The Howey Test: Defining Securities in the US
by FARUK IMAMOVIC | VIEW 574
In the world of finance and investment, the term "security" carries significant legal implications. In the United States, the Howey Test provides the framework for determining whether an asset can be classified as a security under federal law.
Established by the Supreme Court in 1946, the Howey Test has since been utilized in a variety of cases to ascertain the nature of financial offerings and arrangements.
The key outcome of passing the Howey Test is that an asset is deemed a security token. These tokens derive their value from external assets that are traded.
Coincidence? On the same day as the Ethereum Merge, SEC chair Gary Gensler says proof-of-stake cryptocurrencies could be seen as a security under the Howey test.
https://t.co/D24G9edoc7 — Cointelegraph (@Cointelegraph) September 16, 2022
They are contracts for investing in underlying investment assets, such as stocks, bonds, funds, and real estate investment trusts. The tokenization of securities on blockchain technology has enabled smart contracts to govern their behaviors without the need for intermediaries, such as banks.
The Howey Test Criteria: Understanding Security Tokens
To qualify as a security under the Howey Test, an asset must satisfy three key criteria.
- Firstly, there must be a financial investment that puts participants at risk of losing their own money.
This could be in the form of financial or in-kind investments.
- Secondly, there must be a joint venture between the investors, whereby their financial success is linked in some way. Evidence of pooling resources or relying on a third party to manage investments can demonstrate this.
- Finally, there must be an expectation of profit solely from the efforts of others, indicating that investors rely on a third party to realize a return on investment.
Complying with Federal Securities Laws
Cryptocurrency companies must take great care to comply with federal securities laws in the United States, which also apply to cryptocurrencies.
The Securities and Exchange Commission (SEC) considers several cryptocurrencies to be securities, meaning that businesses operating in this space must meet registration and disclosure requirements. Token offerings may be subject to securities laws, depending on the specifics of the sale to the general public.
Companies must also disclose their financial goals and how the funds raised will be used. Trading platforms that facilitate the buying and selling of tokens may also be subject to securities regulations, and failure to comply can lead to significant financial and legal penalties.