What the SEC says about the Howey Test and ICOs

Apr. 04, 2019

For everyone not living under a rock for the past few years, Bitcoin has now become a household term.  We have watched as the value of Bitcoin rose to astronomical heightsfell dramatically, and now appears to be on the rise again.  As interest in Bitcoin and other cryptocurrencies has grown, so too has an interest in “initial coin offerings” or ICOs.  ICOs are public offers of digital tokens that a business sells in order to raise money from investors. Typically, digital tokens are marketed as representing some right to a specific product or service (as opposed to, say, equity in a business or an interest in an actual currency). 


Many cryptocurrency enthusiasts have written at length on various public forums about why ICOs are something other than securities and are therefore not subject to the rigorous registration requirements of the Securities Act and state Blue Sky Laws.  Often, those making this argument point to the Howey test, which is derived from an oft-cited U.S. Supreme Court decision in which the Court decided what constitutes an “investment contract” and thus a security, subject to federal securities regulations.


Those taking the position that widely-promoted ICOs are not securities have, generally speaking, not fared so well.  The SEC has taken aggressive enforcement actions against issuers of ICOs who do not comply with securities regulations.  The SEC has also been VERY vocal in warning investors about the risks of investing in ICOS. 

Nevertheless, there seems to be a persistent attitude that the SEC will eventually come around to realizing digital tokens are the next great thing, and that the SEC should step aside to enable the digital token marketplace to operate without regulatory interference.


Today the SEC issued guidance that should again cause issuers of ICO’s to hesitate before assuming securities regulations do not apply. That said, the guidance should also prove helpful to those who want to do an ICO with a thorough understanding of the guideposts surrounding what is, and is not, a security.  


As a reminder, an “investment contract” exists under the Howey test if there is: 1) an investment of money 2) in a common enterprise 3) with the expectation of profits 4) derived solely from the efforts of others.


Below are a few highlights from the SEC’s Framework regarding the applicability of the Howey test to a digital token:


Regarding the Form of a Digital Token:

The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales).


Regarding the first prong of the Howey test:

The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.


Regarding the second prong of the Howey test:

Courts generally have analyzed a "common enterprise" as a distinct element of an investment contract.  In evaluating digital assets, we have found that a "common enterprise" typically exists.


Regarding the third prong of the Howey test:

Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered "profit" under the Howey test.  [However,] The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit:

  • The digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation of the digital asset.
  • Purchasers reasonably would expect that [a promoter's] efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase.
  • [others]

Regarding the fourth prong of the Howey test:

 A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.  When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an "Active Participant" or "AP") provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.  Relevant to this inquiry is the "economic reality" of the transaction and "what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect."


Regarding when the Howey test may NOT apply:

Perhaps most helpful, the SEC guidance included several factors that, when present, may suggest that the Howey test is not met, and thus securities regulations do not apply.  Among those factors:

  • The distributed ledger network and digital asset are fully developed and operational.
  • Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.
  • The digital assets' creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network.  For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser's expected use.
  • Prospects for appreciation in the value of the digital asset are limited.  For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment.
  • With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency. 
  •  Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
  • Restrictions on the transferability of the digital asset are consistent with the asset's use and not facilitating a speculative market.
  • If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.


Before conducting an ICO, assume its an investment contract, then try to convince yourself otherwise.

When doing the self-convincing, rely on the SEC's Guidance, not what you read on a cryptocurrency blog.

If you can't convince yourself the ICO is not a security, raise money the old fashioned way: via an offering that is registered or exempt under federal and state securities laws.

And of course, when in doubt, call an attorney.

Written By:
Brian Edstrom

Brian Edstrom is a Shareholder and Attorney at Avisen Legal, P.A. He brings to Avisen clients the ability to “speak regulator,” having spent several years working for federal and state regulators in Washington D.C. and Saint Paul, MN before entering private practice. Brian assists clients in all aspects of working with securities regulators, whether it be to obtain a license or registration, prepare for an audit, or respond to an enforcement investigation.  Brian also regularly advises clients on their general business needs, particularly surrounding raising money through securities offerings.

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