By: Steve Masur
Corporate and securities lawyers utilize the Howey test to determine whether a transaction is an “investment contract,” or more simply whether it involves offering a security, and therefore is subject to certain reporting and disclosure requirements. A transaction will be considered an offering of securities if:
- It is a contract or transaction for an investment of money,
- The investment of money is in “a common enterprise,”
- The investor has an expectation of profits from its investment, and
- Those profits would come from the efforts of others, such as a promoter.
The Supreme Court’s test in SEC v. Howey was deliberately written to accommodate undefined or “nontraditional” securities categories, such as those that might be more variable in nature and require further analysis to determine whether they are, in fact, securities offerings. This is evident by the broad definition of “investment contract” applied when courts evaluate the would-be security and would include a “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” Golden v. Garafolo, 678 F.2d 1139, 1144 (2d. Cir. 1982).
Generally, state courts will apply the Howey test in conjunction with other analyses under their respective state securities law (often known as “Blue Sky laws”), such as the risk capital test or the Reves or family resemblance test to determine whether an investment contract is a security. The analysis that the states use to determine a securities offering is subject to statutory law and is at the discretion of state courts.
If a transaction constitutes a securities offering, both federal and state securities laws require that the issuer disclose material information about the company, its principals, and the investment opportunity, including the risks of the investment, such that a reasonable person could make an informed investment decision. Many types of securities and transactions are exempt from registration and heavy disclosure requirements, most commonly under Regulation D, Regulation Crowdfunding, Regulation A. These require limited filings to the Securities and Exchange Commission and supplements under state Blue Sky laws. Many of our clients opt for this route because it’s decidedly less burdensome than full-on registration and sufficiently risk averse than non-compliance.
The Howey Test as Applied to Cryptocurrency Offerings
While cyrptocurrency become more mainstream and accepted as rapidly as the valuations change, so too are the laws and regulation surrounding them. Rob Griffitts recently published his first in a series of posts on U.S. regulations that impact cryptocurrency businesses titled US Regulators & Your Cryptocurrency: It’s Complicated.
Many cryptocurrency promoters have recently attempted to design their digital token offerings to fail one or more of the Howey test prongs and thus avoid federal securities registration, and the high legal and accounting fees that come with it. For example, if the promoter can show that the digital token being offered has uses other than solely to be traded for economic gain, which would be referred to as a “utility token,” it is possible the token won’t be classified as a security―though many of these offerors knows buyers are likely to trade the token for other cryptocurrencies for the purpose of speculative gain. These tokens are usually offered through TGEs (token generation events) or TDEs (token distribution events) as opposed to ICOs to further distinguish them from securities.
The Supreme Court purposely designed the Howey test to be pliable and dynamic enough to be applied to unchartered types of offerings. The SEC is under a lot of pressure to set clear policies for how to deal with these new tradable asset classes. But ultimately, it will not shy way from applying the test broadly, wherever it sees the possibility of fraudulent activity or actual fraud, which can lead to suspension from trading securities, heavy fines, and imprisonment. Once you have made your offering out there in the public, it cannot be taken back. As a result, when applying the Howey test to your cryptocurrency offering, it is best to think of the prongs broadly from the perspective of a prosecutor trying to make them fit your offering, not from a perspective that hopes that by failing one prong, your token will not be considered a security. The SEC will not shy away from applying the test broadly, wherever it sees the possibility of fraudulent activity, or actual fraud, which can lead to suspension from trading securities and heavy fines and imprisonment. As a result, when applying the Howey test to your cryptocurrency offering, it is best to think of the prongs from the perspective of someone trying to make them fit, not from a perspective that hopes for the best. SEC Halts Munchee ICO
*We would like to thank Daniel O’Neill for his contribution to this article.