What is the Howey test. Why the SEC is evaluating cryptocurrencies by 1940s standards

Chief US exchange regulator equates cryptocurrencies with securities according to Howey test criteria list . Which were developed in the middle of the last century and uses this as one of the main arguments

The U.S. Securities and Exchange Commission (SEC), , is actively increasing pressure on the cryptocurrency industry. The main U.S. exchange regulator has already filed lawsuits against two major cryptocurrency exchanges. The agency is making a number of allegations against both exchanges. And the main one is the recognition of a number of cryptocurrency assets. Which are traded on the platforms as unregistered securities, falling under the competence of the regulator.

In the lawsuits, the SEC highlighted a list of crypto-assets on both exchanges, which collectively includes 19 coins. And several of them, including Solana (SOL), Cardano (ADA), Polygon (MATIC), Filecoin (FIL), Sandbox (SAND), Decentraland (MANA), Algorand (ALGO), Axie Infinity (AXS), are listed in the charges for both venues.

According to the documents, they all fall under several of the agency’s designated criteria in one way or another. That’s pre-sale or fundraising. As well as promises to improve the project through continuous business development and marketing, the use of social networks to demonstrate the capabilities and benefits of the project.

The SEC uses the criteria of the so-called Howey test. This test, created by a 1946 Supreme Court decision. Which was related to the Florida citrus plantation deals. And is the basis of the SEC’s securities control authority. Which are considered “investment contracts.” And do not fall under familiar categories such as stocks and bonds.

Although the concept originated in the middle of the last century. But the SEC still applies it to actual assets, including cryptocurrencies. Because the U.S. has yet to develop a unified regulatory approach to crypto-assets. And it may be the one that ultimately forms the basis for cryptocurrency regulation.

Florida citrus plantations equated to cryptocurrencies

The Securities Act of 1933 lists financial instruments. Which fall within the definition of a security. And therefore within the scope of SEC regulation. They are stocks, bonds, bills of exchange, security-based swaps and more than a dozen other instruments. The document also cites the term “investment contract,” which arose as a result of a court decision related to the Howey test.

At the time, the SEC sued the W.J. Howey Company and Howey-in-the-Hills Service for selling citrus plantation lots in Florida to the public along with a service contract. Which gave Howey-in-the-Hills the right to lease and own the plots. Howey, with the necessary experience and equipment, remained responsible for growing, harvesting and marketing. The purchasers of the plots received a share of the profits.

Based on this arrangement, the commission accused Howey of offering and selling unregistered securities in violation of the Securities Act. The case went all the way to the Supreme Court. The judge concluded that these transactions clearly belonged to investment contracts under the Act. And introduced the very criteria that became known as the Howey test.

It includes four key elements that must be met to be considered a securities transaction.

1. investment of money. This can be any type of capital, such as cash, checks or current cryptocurrencies.

2. Joint venture. This means that the investor’s income is tied to the success of the entire venture. Not just the success of its individual investments.

3. a reasonable expectation of return. This means that investors must have a reasonable expectation of profit, either through their own efforts or the efforts of others.

4. Profits derived from the efforts of others. This means that investors must rely on the efforts of a promoter or third party to make a profit.

The Howey test is still used to this day by the SEC to determine whether certain financial products are securities. Some examples of assets and transactions that have been found to be securities under the Howey test. Also include initial coin offerings (“ICO”), tokenized assets, and investment contracts.

New guide to applying the Howey test to cryptocurrencies

The SEC has issued guidance on applying the Howey test to cryptocurrencies and other blockchain-based assets. The SEC has stated that many cryptocurrencies and tokenized assets are securities. Because they meet the four elements of the Hoey test.

One high-profile example is the case of the failed Telegram messenger ICO. That’s when Pavel Durov was able to raise a record $1.7 billion on the sale of Gram tokens to qualified investors. In 2019, the SEC filed a lawsuit against Telegram. And in doing so, claiming that Gram tokens are securities. Also that Telegram violated the law by conducting an unregistered sale of assets. In the complaint, the SEC also cited the Howey test. And argued that Gram tokens meet all four criteria of the test.

Another high-profile example is the case surrounding Ripple’s XRP token. In December 2020, the SEC filed a lawsuit against Ripple. In doing so, claiming that XRP is a security and that Ripple violated securities laws by conducting the initial sale of the tokens. And in its complaint, the SEC again cited the Howey test.

How projects try to bypass the Howey citrus test

Focusing on the U.S. market, crypto businesses are forced to consider the Howey test. Now some projects are calling their assets a governance token. Which is used to vote the decentralized autonomous organization (DAO) created under the project. However, such tokens are also traded on cryptocurrency exchanges. And are valued in the billions of dollars, so it remains to be seen. How regulators will behave towards them in the future.

Many projects offer their tokens only outside the US. In doing so, they restrict U.S. users from trading or participating in token giveaways (airdrops). Some blockchain services reach an agreement with the SEC. In doing so, they often pay significant fines if their asset is found to be a security.

Our experts note that Coinbase, meanwhile, intends to defend its position. It filed a countersuit against the SEC. In doing so, intending to obtain clear rules from the regulator for dealing with crypto-assets. The platform has openly stated that it has no plans to delist tokens. Which the SEC considers to be securities and wind down staking services. According to Coinbase, the company has more than $5 billion on its balance sheet to maintain operations. And to pay legal fees.