What is the Howey Test?

The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract.” It therefore would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. Under the Howey Test of the U.S. Securities and Exchange Commission (SEC), an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

Digital currencies such as bitcoin and Electra Protocol are notoriously difficult to categorize. The Howey Test applies to any contract, scheme, or transaction – on matter if performed on a blockchain or not. The test is important for situating blockchain and digital currency projects with investors and project backers. Most cryptocurrencies and its funding instruments

  • initial coin offerings (ICOs),
  • initial dex offerings (IDOs),
  • initial exchange offerings (IEOs) through launchpad auctions,
  • venture capital (VC), and

may be found to meet the definition of an “investment contract” under the test. As a result, all cryptocurrencies which performed a funding would be subject to be classified as a security by the SEC. Because of the Howey Test, most fundings that take place today are likely to be off-limits to U.S investors. In 2018, then-SEC Chair Jay Clayton said every funding he’d seen could be classified as a security.

Cryptocurrencies Passing the Howey Test

Securities are fungible and tradable financial instruments used to raise capital in public and private markets. The public sales of securities are regulated by the SEC. The definition of a security offering was established by the Supreme Court in a 1946 case called “SEC v. W.J. Howey Co.”

In its judgment, the court derives the definition of a security based on four criteria:

  • The existence of an investment contract.
  • The formation of a common enterprise.
  • A promise of profits by the issuer.
  • The use of a third party to promote the offering.

Just like Bitcoin, Electra Protocol has never sought public funds to develop its technology, which means they are believed to not pass the Howey Test used by the SEC to classify securities. However, by Clayton’s definition, tokens used through the means of funding, are securities. This means that investors in any cryptoproject, which performed a public funding, could face regulation by the SEC. In such a case, Bitcoin and Electra Protocol would not be affected by this regulation.