The 4 Prongs of the Howey Test & Its Application to Crypto

  • The Howey test determines if an asset can be called a security, which comes with various rules and regulations from the SEC.
  • The four prongs of the Howey test dictate that a security is an investment of money in a common enterprise with the expectation of profit derived from the efforts of others.
  • Decentralized assets, such as cryptocurrencies, generally don’t pass the Howey test because value isn’t generated on the efforts of others.

When you make an investment, you put down some money in the hopes that it will see returns. In doing so, you also take on a certain amount of risk. Some investments are riskier than others, and some the Securities Exchange Commission (SEC) deems too risky for the average retail investor.

Yet, the SEC doesn’t oversee everything that might be considered an “investment.” They can’t, for instance, stop you from buying a whole trove of Beanie Babies because you’re convinced that it will appreciate in value. So how does the SEC determine what it regulates and what it doesn’t?

To answer that question, the SEC relies on the Howey test.

What is the Howey test?

The Howey test is a set of standards that an investment must meet for the SEC to consider it a security and regulate it as such. This classification is regulated by several laws designed to protect investors so “you’re not just giving away money without understanding the risks, or potential pitfalls that take place,” says Felix Shipkevichan attorney focused on digital currency and a Special Professor of Law at Hofstra University’s law school.

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

There is a class of unregistered securities, which are often riskier and unregulated by the SEC. These securities are inaccessible to the average retail investor. Instead, an investor must gain accreditation before they’re allowed to invest in these high-risk, unregulated investments. To gain accreditation, an investor must have a

net worth

of $1 million or make $200,000 annually or $300,000 when combined with a spouse.

What are the four elements of the Howey test?

The Howey Test consists of four prongs, all of which must be satisfied for the SEC to classify a transaction as a security. The four elements are as follows: [1] An investment of money [2] in a common enterprise [3] with expectations of a profit [4] to be derived from the efforts of others.

An investment of money… This is generally self-explanatory, though some courts have moved away from “money” specifically and use wealth instead.

In a common enterprise… The term “common enterprise” was never explicitly defined by the Supreme Courts. However, it remains an important prong of this test.

There are generally three ways to understand “common enterprise.” The first, known as the horizontal approach, focuses on the idea that all the investors are putting their money toward the same enterprise. The second, called a vertical approach, is understood to be an investment where the success of the investors is linked to the success of the party that is being invested in. The last, known as the broad vertical approach, defines a common enterprise as an investment that hinges on a promoter or a third party’s expertise.

With expectations of a profit… This part of the test looks at an investor’s intent for buying an asset. Are they engaging in a transaction because they’re looking to turn a profit or are they, for example, trying to store wealth? If it’s the former, then that asset checks the box. If it’s the latter, then it will likely get classified as something else. For example, a stablecoin would be more appropriately categorized as a currency than an investment.

To be derived from the efforts of others. The purpose of this prong is to separate the investor from the third party. If the investor has a significant hand in the success of an investment, it’s most likely not an investment.

Does crypto pass the Howey test?

Bitcoin and ethereumthe first and second most traded cryptocurrencies on the market respectively, are not classified as securities by the SEC. Instead, they’re treated as commodities. This exclusion mainly hinges on the last prong of the Howey test: to be derived from the efforts of others.

Though crypto investors are getting into cryptocurrency to make money, it isn’t necessarily being made from the efforts of a third party. Shipkevich says “there’s nobody pushing bitcoin or ether to increase or decrease in price” compared to the way executives manage a company.

What does this mean for cryptocurrency?

Without the classification from the SEC, cryptocurrency regulation remains up in the air. Shipkevich says the regulation approach is very much “you want to get into this business? You want to invest in crypto? Well, you know, I hope you don’t lose any money.”

On the other hand, some rules for investors don’t apply to cryptocurrency. For example, the wash sale rule, which bars investors from harvesting their investment losses for tax purposes by selling an asset and immediately buying it back, currently applies to securities. Because cryptocurrency isn’t a security, it remains exempt from this rule, though that may change soon. President Biden’s Build Back Better Act included a proposal to apply the wash-sale rule to cryptocurrencies.

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