What the Howey Test Is, and How It Will Help Regulate ICOs

If cryptocurrencies are already becoming the subject of legislative changes in the field of taxation (in particular, in the US and Germany), the tokens issued during the ICOs are in the sights of the SEC but are still far from obeying any single set of rules. And the main question that needs to be determined is whether tokens are securities. If the response is positive, the lack of appropriate clearance when issuing tokens means there is a serious violation of the law, and this will result in a number of measures on the part of the Commission.

In 2016, the Coinbase exchange published in its official blog a document called the A Securities Law Framework for Blockchain Tokens, compiled together with Coin Center, Union Square Ventures, and Consensys. In it, companies apply to courtroom practice on securities and, above all, the so-called Howey test.

The test was introduced into the economic and legal field in the course of the SEC v. Howey precedent-setting case in 1946. In June 1945, Howey Company, a Florida farm that cultivated citrus in Lake County, decided to lease half of its land to “finance additional development.” Thus, buyers “who did not have the knowledge, skills, and equipment necessary to grow citrus fruits” became nominal landowners. By signing a ten-year service contract and “expecting that they will make a profit solely through the efforts of professional farmers,” buyers of citrus acres were in the gray area of ​​investment contracts.

Since Howey Co. had not registered those deals with the Securities and Exchange Commission (SEC), it was found that the company violated the federal securities law of 1933, and it was sent a legal injunction on the further sale of contracts. Howey Co. appealed to the District Court of the Southern District of Florida, and the ban on the sale of contracts was canceled. In May 1946, however, the case was referred to the US Supreme Court, which upheld the SEC’s decision recognizing that Howey’s contracts were investments in nature and therefore should have been regulated in accordance with the Securities Act. Judge Murphy, reading the verdict, ruled “The respondent company offers something more than free land ownership, something other than a farm or a garden with management services. They offer the opportunity to invest money and share the income of a huge citrus production enterprise under the management and partial ownership of the defendants. Thus, all the characteristics of a commercial business are presented here.”

The SEC v. Howey Co. case laid the ground for further regulation of securities by the SEC. The court decision introduced the Howey test, which provides simple criteria for determining whether an investment agreement is present in the transaction and, accordingly, whether the transaction falls within the jurisdiction of the SEC. As Judge Murphy decreed, the decisive criterion for determining an investment contract is the fact of “investing in a common enterprise in which income is provided solely by the efforts of others.” That is, the transaction includes securities, if its value for one party depends on the work of the other, or, in other words, if the investor has a “passive interest.”

By transferring the Howey test to blockchain tokens, the Coinbase document introduces three key elements to determine whether a token is a security:

—the presence of the fact of investing funds;

—whether the fate of the investment depends on the investors or the actions of other parties;

—expectation of profit as a result of the activities of others.

Each element includes several characteristics, for which correspondence points are awarded. The more points (that is, the higher the probability that all three elements are executed for a token), the more the token corresponds to the definition of a security. Coinbase also provides guidance on creating tokens that will not be securities and can be viewed as a simple contract that is identical to a franchise agreement. In this case, the holder of the token has the right to “contribute to the project,” and not merely have “passive investment interest.”

The specific rights that can be assigned to the token so that it does not fall under the definition of securities include “the right to program, develop, or create sets of functions for the system,” “the right to connect to the system or grant a license to the system,” “the right to the use of the system or the results of its work,” “the right to sell products created by the system,” and “the right to vote on expanding or reducing the characteristics and functionality of the system.”

Thus, the SEC investigation into ICO projects, details of which surfaced the other day, will certainly include the Howey test.

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