By CNBCTV18.com Oct 19, 2022, 01:24 PM IST (Published)
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The Howey Test is used to determine whether an investment contract exists. As per the Howey test, an asset can be classified as security if there is an investment of money in a common enterprise and the expectation of profits derived from the efforts of others. How does the test apply to cryptocurrencies? Read here:
In December 2020, the US Securities and Exchange Commission (SEC) brought a lawsuit against the founders of Ripple (XRP). The enforcement agency alleged that Ripple CEO Brad Garlinghouse and co-founder Chris Larsen engaged in an illegal securities offering, selling their XRP holdings for hundreds of millions of dollars. The SEC complaint referenced the Howey Test to establish that XRP was indeed an investment contract and thus subject to securities regulations.
What is the Howey test?
The Howey Test is used to determine whether an investment contract exists. The test gets its name from the 1946 Supreme Court case of SEC versus the WJ Howey Company. The case concerned the sale of citrus groves owned by the Howey Company to investors in Florida.
Investors would buy the groves and immediately lease the land back to the Howey Company, which would tend the land and sell the harvested citrus fruit, sharing profits with the investors. However, the Howey Company had not registered the transactions as securities, leading to the SEC’s intervention.
Eventually, the Supreme Court ruled that Howey’s leaseback arrangements were investment contracts under the Securities Act of 1933. That decision, in turn, led to the Supreme Court establishing landmark criteria for identifying securities. As per the Howey test, an asset can be classified as security if there is an investment of money in a common enterprise and the expectation of profits derived from the efforts of others.
How does the Howey test apply to cryptocurrencies?
There has been a long-standing debate as to whether cryptocurrencies qualify as securities. Some people argue that there is an investment of money as cryptocurrencies need to be purchased with fiat currency. Further, some crypto projects, like XRP, are governed by a common enterprise and sold through centralised exchanges, which can also be considered a common enterprise. And finally, those who purchase cryptocurrency expect to profit from the currency’s rise in value, thanks to the efforts of its founders and developer teams.
Is Bitcoin a security?
Several US regulators, including the SEC, agree that Bitcoin, the largest digital asset by some margin, is not a security. This is because Bitcoin might satisfy points 1 and 3 of the Howey test but point 2 is a miss.
This is because Bitcoin does not have a leader. Its pseudonymous creator, Satoshi Nakamoto, disappeared after launching the project. Moreover, there is no single person in charge of the operation and no identifiable promoters or issuers, and no investor-pooled funds. And finally, no publicly sought funds were used to jumpstart the project. As such, Bitcoin is considered an asset similar to gold or diamonds.
What about ICOs?
Initial coin offerings (ICOs) are an entirely different matter. At a 2018 senate hearing, Jay Clayton, the then chair of the SEC, made a firm statement on ICOs being securities. “Every ICO I’ve seen is a security,” he said.
With an ICO, there is a clear investment of money. Further, the ICO is carried out by a common enterprise, i.e., the project’s founders. It is also hosted on a single platform, usually a centralised exchange. Finally, the investors expect returns based on the efforts of the project founders and developers, who build the project, scale it and help it reach its full potential. As such, ICOs tick all three boxes of the Howey test and are therefore subject to securities regulations.
The future of crypto regulation
Securities or not, regulations on cryptocurrencies are inevitable. They can help prevent events such as the recent Terra collapse, the resulting bankruptcies, and the countless rug pulls and scams that hurt investors daily. In addition, if cryptos are regulated as securities, it may bring added credibility to the asset class and draw even more institutional adoption. This is why several experts welcome regulation and believe it will spur the growth of the crypto industry.
