The Howey Test - I
As it is used frequently in cryptocurrency market, the Howey Test determines;
- if a transaction represents an investment contract,
- if an investor puts money in a common enterprise and
- if an investment is led to expect profits solely from the efforts of the promoter or a third party and
- if an investment asks whether the value of a transaction for one of its participants is dependent upon the other's work.
The name of „Howey” comes from a legal case between the Security Exchange Commission (SEC – the regulatory body of U.S.A. security markets) and Howey Company, a citrus farm that operated on a large swath of land in the southern portion of Florida. The SEC devised the “Howey Test” as a means of determining whether an offering counted as a security. The SEC also declares that cryptocurrencies, which passes the Howey Test are securities and are subject to securities regulation as well.
From the perspective of the Howey Test, the operative question is whether or not cryptocurrency investors are participating in a speculative enterprise, and if so, if the profits are entirely dependent upon the work of a third party. Whether a particular digital asset at the time of its offer or sale satisfies the Howey Test, depends on the specific facts and circumstances. These main four criterias are:
- Monetary Investment, if offering involves a monetary investment: The first component of the Howey Test is the motivation for offer or sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, and its form is a real (or fiat) currency, another digital asset, or another type of consideration.
- The Expectation of Profits, the expectation of profits from the investment: A digital asset under the Howey Test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realise a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. Price appreciation results solely from external market forces impacting the supply and demand for an underlying asset generally is not considered "profit" under the Howey Test. The inquiry into whether a purchaser is relying on the efforts of others focuses on two key issues:
- Does the purchaser reasonably expect to rely on the efforts of an active participant?
- Are those efforts "the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise" as opposed to efforts that are more ministerial in nature?
- Investing in a Common Enterprise, if the investment is in a common enterprise: Courts generally analyse a "common enterprise" as a distinct element of an investment contract. A "common enterprise" typically exists in digital assets.
- Profits from a Third Party, if any profit comes from the efforts of a promoter or a third party: When a promoter, sponsor, or other third party provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.
As the most popular cryptocurrency, BitCoin investments involve a monetary investment and provide expectations of profits. However, it is not in a common enterprise and any profit does not come from the efforts of a promoter or third party.
We will touch more points about the Howey Test in the second article. For any further questions, please reach us via firstname.lastname@example.org or visit our CryptoIndexSeriesTM Platform for better analysis of the crypto market space.
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