That is, first of all, whether crypto assets can be considered financial products/securities. Crypto Assets If they qualify as financial instruments or securities, they are subject to capital markets regulations, meaning that the obligations of the issuer are significantly different from those of a utility token issuer.
The Howey test is related to a case in 1944 by the U.S. Supreme Court that established whether a particular transaction qualifies as an “investment contract.” If a transaction qualifies as an investment contract, it is considered a security.
Therefore, registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934 apply. Under the Howey test, a transaction qualifies as a security if it cumulatively contains the following four elements:
- investment in money;
- In a common enterprise;
- With reasonable expectations of profit;
- Derived from the efforts of others.
The conditions of the Howey test are at first glance very logical and easy to understand. The essence is that money is invested with the expectation of a return. In this scenario, the investor is not actively involved in the venture, but is limited to providing an investment.
SEC Interprets Howey Test for Crypto Assets
The Howey Test has proven to be reliable over decades of practice. However, the SEC quickly realized that a strict interpretation of the test could result in inconsistent application to new financial assets such as cryptocurrencies.
Accordingly, the SEC has issued guidance on applying the Howey Test to crypto assets. According to the SEC, crypto assets are considered securities if there is a reasonable expectation that a profit will be realized through the efforts of others.
This applies to any contract, plan, or transaction, regardless of whether it has the characteristics of a traditional security. The SEC further emphasizes that the network of crypto assets must be sufficiently decentralized. Purchasers will no longer expect that a person or group is exerting significant management effort. This may mean that these crypto assets do not constitute investment contracts.
In other words, the more centralized the institution, the greater the risk. Selling crypto assets can be considered selling securities.
We will analyze the SEC’s position on the four elements of the Howey test. We will also provide guidance on how to identify potential risks for U.S. issuers of crypto assets and avoid securities status. So the first two elements are:
Investment of money
This condition is usually used when the crypto asset is often pegged to a fiat currency (e.g. USD) or other crypto assets (e.g. BTC, ETH or Stablecoin).
Common enterprise
The concept of a common enterprise has been explored in U.S. case law, demonstrating 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, such as an investment of money, exists in all business ventures. This condition applies to almost all types of crypto assets.
Investor expectations and management efforts evaluation for crypto assets
The other two factors are logically and functionally interconnected, so we will address them together. When applying the Howey test to crypto assets, the general question is whether the purchaser reasonably expects to profit or other financial returns from the efforts of others.
Buyers may expect to receive income through dividends, or they may expect to realize the value of the asset through capital gains from secondary market sales.
When an active participant (AP) exerts significant managerial effort, it affects the success of the venture. Buyers expect to benefit from this effort, which satisfies part of the Howey test.
The key criterion is the “economic reality” of the transaction. This includes the characteristics of the instrument, the terms of the offering, the distribution plan, and the incentives offered to the buyer. The focus is on how the crypto asset is offered and sold.
When analyzing whether buyers rely on the efforts of active participants, two key questions arise.
- Can the buyer reasonably be expected to rely on AP’s efforts?
- Are these efforts “definitely” critical core management efforts that will affect the success or failure of a venture, or are they essentially administrative efforts?
None of the following characteristics are necessarily determinative in themselves, but the more of these characteristics present, the more likely it is that the buyer will rely on “the efforts of others”, which satisfies this condition.
The Role of Active Participants (APs) in Network Development and Investor Expectations
AP is considered responsible for operational development and execution. This includes promoting the platform/network. This is especially true when the buyer does not expect AP to perform essential tasks that are essential to achieving the functionality of the network.
If the network or crypto asset is still under development, the buyer will expect continued development. AP may develop the network or crypto asset directly or indirectly.
These expectations are further strengthened when APs commit to further development efforts, which is intended to increase the value of crypto assets. Important criteria include that APs play a leading role in guiding ongoing developments.
This condition is met when the AP plays a central role in decision-making. This includes allocating funds for crypto asset sales, management, and code updates. The AP plays an ongoing management role in decisions related to the network.
Compensation for individuals who perform network maintenance services is also important. This includes miners, validators, and those who decide where crypto assets will be traded.
if Decentralized network The situation changes when major tasks are delegated to independent and decentralized communities, where expectations of benefits arising from the efforts of others may not be met.
In addition to AP’s efforts, a key criterion for meeting the Howey test is a reasonable expectation of profit. The SEC notes that the more of the following characteristics are present, the more likely it is that a buyer will have a reasonable expectation of profit:
- Cryptocurrencies give their holders the right to participate in the earnings or profits of the issuer or to profit from an increase in the value of the cryptocurrency (capital gains).
- The increase in the value of a crypto asset is the result of proactive actions taken by APs, and buyers reasonably expect that these efforts will lead to an increase in the value of the asset.
- The existence of a secondary market where crypto asset holders can sell their holdings and realize profits.
- Investors may be able to transfer or trade cryptocurrency assets on secondary markets or platforms, or may anticipate that such a possibility will be available in the future.
- Sellers offer crypto assets to potential buyers in quantities much larger than the anticipated demand for network functionality.
- Buyers purchase crypto assets for amounts that represent investment intent rather than network usage, for example, purchasing amounts that are much larger than what is needed for average network usage or purchasing amounts that are so small that actual use of the crypto asset is impractical.
The way a marketer presents a crypto asset is important in determining whether the buyer has a reasonable expectation of return. Pay particular attention to the following:
- Marketers highlight the AP’s expertise, experience, capabilities, or market position in relation to building or increasing the value of a network or crypto asset.
- They also emphasize that the proceeds from the sale of crypto assets are used for the development of the network or crypto assets.
- Focuses on the future rather than the current functionality of the network or crypto asset, emphasizing the prospect that the AP will provide that functionality. Focuses on implicit or explicit commitments to business development rather than current uses of the network or crypto asset.
- The potential to transfer cryptocurrency assets is a major selling point.
- Marketing and promotional materials highlight the potential profitability of the investment and the potential for the crypto asset to increase in value.
- In particular, when APs promise to create or support such markets, they emphasize the availability of a crypto asset trading market.
At a simplified level, the SEC has stated that the following characteristics should be taken into consideration when determining whether a crypto asset is a security or not. Below are the points highlighted by the SEC and the corresponding comments from the author.
Funds raised from sales
Funds raised from the sale of cryptocurrency assets will not be used for construction. platformNetwork or application. This is an important aspect because the main purpose of the investment contract is to raise capital from investors who will invest in building infrastructure, business or platform. In other words, without the raised capital, the venture cannot start.
Available immediately
Crypto assets can be used for their intended purpose immediately after sale, i.e. there is no waiting period. Users can access their crypto assets freely. This prevents sudden price increases or decreases due to speculative activities.
Transmission Limit
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: Know Your Customer (KYC) And we verify these individuals through AML procedures. We also select wallets that are suitable 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 wallet where the crypto assets are stored is unknown.
Correlation with market price
There is a direct correlation between the purchase of cryptocurrency assets and their market price.
Platform Exclusive
Sellers offer cryptocurrencies that can only be used within the platform, meaning buyers cannot use them as a means of exchange or investment outside the platform.
Functionality over market value
They market their crypto assets in a way that emphasizes functionality rather than the potential for market value growth. This is one of the most important distinctions. They emphasize the utility of crypto assets within the platform rather than the potential for value growth. This is undoubtedly the main reason to invest in securities.
In the next article, we will continue to explore the state of cryptocurrency regulation in the United States. Stay tuned for more useful content!