the SEC until there is more certainty about how these assets will be dealt with.

Decentralization: A hallmark of many cryptocurrencies is their decentralized nature, meaning that they operate independently of any central authority. This characteristic can present a challenge for these projects to comply with financial securities regulations as there is no single entity in charge of overseeing these assets.

Balancing the Pros and Cons

As with most things in life, regulation can have both positive and negative effects on the crypto industry. On one hand, overly stringent rules can inhibit progress and throws creativity out of the window, while on the other, a lack of oversight can result in malpractice and abuse of the system.

The world of cryptocurrencies is still in its infancy, and navigating its intricacies can be challenging. Adding more involvement from financial securities regulators may only add to the complexity, potentially deterring new participants and startups from entering the field.

It is worth mentioning the claims of some people that the SEC is biased against cryptocurrencies due to potential conflicts of interest.

As a governmental organization, the SEC is vulnerable to political influences and this may impact its decision-making process, particularly regarding cryptocurrencies that operate on principles at odds with the prevailing centralized financial system.

Some people argue that the Howey Test is “too broad” and fails to consider the distinct features of cryptocurrencies. On the other hand, others stress the significance of this evaluation and other regulatory measures in safeguarding individuals from potential unmeasured risks and deceptive investments.

Just like how citrus trees grow in warm and sunny climates, cryptocurrencies “grow” in the virtual world, on decentralized networks and servers. Investing in either can result in a financial loss and requires a considerable amount of knowledge, experience (and even luck) to succeed.

In conclusion, the decision to use the Howey test or any other potential mechanism after studying their compatibility with the field will be the responsibility of the courts and legislative authorities, but finding the right balance between regulation and innovation will be crucial for the growth and sustainability of the crypto industry.

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