What Is the Howey Test?

The U.S. Supreme Court articulated the Howey Test for determining whether U.S. securities laws govern the transaction. It originates from the 1946 Supreme Court case, SEC v. Howey.

Courts use the Howey Test to determine whether certain transactions qualify as investment contracts. If so, the Securities Act of 1933 and the Securities Exchange Act of 1934 apply to those transactions. Securities are subject to certain disclosure and registration requirements.

This article explains the Howey Test in securities law. The results of the test determine the regulation of certain transactions.

What Is a Security?

The Securities Act and Securities Exchange Act broadly define security. Consult the Basic Terms for Shareholders and Investors for additional securities terminology. Under these Acts, a security includes many familiar investment instruments. These include the following:

• Notes
• Stocks
• Bonds
• Investment contracts

Whether a particular investment is considered a security is critical. Financial instruments considered securities mean they are subject to specific registration requirements.

The Securities and Exchange Commission (SEC) requires registration for securities offered in the United States. However, there are some exceptions. A company offering securities that are not exempt from the SEC registration process must register them. It's a process that also involves the disclosure of certain information in connection with the sales of securities. The disclosure must include the following:

• A description of the company's properties and business purpose
• A description of the security offered
• Information about the company's management
• Financial statements about the company which must be certified by independent accountants

Determining whether certain transactions qualify as investment contracts is crucial. When a transaction qualifies as an investment contract under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities under federal securities law.

Background of the Howey Test

SEC v. Howey and subsequent caselaw determined what qualifies as an investment contract. When an asset is an investment contract, it's subject to U.S. securities laws.

Howey involved a leaseback agreement. The Court had to determine whether the agreement was an investment contract. An investment contract is one type of investment listed as a security under the Acts.

In Howey, two Florida-based corporate defendants offered real estate contracts for tracts of land with citrus groves. The defendants offered buyers the option of leasing any purchased land back to the defendants. The defendants would tend to the land. They would also harvest, pool, and market the citrus. Because most buyers did not have agricultural expertise, they were happy to lease the land back to the defendants.

The SEC sued the defendants over these transactions. The SEC claimed that the defendants broke the law by failing to file a securities registration statement. The Supreme Court found that the defendants' leaseback agreement is a form of security.

Test to Determine Whether Transactions Are Investment Contracts

The Court developed a landmark test for determining whether certain transactions are investment contracts known the Howey Test. Under the Howey Test, a transaction is an investment contract if:

• It is an investment of money
• There is an expectation of profits from the investment
• The investment of money is in a common enterprise
• Any profit comes from the efforts of a promoter or third-party

The Howey Test uses the term "money." However, later cases have expanded this to include investments of assets other than money. 

The term "common enterprise" isn't precisely defined. Courts have used different interpretations. Most federal courts define a common enterprise as a horizontal commonality. That means investors pool their money or assets together to invest in a project. Other courts use different definitions.

The final factor of the Howey Test concerns whether any profit from the investment is largely or wholly outside the investor's control. If so, then the investment might be a security. However, if the investor's actions largely dictate whether an investment will be profitable, the investment is probably not a security.

Substance Over Form

In deciding Howey, the Supreme Court created a test that looks at an investment's substance rather than its form. The substance is the determining factor for whether it is a security. Even if an investment is not labeled a stock or bond, it may be a security under the law. This means that registration and disclosure requirements apply.

After the creation of the Howey Test, some promoters tried to escape registration requirements. For example, promoters could call an offer of securities an interest in a general partnership. Courts look at an investment scheme's economic realities rather than its name or form. This analysis determines whether it is a security.

If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

Other Tests

The Howey Test is not the only test courts have used to determine whether an investment is a security. In 1990, the Supreme Court created the "family resemblance test." This test allows issuers to show that the note should not be considered a security. It is not a security if the investor can show that the note has a "family resemblance" to other investments that are not considered securities.

States have securities registration requirements, often called Blue Sky laws. Some states, such as California, use what is known as the risk capital test.

California's capital risk test focuses on why money or assets are invested. It also looks at what risks the investment poses for any investors. This determines whether an investment is a security and subject to securities regulation.

The Howey Test Applies to Digital Assets

The Howey Test originated in a context very different than that for digital assets. However, the SEC continues to apply the framework and principles to a broad range of digital assets.

Digital assets encompass anything stored digitally that are uniquely identifiable and can be used to realize value. There are many types of digital assets. Perhaps the most well-known digital asset form is cryptocurrencies, such as bitcoin. A common characteristic of digital assets is that they use blockchain technology. They are a virtual currency of sorts.

Investors can participate in initial coin offerings (ICO) issued by developers of digital currency to raise funds for products and services related to crypto assets. Issuance of coins in an ICO can also be useful for a software service or product.

Whether a particular digital asset satisfies the Howey test depends on the specific facts and circumstances of each case. The SEC is currently exploring whether more digital assets should be deemed securities. It's also considering whether more participants in the digital asset industry should be subject to SEC oversight.

The Investment of Money

The first prong of the Howey test is usually satisfied in an offer and sale of a digital asset. The digital asset is purchased for value. The purchase can occur in the form of the following:

• Real or fiat currency
• Another digital asset
• Other type of consideration

Regarding services provided by miners, the SEC and the courts have yet to confirm if the services offered meet the first element of the Howey Test.

A Common Enterprise

Courts have found that the common enterprise requirement is met when evaluating digital assets. The common enterprise element is a distinct element of an investment contract. A common enterprise looks to identify ties among people owning the asset.

The SEC has stated that when evaluating digital assets, they have found a common enterprise typically exists. However, as developed by the courts, SEC statements, and court decisions, certain digital assets might not meet this test.

A Reasonable Expectation of Profits Derived From the Efforts of Others

The "expectation or promise of profits derived from others" requirement of the Howey test is often the central issue in analyzing a digital asset. The SEC combines the third and fourth conditions as one element: a reasonable expectation of profits derived from the efforts of others.

The following factors are relevant in determining whether a digital asset satisfies this element of the Howey Test.

• Reliance on the efforts of others
• A reasonable expectation of profits
• Other relevant considerations

Other relevant considerations can include whether the instrument is offered and sold for the use or consumption by purchasers. The SEC outlines several characteristics in its Digital Assets Framework. The SEC notes that none of the characteristics are determinative. However, the stronger the presence of these characteristics, the less likely the transaction is to satisfy the Howey Test.

Get Professional Legal Help With Your Security-Related Matter

Securities laws are complex and often confusing. Courts may apply tests differently to determine whether an investment is a security. Do you have questions about whether a particular investment? Do you have a question about your state's securities laws? If so, it's wise to contact an experienced attorney specializing in securities law near you.