The Four Prongs of Howey’s Test and Its Application to Cryptography

  • The Howey test determines whether an asset can be called a security, which comes with various rules and regulations from the SEC.
  • The four axes of Howey’s test dictate that a security is an investment of money in a joint enterprise with the expectation of profit resulting from the efforts of others.
  • Decentralized assets, such as cryptocurrencies, generally do not pass the Howey test because value is not generated by the efforts of others.

When you make an investment, you put in some money in the hope that it will pay off yields. In doing so, you also take on a certain amount of risk. Some investments are more risky than others, others Securities Commission (SEC) It is too risky for the average retail investor.

However, not everything that can be considered an “investment” is supervised by the Securities and Exchange Commission. They can’t, for example, stop you from buying an entire set of Beanie Babies because you’re convinced they’ll appreciate their value. So how does the SEC determine what it regulates and what it doesn’t?

To answer this question, the Securities and Exchange Commission relies on the Howey test.

What is the Howey test?

The Howey test is a set of criteria that an investment must meet in order for the SEC to consider it safe and regulate it as such. This classification is regulated by Several laws It’s designed to protect investors, so “you don’t just donate money without understanding the risks, or the potential risks that occur,” he says. Felix ShipkevichD., a cryptocurrency-focused attorney and private professor of law at Hofstra University Law School.

For example, the Securities Act of 1933 requires companies that offer securities to register with the Securities and Exchange Commission. This provides information about the company and the securities offered to investors for the sake of transparency.

There is a category of unregistered securities, which are often riskier and not regulated by the SEC. These securities are not accessible to the average retail investor. Instead, the investor must earn Accreditation Before they are allowed to invest in these high-risk and unregulated investments. To obtain the accreditation, the investor must possess a

net value

$1 million or earn $200,000 annually or $300,000 when you combine.

What are the four components of the Howey test?

Howey’s test consists of four axes, all of which must be met in order for the Securities and Exchange Commission to classify a transaction as a security. The four elements are as follows: [1] investing money [2] in a joint venture [3] With profit forecast [4] To be derived from the efforts of others.

investing money… This is generally self-explanatory, although some courts have moved away from “money” specifically and used wealth instead.

In a joint venture… The term “joint venture” was It is not explicitly defined by the higher courts. However, one important prong remains for this test.

There are generally three ways to understand the “joint venture”. The first, known as the horizontal approach, focuses on the idea that all investors put their money into the same project. The second, called the vertical approach, is understood as an investment in which the success of the investors is related to the success of the party in which the investment is made. The latter, known as the broad vertical approach, defines a joint venture as an investment that depends on the promoter or the expertise of a third party.

With profit forecast… This part of the test looks at the investor’s intent to buy an asset. Are they engaging in a deal because they are looking to make a profit or are they, for example, trying to store wealth? If it is the first, then this asset checks the box. If it was the latter, it would probably be categorized as something else. For example, a stablecoin It is more appropriate to classify it as a currency than as an investment.

To derive from the efforts of others. The purpose of this split is to separate the investor from the third party. If the investor has a significant role in the success of the investment, it is most likely not an investment.

Does encryption pass the Howey test?

Bitcoin And the raisedthe first and second most popular Cryptocurrency In the market respectively, they are not classified as securities by the Securities and Exchange Commission. Instead, they are treated as goods. This exclusion depends mainly on the last prong of Howey’s test: to derive from the efforts of others.

Although cryptocurrency investors get into cryptocurrency to make money, it is not necessarily made from the efforts of a third party. “Nobody is pushing bitcoin or ether to raise or lower the price,” Shipkevich says, compared to the way executives run the company.

What does this mean for cryptocurrencies?

Without the rating from the Securities and Exchange Commission (SEC), cryptocurrency regulation remains in the air. The approach to regulation, says Shipkevich, is largely “Do you want to get into this business? Do you want to invest in cryptocurrency? Well, you know, I hope you don’t lose any money.”

On the other hand, some rules for investors do not apply to cryptocurrencies. For example, the wash sale rule, which prevents investors from realizing their investment losses for tax purposes by immediately selling and repurchasing an asset, currently applies to securities. Because cryptocurrency is not security, it remains so excluded from this rule, although that may change soon. President Biden’s Building Back Better Act included a proposal to implement The rule of washing sale for cryptocurrency.