How The Howey Test Came About

The Howey Test was born in 1946 when a case involving the SEC v. W.J. Howey Co. had to be settled in the Supreme Court. The lawsuit involved the Howey Company based in Florida – a citrus farm that operated on a large piece of land in the southern portion of the state.

In a bid to raise more funds for additional development, the company decided to lease out half of the farm to visitors. The company targeted tourists who were staying at a hotel owned by Howey Co. and sold land plus service contracts for producing, harvesting and marketing citrus fruits in Lake County, Florida.

The SEC sought to understand if the land purchase plus the service contract had created an investment contract. According to the Securities Act of 1933 and the Securities Exchange Act of 1934, any transaction that qualifies as an “investment contract” can be considered as security, and this means they are subject to specific requirements with disclosure and registration.

The court would eventually agree that the agreement was an investment contract and come up with the Howey Test to determine whether things that don’t look like securities can, in fact, be seen as securities.

The test comprises of three components

  1. There is an investment of money
  2. The investment comes with the expectation of profit
  3. The expectation of the profit is based on the efforts of others


The court determined that since the purchasers of the Howey land had no “knowledge, skill, and equipment to care and cultivate the citrus trees,” they acted as speculators. They bought the property based on the assumption that it would generate a profit for them as a result of the efforts of other people.

The court would also determine that the transactions involved in the case were indeed investment contracts since the company was offering something more than simple interests in land, they were providing an opportunity to contribute money, and in return, they would get a share of profits of a large citrus fruit enterprise.

Eventually, the company was found in violation of the law for failing to register the transactions with the SEC.


Comparisons between The Howey Fact Pattern and Modern day ICO fundraising

Over the years the Howey Test has been used to determine regulatory oversight. It has specifically come into play over the past few years as cryptocurrencies have become more prominent. Using the test, the SEC seeks to understand if crypto investors are participating in a speculative enterprise. And if this is the case, if the profits they are expecting are dependent upon the work of a third party.

Let’s have a look at a few comparisons between the test and the ICO model.

Howey Co. every year planted about 500 acres annually and kept half of the groves to itself and offered the other half to the public

ICO issuers dedicate only a portion of the total allocation for sale to the public. The remaining tokens are given to the founding team of the ICO, advisors and bounty programs.

The aim of the Howey leaseback was to help the company finance additional development

The aim of ICOs is to raise capital to develop a platform or protocol often from scratch

The Howey Co. land sale contract offered a uniform purchase price per acre or fraction of the land

During ICOs tokens are sold at fixed prices

Of the 500 acres available for sale every year, the average investor held only 1.33 acres. There was also the sale of smaller fractions of land. All in all, the scheme was more like a crowd sale

ICO public sales are also modeled as crowd sales with the average investor purchasing a fraction of the total token offering.

The purchasers were people of different backgrounds that lacked the knowledge, skill, and equipment that was necessary to care and cultivate the citrus trees

Many of the people that buy tokens don’t have the technical, economic business and financial background that is necessary to understand the token economics that they are subscribing to.

There was speculation with profits in 1943-1944 expected to be 20% and even greater the following year.

Some ICOs also make speculatory claims about their tokens with investors made to believe they will appreciate in value. This is prohibited with regulated securities.


Examples Of The SEC Using The Howey Test To Judge An ICO

In the past, the SEC has used the Howey Test to determine that the DAO ICO transactions were indeed securities. DAO was a “Decentralized Autonomous Organization” that had been created by UG – a German corporation.

The organization was designed to operate as a for-profit entity whose assets were supposed to fund other blockchain projects based on a voting system. The public offering lasted for a month and managed to raise 12 million Ethereum tokens worth $150 million at the time.

Even though the SEC had previously never investigated such an enterprise structure, the agency used the principle of “form over function” to argue that the economic realities made this case similar to an investment in the common enterprise.

“Some of the most important languages 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]


So, Are All Cryptocurrencies Securities?

Currently, two types of tokens exist; security and utility tokens. Security tokens offer their holders’ ownership rights in a company. According to the Howey Test, this makes clear security since there is an investment of money and a profit is expected. Also, the gain is based on the labor of others (if the project is to succeed).

However, determining if utility tokens are securities can be harder. Utility tokens usually represent a unit of account within a network. The more the system grows so does the utility of the token. As the network grows in size so does the transaction volumes, and this increases demand for the tokens.

So, answering the question if utility tokens are securities? The first rule of the Howey Test is satisfied since there is an investment of money. There is also the expectation of profit. And even though a utility token may not represent shares in a company, they usually grow in value.

This will lead to profit in the future for token holders which also satisfies the second Howey rule. Finally, profit is also based on the labor of others. Therefore, all the rules are satisfied which means utility tokens are securities as well.

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