Howey Test

Howey Test is a criterion the US Supreme Court decided to determine whether a transaction qualifies as an investment contract. If so, those transactions are viewed as securities and thus subject to certain disclosure and registration conditions under the Securities Act of 1933 and the Securities Exchange Act of 1934.

It can thus be said that the Howey Test prescribes a set of standards that investment should fulfill for it to be considered a security by the SEC.

The test is applicable to any contract, scheme, or transaction and is crucial for situating blockchain and cryptocurrency projects with investors as well as the supporters of the project. Under the test, certain cryptocurrencies and Initial Coin Offerings are likely to meet the definition of an “investment contract”.

As per the Howey Test, an investment contract is considered to exist when money is invested in a common enterprise with a reasonable expectation of profits to be obtained from the efforts of others.

Four elements of the Howey test:

The Howey Test comprises four prongs. All of these four elements must be met for a transaction to qualify as a security by the SEC. These four elements include:

An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others

If we look at the fourth element of this test, “To be derived from the efforts of others,” we see that this is aimed at separating investors from the third party. This suggests that if an investor makes a significant contribution to the success of an investment, it’s most likely not an investment.

The SEC has not classified the top cryptocurrencies, Bitcoin and Ethereum, as securities. Instead, they are treated as commodities. This exclusion is mainly due to the last element of the Howey test – “to be derived from the efforts of others.”

Even Stablecoins do not pass the Howey Test because of the non-fulfillment of the third requirement.

Origin of the Howey Test:

The origin of the Howey Test can be traced back to SEC v. W.J. Howey Co., which went to the Supreme Court in the year 1946. In this case, the Supreme Court developed a landmark test for determining whether certain transactions are investment contracts. And thus, the four prongs of the Howey Test to determine if a transaction is an investment contract came into existence.

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