What is The Howey Test and How Does it Determine if a Token is a Security?

Definition of the Howey Test

According to the US Supreme Court’s decision in SEC v. Howey Co, a transaction is an investment contract (security) if it fits all four of the following criteria:


   1. It is an investment of money
   2. There is an expectation of profits from the investment
   3. The investment of money is in a common enterprise
   4. Any profit comes from the efforts of a third party

If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck

From Orange Groves to ICO's

The Howey Test is named after the landmark 1946 Supreme Court case SEC v. Howey Co, which established a firm precedence in securities law.

 

Some of the most important language in Howey surrounds the concept that US securities laws embody “flexible rather than static principle[s]…that [are] capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of benefits.” [Howey p. 299]

 

This keystone language motivates the following comparison between the 1946 Howey fact pattern and their analogies in modern day ICO fundraising

SEC v. Howey Fact PatternICO Analogy
“[Howey-in-the-Hills Inc] planted about 500 acres annually, keeping half of the groves itself and offering the other half to the public.”ICO issuers only dedicate a portion of the total allocation for sale to the public. The rest of the tokens a re allocated to the founding team of the ICO as well as to advisors, bounty programs...etc.
The purpose of the Howey leaseback contracts was ‘‘to help us finance additional development.’” The purpose of ICOs is to raise capital in order to develop a protocol or platform, often from scratch.
“The land sales contract with the Howey Company provides for a uniform purchase price per acre or fraction thereof…” Tokens are sold at a fixed price during ICO.
Out of 500 total acres available for sale per year, “the average holding of [the purchasers] was 1.33 acres and sales of as little as 0.65, 0.7 and 0.73 of an acre were made.” This scheme is tantamount to a crowd sale. ICO public sales also follow the crowdsale model, with the average participants purchasing only a minute percentage of the overall token offering.
“[The purchasers] are predominantly business and professional people who lack the knowledge, skill and equipment necessary for the care and cultivation of citrus trees.” The majority of token purchasers do not have the technical, economic, financial and business backgrounds to understand the token economies that they are subscribing to. This is especially true for those that use a shotgun approach to purchase a small number of tokens distributed across many different ICOs.
“It was represented...that profits during the 1943-1944 season amounted to 20% and that even greater profits might be expected during the 1944-1945 season…” Some ICOs make similar speculatory claims about their token’s supposed inevitable appreciation in value. Such claims would be strictly forbidden if these tokens were regulated as securities.
“The [Howey Company’s] hotel’s advertising mentions the fine groves in the vicinity and the attention of the patrons is drawn to the groves as they are being escorted about the surrounding countryside.” Though advertisements for ICOs are now banned on many social media sites and search engines, previously ICO sale banner ads would draw the attention of their audience as they were browsing related material on the internet.
How ICO’s compare to the Howey Test

Background: Applying the Howey Test to The DAO ICO

The DAO was created by Slock.it UG, a German corporation led by a team of three founders: Christoph Jentzsch, Simon Jentzsch, Stephan Tual

The DAO is meant to be a “Decentralized Autonomous Organization,” so named because it describes a virtual organization whose governance is executed on a distributed ledger (blockchain).

The DAO was meant to operate as a for-profit entity whose assets would be used to fund other blockchain projects based on a voting system.

This “corpus of assets” were obtained in the form of ETH through an ICO of DAO Tokens.

The public token offering lasted from April 30, 2016 through May 28, 2016 and raised a total of 12,000,000 ETH ($150M USD at the time).

Token purchasers had rights to vote on which projects received funding, rights to eventual profits from the DAO investments, and rights to sell their tokens on “web-based platforms that supported seconding trading in DAO tokens”

Curators were designated by Slock.it on the basis of purported expertise, and had great influence over which projects token holders could vote on and what information about these projects they would be exposed to.

Though not directly relevant to the Howey Test, it should be noted that post-ICO, an attacker exploited a flaw in The DAO’s code and used it to divert a third of its assets (~$50M USD) to a private Ether wallet.

This is what initially prompted an investigation into The DAO by the SEC. The findings of that investigation are found in SEC Investigative Report No. 81207.

Analysis: Applying the Howey Test to The DAO ICO

In it’s report, the SEC uses the Howey Test to determine whether the DAO ICO transactions constitute securities. It’s findings along the test’s four key dimensions are as follows:

Was the investment of money in a common enterprise?

Though the SEC had no previous experience dealing with “a capital raising entity making use of distributed ledger technology,” (DLT) it was quick to use the Supreme Court’s findings in SEC v. Howey Co to expand the scope of its authority to “virtual organizations.”

In its determination of whether The DAO constitutes a “common venture,” the SEC relies on keystone language from SEC v. Howey Co: The definition of a security embodies a “flexible rather than a static principle...”

The SEC further cites United Housing Found 421 U.S. in its analysis: “the emphasis should be on economic realities underlying a transaction…”

As found in this investigative report, the economic reality here is that The DAO was a for-profit entity that received payment in exchange for tokens “premised on a reasonable expectation of profits.”

Thus, though the SEC had not previously investigated such an enterprise structure, it uses the principle of “form over function” to argue that the economic realities make this case akin to an investment in a common enterprise.

Does the token sale constitute an investment of money?

Our knee-jerk reaction may be to conclude that Ethereum is not money, and therefore this second prong of the Howey Test does not apply.

However, the SEC takes a more nuanced approach here.... They do not argue that Ethereum constitutes “money.”

Rather, they argue that the definition of “money” constitutes more than simply cash. Citing Uselton, 940 F.2d at 574, the SEC posits that “[money]...may take the form of ‘goods and services,’ or some other ‘exchange of value.’”

They further conclude that ETH transactions in exchange for tokens thus constitute “an investment of money.”

If so, was there an expectation of profits from the investment?

Slock.it’s promotional materials for The DAO reveal it as a for-profit entity in the business of funding projects for a return on investment.

DAO Token holders had the right to vote for and share in the profits of the projects that The DAO invested in.

These facts lead the SEC to conclude that any reasonable investor would have been motivated, “at least in part, by the prospect of profits on their investment of ETH in The DAO.”

Do the profits from the investment stem from the efforts of a third party?

This last prong of the Howey Test is better formulated in SEC v. Glenn W. Turner Enters., Inc.,: The question is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure of success of the enterprise.”

This is the most vigorously debated prong of the Howey Test, and one that most ICOs bank on in order to escape designation as a security.

SEC v. Howey Co contains language from Justice Murphy delivering the opinion, which asks whether investors “expect profits solely from the efforts of the promoter or a third party.”

This is why many ICOs justify their token appreciation by overemphasizing the efforts of their communities rather than their aggressive (and expensive) hype marketing tactics or the existence of deep-pocketed speculators of their token.

The SEC’s report on The DAO, however, casts doubt on such assertions. They argue that “the creators of The DAO held themselves out to investors as experts in Ethereum, the blockchain protocol on which The DAO operated, and told investors that they had selected persons to serve as Curators based on their expertise and credentials.”

Sound familiar? When speaking with someone about a project, how many times have you heard references to how strong a founding team or advisory board is? How many Blockchain Experts are you connected to on LinkedIn? “Have you heard of [project name]. It’s a great project. They have a really strong team. Trust me, I’m a blockchain expert.”

Take-away: ICOs as a whole have a high likelihood of being classified as securities.

Having assessed The DAO as passing all four prongs of the Howey Test, the SEC has classified it as an unregistered security offering.

While it is not pressing charges or levying fines, the agency is sending a clear message that ICOs are fully within its regulatory purview.

This report does not specifically address whether tokens that purport to have a pure utility function (i.e. no profit sharing) are securities.

What this report does address is the power of the SEC v. Howey Co and the legal weight of the “form over function” principle to govern token issuers who attempt to evade classification as a security.

The bottom line is if investors buy tokens speculatively, it does not matter what the underlying token mechanics are or what the token issuers claims them to be.

In fact in a Congressional hearing, SEC Chairman Jay Clayton went so far as to assert “every ICO I’ve seen is a security.”

At this point, we assess that the SEC will more likely than not regulate the majority of ICOs as securities.

The potential retroactive ramifications against unregistered securities issuers could be far-reaching, and will pose a long-term structural challenge to the ICO model.

Ultimately, we believe that regulation and increasing investor sentiment against ICOs will lead to the accelerated emergence of Security Token Offerings (STO).

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