What is the Howey test?
The Howey test is a legal test used in the United States to determine whether a transaction qualifies as an investment contract and is therefore considered a security under federal law. The test was established by the US Supreme Court in SEC v. WJ Howey Co. (1946), and has since been applied in numerous cases to determine whether various financial arrangements and offers constitute securities.
According to the Howey test, a transaction must contain an investment of funds in a group enterprise with the expectation that all profits will come from group efforts. A transaction is considered a security if it meets these requirements, in which case it is subject to federal securities laws and regulations.
Understanding the criteria for a security
The test involves three key criteria that must be met for a transaction to qualify as a security, as discussed below:
The first criterion is a financial investment, which means that the participants in the transaction must risk their own money. This includes both financial and in-kind investments.
The second requirement is a joint venture, which denotes that the investors’ financial success is connected in some way. This can be proven by providing evidence of investor pooling of resources or trust in a third party to manage their investments.
The third criterion is an expectation of profit solely from the efforts of others, which means that investors trust someone else to generate a return on their investment. This could include, for example, profit generated by a third-party administrator or profit generated by the efforts of a particular group or organization.
Coincidence? On the same day as the Ethereum merger, SEC Chairman Gary Gensler says that proof-of-stake cryptocurrencies could be seen as a security under the Howey test. https://t.co/D24G9edoc7
— Cointelegraph (@Cointelegraph) September 16, 2022
Howey’s Test Implications for Cryptocurrencies: Is It a Security or Not?
The implications of the Howey test for cryptocurrencies are significant, as the test provides a framework for determining whether a particular cryptocurrency offering should be classified as a security under US law. If a cryptocurrency offering complies with criteria described in the Howey test, may be considered a security and subject to federal securities laws.
This has significant ramifications for crypto companies and investors, as breaking federal securities laws can lead to penalties, legal action, and damage to the company’s reputation. To ensure they comply with federal securities laws, cryptocurrency companies should carefully consider the Howey test before creating their offerings.
Related: Crypto and Securities: New Interpretation of the US Howey Test Gaining Ground
Tokens that do not pass the Howey test are considered utility tokens that give investors access to a future product or service or can be redeemed for discounted rates. While utility tokens are not generally considered securities, the SEC has suggested that the presence of a utility token framework does not necessarily mean that a project is exempt from being classified as a security.
Ultimately, the implications of the Howey test for cryptocurrencies will depend on how regulators choose to apply the test in practice and how cryptocurrency companies choose to structure their offerings to comply with federal securities law.
Compliance with Federal Securities Laws: What Cryptocurrency Firms Need to Know
Cryptocurrency companies must be aware of the federal securities laws in the United States to ensure compliance. Here are some key things to keep in mind:
- Securities Laws Apply to Cryptocurrencies: The Securities and Exchange Commission considers various cryptocurrencies to be securities. This implies that cryptocurrency companies must comply with federal securities laws, including registration and disclosure requirements.
- Token offerings may be subject to securities laws: It can count as a securities offering if a cryptocurrency company sells tokens to the general public in exchange for cash or other assets. As a result, the company would have to adhere to securities regulations, which would include filing the offering with the SEC.
- Use of funds must be disclosed: A cryptocurrency company must declare its financial goals when raising money through a security offering. The company must also keep investors informed about how the money is used.
- Trading Platforms May Be Subject to Securities Laws: Securities exchanges may include cryptocurrency trading platforms that allow users to buy and sell tokens. If so, the platform would have to file an SEC registration form and comply with other securities regulations.
- Penalties for non-compliance can be severe: Significant penalties can be imposed for non-compliance: A cryptocurrency corporation could incur serious consequences, such as fines and legal action, if it violates federal securities regulations.
Therefore, cryptocurrency companies must be aware of and comply with federal securities laws in the United States. This includes understanding whether your tokens are considered securities, disclosing the use of funds, and complying with registration and disclosure requirements.