The Howey Test and Cryptocurrency: Which Coins May Apply?
If you have been following the news over the past few days then you will no doubt have heard of the "Howey test" and whether it can be applied to cryptocurrencies.
This is indeed an important question as the Howey Test is one of the most fundamental rule-of-thumbs that exists in order to determine whether an asset of some sort can be termed as an "investment contract" and hence classed as security.
There are numerous implications that come from this and the most important comes down to regulation.
If a cryptocurrency is termed a security, it implies that the security falls under the jurisdiction of the Securities and Exchange Commission (SEC) and hence has to meet a number of requirements. This can open up a legal can of worms for a number of cryptocurrency projects.
We will take an in depth look into the law, the current environment and which cryptocurrencies could fall under the law.
Howey Test Overview
The Howey test was created by the United State Supreme Court as a quick and easy way to determine whether a transaction could be termed as an "investment contract". Since this court case in 1946, it has been used on numerous occasions to make that determination.
The test itself involves a series of four questions that need to be asked about the particular transaction. If the asset meets these criteria then it can be considered an investment contract.
- It is an Investment of money
- There is an expectation of profits from the investment
- The money invested is in a common enterprise
- Any profit comes from the efforts of a promoter of a third party
The last point is based on whether the money that is generated from the investment is largely out of the control of the investor. If, on the other hand, the investor has an impact on the profitability of the asset then it will not be a security.
Similarly, although the first point talks about a contribution of "money", the definition has largely been expanded to also include any other types of assets.
With these points in our mind, let’s take a look through each one and see whether it could apply to a cryptocurrency.
1. Is it an Investment?
This is one of those nuanced points. If you have ever considered buying tokens in an ICO of some sort, you will see that they always use the term "contribute". This is for a very specific reason: they don't want it to be construed as an investment.
In fact, given the wording of the contribution of many of these ICOs, the interpretation is more along the lines of a "donation" than an investment.
Now, we all know that your intent is for it to be an investment and not as a donation, but that is not what the courts will consider. Legal definitions are based on fact and not opinion.
It is also important to take a look at what the token actually is. If it is meant to be used as a utility token that will be used in a decentralised open source ecosystem then it is less likely to be viewed as an investment security.
However, if the token affords the holder a claim to a tangible asset of some form then it can be seen as an investment. For example, a DAO investment vehicle that invests in other tokens can be seen as an investment. Similarly, an asset backed cryptocurrency such as a gold backed cryptocurrency can be seen as an investment.
2. Expectation of Profit
This is another sticking point where the token holder's expectations may differ from the stated objectives. While you may hope that the contribution that you have put into that ICO is likely to increase in value, there are no promises of the sort.
Of course, this dynamic changes if the token is to pay you a stream of regular income. Here there is an expectation of profit as it is hard-coded into the protocol and is a verifiable fact.
Hence, the tokens that generate a reward for the holder on an ongoing basis are most likely to fall foul of this criteria. This could be viewed as analogous to dividends that are paid to holders of shares in a company.
3. Is a Crypto Project a "Common Enterprise"
Most courts would define a common enterprise as one that has a "horizontal structure". This means that the investors would pool their funds together to invest in a project. This is indeed something that most ICOs are currently involved in.
When you are buying tokens in an ICO, your Bitcoin or Ethereum will be used by the project to fund the development. This is often outlined in the project's whitepaper and clear for all to see. Hence, initial ICO investors can be seen as forming part of a "common enterprise".
On the other hand, if there is an established project that has tokens readily available on the market, the connection is less clear. Your purchase of these tokens are not being used to further the development of the project. You are not part of a common enterprise that is using pooled funds for this budget.
Many of these established cryptocurrency projects have core developer teams that have sufficient funds available to power the project forward.
4. Who are the Promoters?
If the profit that is generated from the tokens is completely outside of the control of the token holder, then the cryptocurrency will meet this criteria. However, the mere fact that a project is open source implies that it belongs to the community.
Most cryptocurrencies are decentralised which means that each individual who participates could theoretically impact the return on that investment. Do you have any control on the price of a token if you buy a single unit and never contribute to the community?
However, if you are a substantial holder of tokens and you are actively involved in projects that aim to increase adoption of the utility token, then you could have an impact on your profits in the long run.
We also know how a great deal of cryptocurrency returns are driven by the behaviour a small number of token holders. High Net Worth whales, institutions and miners will have much more impact on the price of the token than on the core developer group.
A Look at Current Projects
The talk of the Howey test and the security classification are particularly important right now given that two of the largest cryptocurrency projects are under the magnifying glass.
Last week it was reported by the Wall Street Journal that the SEC is taking a close look at Ethereum to consider whether it will fall under their jurisdiction. There was also the news last week that Ripple XRP is being sued in a class action lawsuit on the grounds that they were selling a "security".
Moreover, in an interview with the New York Times, a former regulator on Wall Street echoed similar sentiments about both of these cryptocurrencies.
Do they have any weight behind their arguments? Probably not.
As the Ethereum foundation pointed out prior to the disclosure, they are a large open source project with the core team controlling no more than 1% of the total supply of tokens.
They also stressed that there are numerous other entities and actors who have more control over the price of the token than they do.
Similarly, there are many people who are arguing that Ripple cannot be classed as a security. For example, the XRP token does nothing more than facilitate interbank liquidity and is not tied to the performance of Ripple the company.
Ripple labs sells banks software solutions and technology. The adoption by the banks of the XRP token is what will drive the price of the token in the long run and not the profits of company itself.
Moreover, in the case of both Ethereum and Ripple, there are no regular returns that come from holding the tokens. Even when Ethereum implements their Casper PoS consensus algorithm, the staking returns are based on those who volunteer to stake their coins and not from those who merely hold tokens.
Which Tokens Could be Securities?
As mentioned, some models of ICO investments are likely to be classed as securities. This is because they are the main drivers behind the project and they form the common enterprise.
Of course, if they were to institute some form of asset backed token that would pay out regular income then they are much more likely to be termed a security. This is probably the reason that many ICOs have shelved their plans in the face of SEC scrutiny.
In terms of the more established cryptocurrencies, NEO could also be termed a security due to the way that holders will earn NeoGas. This NeoGas is paid to NEO token holders who store their NEO in a wallet off an exchange.
NeoGas is used in the NEO smart contract ecosystem to pay for computing power. It can also be traded on exchanges and has value. This regular stream of NeoGas is also guaranteed in the protocol so it is likely that the SEC could view this as an expected and sure return.
Another cryptocurrency that would most likely pass the test is KuCoin shares. They are tied to the performance of the KuCoin Exchange and will also pay the holder out a stream of income that is even termed "dividends".
While regulatory uncertainty is not helpful for any business or investor, these questions were bound to have come up. Perhaps they have gone after Ripple and Ethereum as they are both in the top three of market capitalisation of coins.
If the SEC is to bring any sort of action to the cryptocurrencies, then a lawsuit is likely to ensue. Given the extent and implications of the decision, it will be quite a dragged out process. There is no doubt that the Howey test will play a large part in that.
One can understand the motives behind the SEC. They are trying to stop nefarious activities in a largely unregulated market.
However, users of Ethereum and Ripple are in much less need of protection than those who invest in untested and questionable ICOs.
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.