Crypto Regulatory Framework in the USA – Howey test: Part II

Namely, in the first place if crypto assets can be considered financial instruments/security or not. If a crypto asset qualifies as a financial instrument or security, capital market regulations will apply. This means the issuer’s obligations will differ significantly from those of utility token issuers.  

The Howey test pertains to a case by the U.S. The Supreme Court from 194 establishes whether a particular transaction qualifies as an “investment contract.” When a transaction qualifies as an investment contract, it is deemed a security.  

Accordingly, it is subject to registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the Howey test, a transaction qualifies as a security if it cumulatively includes the following four elements: 

• An investment of money; 

• In a common enterprise; 

• With a reasonable expectation of profits; 

• Derived from the efforts of others. 

At first glance, the conditions of the Howey test seem quite logical and easy to understand. The essence lies in the investment of money with an expectation of profit. In this scenario, the investor does not actively participate in the venture but limits themselves to just providing the investment. 

SEC’s Interpretation of the Howey Test for Crypto Assets 

The Howey test has proven reliable through decades of practice. However, the SEC quickly realized that a strict interpretation of the test might not consistently apply to new financial assets like crypto. 

Therefore, the SEC issued guidance on the application of the Howey test to crypto assets. According to the SEC, crypto assets will be considered securities if there is a reasonable expectation of profits to be realized from the efforts of others.  

This applies to any contract, scheme, or transaction regardless of whether it has the characteristics of traditional securities. The SEC further emphasizes that a crypto asset’s network must be sufficiently decentralized. Buyers would no longer expect that a person or group is undertaking significant managerial efforts. This may mean that such crypto assets do not constitute an investment contract. 

In other words, if the entity is more centralized, there is a higher risk. The sale of crypto assets may be considered a sale of securities. 

We will analyze the SEC’s stance on all four elements of the Howey test. We’ll also identify potential risks for crypto asset issuers in the U.S. and provide guidance on how they can avoid securities status. So, the first 2 elements are: 

Investment of Money 

This condition usually holds true since crypto assets often obtain acquisition with fiat currency (like dollars) or other crypto assets (e.g., BTC, ETH, or stablecoins). 

Common Enterprise 

The concept of a common enterprise has been explored in U.S. case law. It shows that a common enterprise exists when participants work on the same project, engage in similar activities, and face similar risks. 

The concept of a common enterprise, like the investment of money, is present in every business venture. This condition will apply to nearly every type of crypto asset. 

Assessing Investor Expectations and Managerial Efforts in Crypto Assets 

The other two elements are logically and functionally interconnected, so we will address them together. A common question when applying the Howey test to crypto assets is whether the buyer reasonably expects profits or other financial returns from the efforts of others. 

Buyers might expect returns from distributions or by realizing the asset’s value through capital gains in secondary market sales. 

When an Active Participant (AP) contributes significant managerial efforts, it affects the venture’s success. Buyers expect profits from these efforts, which meets part of the Howey test. 

A key criterion is the “economic reality” of the transaction. This includes the instrument’s nature, terms of the offering, distribution plan, and incentives offered to buyers. The focus is on how the crypto asset is offered and sold. 

When analyzing whether the buyer relies on the efforts of active participants, two key questions are posed: 

1. Does the buyer reasonably expect to rely on the efforts of the AP? 
2. Are these efforts “undeniably” significant, key managerial efforts affecting the success or failure of the venture, as opposed to efforts that are more administrative in nature? 

None of the following characteristics are necessarily decisive on their own. However, the more present they are, the more likely it is that the buyer relies on “the efforts of others.” This fulfills this condition. 

Role of Active Participants (AP) in Network Development and Investor Expectations 

The AP will be considered responsible for the development and execution of operations. This includes the promotion of the platform/network. This is especially true if buyers do not expect the AP to perform essential tasks. These tasks are crucial for achieving the network’s functionality.  

If the network or crypto asset is still under development, buyers would expect continued development. The AP may develop the network or crypto asset directly or indirectly.  

This expectation is stronger if the AP promises further development efforts. This is to enhance the value of the crypto asset. Important criteria include that the AP has a leading role in guiding ongoing development. 

This condition will be met if the AP plays a central role in decision-making. This includes fund allocation from the sale of crypto assets, management, and code updates. The AP will have a continuous managerial role in decision-making related to the network.  

Compensation for individuals performing network maintenance services is also crucial. This includes miners and validators, as well as decisions about where the crypto asset will be traded.  

If a decentralized network delegates key tasks to an independent, distributed community, the situation changes. In this case, the expectation of profits arising from the efforts of others might not be met. 

Besides the efforts of the AP, a key criterion for satisfying the Howey test is the reasonable expectation of profit. The SEC indicates that the more of the following characteristics are present, the more likely it is that there is a reasonable expectation of profit by the buyers: 

• The crypto asset grants the holder the right to participate in the issuer’s revenue or profits, or to benefit from an increase in the value of the crypto asset (capital gains); 

• The increase in the value of the crypto asset results from active actions taken by the AP, with buyers reasonably expecting that these efforts will lead to an increase in the asset’s value; 

• The existence of a secondary market where holders of the crypto asset can sell their holdings and realize a profit; 

• Investors can transfer or trade the crypto asset on a secondary market or platform, or they expect this possibility to exist in the future.  

• Sellers offer the crypto asset to potential buyers in quantities significantly larger than the expected demand for the network’s functionality. 

• Buyers purchase the crypto asset in amounts that indicate an intention to invest, rather than for network use. For example, they buy quantities much larger than what average network usage requires, or they buy such small amounts that practical use of the crypto asset becomes impractical. 

The way marketers present the crypto asset is crucial in determining whether buyers have a reasonable expectation of profit. Special attention must focus on the following points: 

• Marketers emphasize the expertise, experience, capabilities, or market position of the AP in relation to building or increasing the value of the network or crypto asset. 

• They also highlight that the proceeds from the sale of the crypto asset are intended for the development of the network or crypto asset. 

• The focus is on the future, rather than the current functionality of the network or crypto asset, emphasizing the prospect that the AP will provide that functionality. The emphasis is on promises, whether implicit or explicit, about business development, rather than the current use of the network or crypto asset. 

• The potential for transferring the crypto asset is a key selling point; 

• Marketing and promotional materials highlight the potential profitability of the investment and the possible increase in the value of the crypto asset. 

• They emphasize the availability of a market for trading the crypto asset, especially if the AP promises to create or support the creation of that market. 

On a simplified level, the SEC has indicated that attention should be given to the following characteristics when determining whether a crypto asset is a security or not. Below are the points highlighted by the SEC, with corresponding comments from the author: 

Funds Raised from Sales 

Funds raised from the sale of crypto assets are not used for building the platform, network, or application. This is a crucial aspect because the main purpose of an investment contract is to raise capital from investors that will be invested in building infrastructure, business, or platform. In other words, without the raised capital, the venture could not be initiated. 

Immediate Availability 

Crypto assets are immediately available for their intended use after sale. This means there is no waiting period. Users can freely access crypto assets. This prevents sudden price increases or decreases caused by speculative activities. 

Transfer Restrictions 

The platform restricts the transfer of crypto assets to wallets registered on the platform. This means that only authorized individuals can hold and transfer crypto assets on the platform. The platform uses KYC and AML procedures to verify these individuals. It also selects appropriate wallets for this purpose. This effectively prevents the transfer of crypto assets to unregistered individuals. Crypto assets cannot be transferred without authorization. Therefore, the ownership of the wallets where crypto assets are held remains unknown. 

Correlation with Market Price 

There is a direct correlation between the purchase of crypto assets and their market price. 

Platform Use Only 

Sellers offer crypto assets only for use within the platform, meaning buyers cannot use them outside the platform as a means of exchange or investment. 

Functionality Over Market Value 

They market crypto assets in a way that emphasizes their functionality; rather than the potential for an increase in market value. This is one of the most important distinctions. It highlights the utility of the crypto assets within the platform rather than the possibility of value growth. This is undoubtedly the primary reason for investing in securities. 

In the next article, we will continue with crypto regulatory status in the USA. Stay with us for more useful content!