A closer look at the Howey Test, and what it might mean for your ICO ambitions

November 30, 2017

So you’re thinking of launching an ICO ?

Although the regulatory framework governing ICOs varies by country and is still emerging, the U.S. Government has indicated that it will apply the Howey Test in determining whether your token is a security or not. If your intent is to avoid running afoul of the U.S. Federal Securities Laws, you’ll probably want to determine with a reasonable degree of comfort whether they apply to your project.

A number of aspiring ICO issuers who have approached me say they’ll simply steer clear of U.S. investors in their coin offering in order to avoid problems. I typically urge them to reconsider because i) many developed countries may follow the U.S. government’s treatment of tokens, and ii) even the U.S. government’s reach can extend beyond its borders. Japan, for example, which is thus far succeeding in providing constructive regulation around cryptocurrency, is looking closely at the security aspect of token sales.

This post represents a gross oversimplification purely to explain some basic concepts of the U.S. government’s position on ICOs and should not be construed as legal advice.

First, it’s important to understand the jurisdiction of the U.S. Securities Exchange Commission (SEC). Simply speaking, the SEC’s remit of governance is limited to:

  1. Securities (i.e. if it’s not a security, it falls outside the SEC’s mandate)
  2. U.S. investors (though with some exceptions)

As a result, if your token qualifies as a security and is offered for sale to U.S. investors, your token sale will need to be registered as a security with the SEC, or obtain an exemption. Other developed countries of course provide different regulatory frameworks governing ICOs, if any — after all, these are still early days. Since many seem to be drawing inspiration from the SEC’s approach, even if your project intends to circumvent U.S. investors entirely, the determination of whether your token is a security will probably interest you.

So how does the SEC determine whether your token is a security ? As per its ruling in the case of DAO, the SEC signaled that it will apply the Howey Test to make this determination.

Who is Howey ?

Referred to by legal scholars as the “Howey Test” or simply “Howey,” it’s shorthand for a 1946 legal case brought by the U.S. Securities and Exchange Commission against two Florida corporations: W. J. Howey Co. and Howey-in-the-Hills Service, Inc. W.J. Howey owned large tracts of citrus groves in Florida and sold real estate contracts for half of the land to out-of-state investors inexperienced in agriculture and lacking the skill or equipment to tend to the land by themselves. The SEC sought to block Howey from selling these contracts, claiming that they constituted investment contracts and hence required registration as a security with the SEC.

The U.S. Supreme Court agreed with the SEC, claiming that such real estate contracts did in fact constitute investment contracts. The Court’s ruling established a precedent, thereafter becoming known as the Howey Test, which employed four criteria to determine whether an instrument offered for sale qualifies as a security.

Specifically, the Howey Test defines a security as “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

4 Components of Howey

Let’s break out the four components of the Howey Test:

  1. an investment of funds — self-explanatory
  2. in a common enterprise — i.e. is there a pooling of investors’ money in a common venture
  3. with a reasonable expectation of profits — i.e. do the the individuals investing the funds expect a financial gain? Note that the SEC focuses its assessment on the expectation of the investors, not the expectation of the ICO issuer.
  4. to be derived from the entrepreneurial or managerial efforts of others — i.e. are the individuals advancing the funds considered passive or active investors ?

Note that all of the above ignores whether actual shares are issued, whether the endeavour is speculative or non-speculative, and whether the underlying asset has any intrinsic value (so “the token is just a currency” argument probably wouldn’t hold).

Since the 1946 ruling, the Howey Test has been applied to numerous cases — earthworm farming, anyone? — and now apparently could encompass many initial coin offerings. Just a few days ago a former SEC commissioner suggested that, “ICOs represent the most pervasive, open and notorious violation of federal securities laws since the Code of Hammurabi.

I strongly encourage anyone thinking about launching an ICO, in any jurisdiction, to solicit legal council.


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posted in venture capital by mark bivens

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