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What Is the Howey Test?

The Howey test examines a financial contract based on several criteria to make it a security. To better understand the Howey test, we must first become familiar with the concept of securities.

 

What are Securities?

Securities are any tradable assets that have a monetary value and are used to raise capital in public and private markets. Securities can be in the form of a position of ownership in a company whose shares are publicly traded on the stock exchange. It can also be a kind of credit relationship with a government or corporation through the ownership of the bonds of these institutions or the ownership through a contract of option.

Securities can be divided into three main categories:

  1. A stock that provides property rights to its holders.
  2. Debts are loans that are repaid periodically.
  3. A combination of debt and stock characteristics.

The Securities Act of 1933 and the Securities Exchange Act of 1934 in the United States have broad definitions of the term “securities.” Under these rules, securities include many familiar investment instruments such as cash, stocks, bonds, or any other things that can be classified as an investment contract.

It is especially important to consider special investments as securities; Because it makes the investment subject to the rules of registration in the US Securities and Exchange Commission. In general, all securities offered in the United States must be registered with the Securities and Exchange Commission; however, exceptions exist.

 

Howey test history

The Howey test goes back to the case of the US Securities and Exchange Commission against Howey, which reached the US Supreme Court in 1946. Howey first sold citrus orchards to buyers in Florida and then they leased the land to Howey. The employees of the Hawaiian company maintained the orchards and sold the fruits on behalf of the owners, and both parties shared in the profits. Most buyers had no experience in agriculture and did not need to take care of the land themselves.

However, Howey failed to register a transaction; As a result, the US Securities and Exchange Commission intervened. The Supreme Court ruled that the lease of the land after the sale was an investment agreement.

 

Howey test and digital currencies

Howey testing has been an important determinant of legal oversight for decades. In the following, we will see if this test can be used for tokens that act as securities. Tokens are divided into two categories: Security Token and Utility Token.

 

Securities tokens are created to provide property rights to the company. The expected return on financial investment is based on the work of third parties; As a result, the project will be successful and the value of the tokens will increase. Securities tokens have many benefits, including lower issuance fees, improved market productivity, and the ability to split larger assets.

 

Application tokens in a network can represent an accounting unit. As the network grows, applications are added to the token. As the size of the network grows and the volume of transactions increases, the demand for tokens increases.

 

If you’re still curious to know whether application tokens are an investment or not, we have to say yes, they are a financial investment that meets the first Howey test criteria. Although these tokens may not represent a company’s stock, this does not mean that the value of the token will not increase.

 

The value of the token increases based on the project’s ability to attract users and the token progress over time. The token holders’ profits are expected to increase, which fulfills the third criterion of the Howey test. Also, the return on investment comes from the efforts of third parties; Thus, the Howey test criteria are met and can also be converted into functional tokens.

 

It is very difficult to classify digital currencies like Bitcoin on this basis; Because digital currencies are decentralized and largely evade regulation. Nevertheless, the Securities and Exchange Commission is focusing on digital currencies and seeking to determine when their sale meets the conditions set out in the investment contract definition.

 

According to the US Securities and Exchange Commission, the “financial investment” test is done simply by selling digital currencies; Because in this process, Fiat money or other digital currencies are exchanged. The “joint venture” test is performed in the same way.

 

In most cases, having the terms of an investment contract for a digital currency depends to a large extent on whether one expects to make a profit from the efforts of third parties. For example, if buyers of a digital currency depend on project sponsors to develop and maintain a digital network, especially in the early stages, it may be dependent on the efforts of third parties rather than a scattered set of unrelated users.

 

The test will also be completed if project sponsors take action, such as reducing tokens by burning tokens, to support the price of digital currency. Another method that satisfies the condition of making a profit from “third party efforts” is that the project sponsors continue to work in a managerial role.

 

These are just a few of the examples identified by the US Securities and Exchange Commission. If the success of a project depends on the continued participation of its sponsors, the buyer of the digital currency is likely to rely on the efforts of third parties.

 

If the Securities and Exchange Commission determines that it is a digital securities currency, there are consequences. This means that the US Securities and Exchange Commission determines whether a token can be sold to US investors and forces the project to register with the Securities and Exchange Commission.

 

The bottom line

Howey test was created by the US Supreme Court in the case of the Securities and Exchange Commission against Howey, it allows for a link between financial transactions and the investment contract as securities.  Howey testing is important for investors and supporters in determining the status of blockchain and digital currency projects.  However, the US Securities and Exchange Commission is focusing on digital currencies to determine when their sale meets the conditions set out in the investment contract definition.

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