US SEC: How to Use Howey Test to Determine Whether a Cryptocurrency is a Security?

US SEC: Using the Howey Test to Determine if a Cryptocurrency is a Security

Compiled by | Wu Shuo Blockchain

Original text | SEC

This article compiles the main content of the “Framework for “Investment Contract” Analysis of Digital Assets” published by the SEC, which mainly outlines how to use the Howey Test to determine whether encrypted assets are securities. The SEC also stated in its conclusion that “these factors are not intended to comprehensively assess whether a digital asset is an investment contract or any other type of securities, and no single factor is determinative.” The original text was last revised on March 8, 2023.

A. Investment Funds

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When offering and selling encrypted assets, the first element of the Howey test is usually satisfied because encrypted assets are purchased in value or obtained in other ways, whether in real (or legal) currency, another encrypted asset, or other types of consideration.

(SEC note: Cash is not the only form of contribution or investment, and an investment contract can be formed without cash; for encrypted assets distributed through so-called “airdrops”, even if there is no currency consideration, it does not mean that the condition of investing money has not been met; therefore, airdrops may constitute sales or distribution of securities. In so-called “airdrops”, encrypted assets are distributed to holders of encrypted digital assets, usually to facilitate their circulation.)

B. Common Enterprise

Courts generally regard “common enterprise” as an independent element of an investment contract. When assessing encrypted assets, we find that “common enterprise” usually exists.

(SEC note: Based on our experience so far, investment in encrypted assets constitutes an investment in a common enterprise because the fate of buyers of encrypted assets is interdependent, or linked to the success of the initiator’s efforts.)

C. Expectation of Profit through the Efforts of Others

Usually, when analyzing encrypted assets based on the Howey test, the main issue is whether buyers have a reasonable expectation of making a profit (or other financial returns) through the efforts of others. Buyers may expect to profit by participating in distribution or by other means of increasing asset value (such as selling at a high price in the secondary market). When promoters, sponsors, or other third parties (or related third-party organizations) (each referred to as “active participants” or “AP”) provide key management efforts that decisively contribute to the success of the enterprise, and investors reasonably expect to profit from these efforts, then this test element is satisfied. For this query, “the economic reality of the transaction” and “the tools given in business under the proposed terms, distribution plan, and economic incentives for prospects” are relevant. Therefore, this query is objective, focusing on the transaction itself and the way in which encrypted assets are offered and sold.

The following characteristics are particularly relevant when analyzing whether the third prong of the Howey test is satisfied.

1. Dependence on the efforts of others

In determining whether a purchaser is relying on the efforts of others, two key questions are paramount:

● Whether the purchaser reasonably expects to rely on the efforts of a promoter or other third party (including management) to generate a return on the investment.

● Whether those efforts are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature.

While no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely the purchaser is to be relying on the “efforts of others”:

● The promoter, sponsor, or other third party (or affiliated group of third parties) that is responsible for developing, improving (or enhancing), operating, or promoting the network or asset, plays a significant role in the maintenance and ongoing development of the network or asset and its potential increase in value.

○ Purchasers would reasonably expect such third parties to undertake efforts to promote their networks or assets, and thereby generate capital appreciation.

○ Purchasers would reasonably expect to rely on those efforts and the success of the enterprise.

● Any tasks necessary for the network or asset to achieve or retain its intended purpose or functionality would be difficult or impossible for purchasers to perform.

○ The degree of difficulty would depend on the nature of the tasks, the expertise required to perform them, and the availability of alternative channels.

○ Purchasers would reasonably expect to rely on the efforts of those other than themselves to achieve or retain the intended purpose or functionality of the network or asset.

● The efforts of the promoter, sponsor, or other third party (or affiliated group of third parties) that are going to be relied upon by the purchaser are expected to be undertaken by those other than the purchaser.

● The success of the enterprise (or any token offering) is significantly correlated to the efforts of the promoter, sponsor, or other third party (or affiliated group of third parties).

● There are factors that give rise to a reasonable expectation of managerial or entrepreneurial efforts on the part of the third party, such as:

○ An ability to exercise meaningful control over the asset or the network or a degree of influence over the success of the enterprise.

○ The expertise of the promoter or third party or their ability to select a successful investment.

○ A financial stake in the success of the enterprise or the appreciation in value of the asset.

○ The creation of a market for the purchase or sale of the asset or the availability of a mechanism for re-selling or redeeming the asset.

○ The imposition of contractual restrictions on the transfer of the asset or the promulgation of other rules that govern the asset’s operation.

● Deciding who will receive additional cryptocurrency under what conditions.

● Making or contributing to business decisions by management.

● Making decisions that directly or indirectly affect the success of the network or the value of the cryptocurrency, such as how to deploy funds raised through the sale of cryptocurrency.

● Playing a leading role in verifying network transactions or ensuring the ongoing security of the network in other ways.

● Making other managerial judgments or decisions that directly or indirectly affect the success of the network or the value of the cryptocurrency.

● Purchasers would reasonably expect AP to promote its own interests and increase the value of the network or the cryptocurrency, for example:

● AP has the ability to realize capital appreciation from the value of the cryptocurrency. For example, if AP retains an interest or stake in the cryptocurrency, purchasers would reasonably expect AP to promote its own interests and increase the value of the network or the cryptocurrency.

● AP distributes the cryptocurrency as compensation to management, or AP’s compensation is tied to the market price of the cryptocurrency. In these situations, individuals who are compensated can reasonably be expected to take steps to increase the value of the cryptocurrency.

● AP directly or indirectly owns or controls the intellectual property relating to the network or the cryptocurrency.

● AP profits from the cryptocurrency, especially when the cryptocurrency’s functionality is limited.

When assessing whether cryptocurrency previously sold as a security needs to be reassessed when offered or sold later, additional considerations related to the “efforts of others” may apply, including, but not limited to:

● Whether AP’s efforts, including those of any successor AP, are still important to the value of the investment in the cryptocurrency.

● Whether the manner in which the network is operated makes it no longer reasonable for purchasers to expect AP to carry out key managerial or entrepreneurial efforts.

● Whether AP’s efforts are no longer affecting the success of the enterprise.

2. Reasonable Profit Expectations

The assessment of cryptocurrency should also consider whether there are reasonable profit expectations. Profits can be capital appreciation resulting from initial investment or the development of a business enterprise, or a share of earnings resulting from the use of purchaser funds. Price appreciation solely from external market forces, such as general inflation trends or the economy, affecting the supply and demand of the underlying asset, is generally not considered “profit” under the Howey test.

The more of the following characteristics exist, the greater the likelihood of a reasonable expectation of profit:

● Cryptographic assets give holders the right to share in the enterprise’s income or profits, or to profit from an increase in the value of cryptographic assets.

○ This opportunity may at least in part stem from the positive developments resulting from the operation, promotion, improvement, or other positive development of the network that leads to an increase in the value of cryptographic assets, particularly if there is a secondary trading market that allows cryptographic asset holders to sell their cryptographic assets and realize a profit.

○ This may also occur when cryptographic assets give holders the right to receive dividends or distributions.

● Cryptographic assets can be transferred or traded on a secondary market or platform, or are expected to be able to do so in the future.

● Purchasers reasonably expect that AP’s efforts will result in an increase in the capital value of cryptographic assets, and therefore they can obtain a return on their purchase.

● Cryptographic assets are widely offered to potential purchasers, not just to users of expected goods or services, or those who need network functionality.

○ The supply and purchase of cryptographic assets indicate investment intentions rather than the number of network users. For example, the amount offered and purchased clearly exceeds the amount that any reasonable user would need, or the amount is so small that the actual use of the asset in the network becomes impractical.

● There is little correlation between the purchase/provision price of cryptographic assets and the market price of specific goods or services that can be exchanged for cryptographic assets.

● The number of cryptographic assets typically traded (or the amount typically purchased by purchasers) has little correlation with the amount of basic goods or services that a typical consumer would purchase for use or consumption.

● AP raises more funds than the amount required to establish functional networks or cryptographic assets.

● AP can benefit from its efforts by holding cryptographic assets of the same type as those distributed to the public.

● AP continues to use revenue or operating funds to improve the functionality or value of the network or cryptographic assets.

● Cryptographic assets are marketed, directly or indirectly, using any of the following:

○ AP’s expertise or its ability to establish or enhance the value of networks or cryptographic assets.

○ Marketing of cryptographic assets implies that they are an investment, or that the solicited holders are investors.

○ The expected use of the proceeds from the sale of cryptographic assets is to develop the network or cryptographic assets.

● The future functionality of a network or cryptographic asset, as opposed to its current functionality, and the prospects for AP to deliver that functionality.

● Commitments (implicit or explicit) to create a business or operation, as opposed to providing currently available goods or services for use on an existing network.

● The ease of transferability of cryptographic assets is a key selling point.

● Emphasizing the potential profitability of network operations or the potential appreciation in value of cryptographic assets in marketing or other promotional materials.

● The availability of a market for the trading of cryptographic assets, particularly when AP has implied or explicitly promised to create or support such a market for those assets.

When evaluating whether a cryptographic asset previously sold as a security should be reevaluated as part of a later offer or sale, additional considerations relating to “reasonable expectation of profits” may include, but are not limited to:

● Purchasers of cryptographic assets no longer reasonably expect that efforts by AP will be a key factor in determining the value of the cryptographic asset.

● The value of the cryptographic asset has shown a direct and stable correlation to the value of the goods or services for which it can be exchanged or redeemed.

● The volume of transactions involving the cryptographic asset is indicative of the level of demand for the goods or services for which it can be exchanged or redeemed.

● Whether holders of the cryptographic asset are able to use it for its intended functionality, such as to purchase goods and services on a network or platform.

● Whether any economic benefit that may be derived from an increase in the value of the cryptographic asset is incidental to obtaining the right to use the asset for its intended functionality.

● There is no AP that obtains important, non-public information or that can be viewed as holding material, non-public information about the cryptographic asset.

3. Other Relevant Considerations

When evaluating whether there is a reasonable expectation of profits to be derived from the efforts of others, federal courts examine the “economic realities” of the transaction. In doing so, courts also consider whether the instrument is being sold and/or marketed to purchasers for use or consumption.”

Although no one of the following characteristics is determinative, the stronger their presence, the less likely it is that the Howey test will be met:

● The network and cryptographic asset are fully developed and operational.

● Holders of the cryptographic asset can immediately use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.

● The creation and structure of cryptographic assets are designed and implemented to meet the needs of their users, rather than to drive speculation about their value or network development. For example, cryptographic assets can only be used on the network, and are typically held or transferred only in quantities that meet the expectations of the purchaser.

● The potential for cryptographic asset value appreciation is limited. For example, the design of cryptographic assets specifies that their value will remain constant or even decrease over time, so reasonable purchasers would not expect to hold cryptographic assets as long-term investments.

● Regarding cryptographic assets, also known as virtual currencies, they can be used immediately in a variety of situations to pay for goods or services, or as a substitute for real (or fiat) currency.

○ This means that cryptographic assets can be used to pay for goods or services without first converting them to other cryptographic assets or real currency.

○ If it is classified as a virtual currency, then cryptographic assets actually act as a value storage tool that can be saved, retrieved, and exchanged for something valuable at a later time.

● Regarding cryptographic assets that represent rights to goods or services, they can now be exchanged on a developed network or platform to obtain or use those goods or services. Relevant factors may include:

○ The correlation between the purchase price of cryptographic assets and the market price of specific goods or services that may be exchanged or traded for them.

○ Cryptographic assets are provided in increments that align with consumer intent, not investment or speculative purposes.

○ If the only way to obtain or more effectively obtain goods or services based on cryptographic assets is to use cryptographic assets on the network, then the consumer intent to consume cryptographic assets may be more apparent.

● Any economic benefit that may be obtained from the appreciation of cryptographic asset value is an incidental result of obtaining the right to use its intended functionality.

● The marketing of cryptographic assets emphasizes their functionality rather than their market value.

● Potential purchasers have the ability to use the network and use (or have used) cryptographic assets to achieve their intended functionality.

● Restrictions on the transferability of cryptographic assets are consistent with the intended use of the asset and do not promote speculative markets.

● If AP promotes the creation of secondary markets, the transfer of cryptographic assets can only be done by users of the platform.

Cryptographic assets with these types of usage or consumption characteristics are unlikely to be investment contracts. For example, take an online retailer that operates a very developed business. The retailer creates cryptographic assets for consumers to purchase products exclusively on the retailer’s network, provides cryptographic assets for sale in exchange for fiat currency, and cryptographic assets can be exchanged for products priced in that fiat currency. As part of these efforts, the retailer continues to promote its products to existing customer groups, advertise its cryptographic asset payment method, and may “reward” customers with cryptographic assets based on product purchases. Upon receipt of cryptographic assets, consumers can immediately use them to purchase products on the network. Cryptographic assets are not transferable; instead, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount below the original purchase price. Based on these facts, cryptographic assets would not be investment contracts.

Even if digital assets can be used to purchase goods or services on a network and the network or digital asset is undergoing development or improvement, there may still be a securities transaction if, among other factors, the digital asset is sold or provided to purchasers at a discount to the value of goods or services expected to be provided in exchange for the digital asset; the digital asset is offered or sold in quantities that exceed the reasonable needs of users; and/or the purchaser is immediately able to resell the digital asset on a secondary market or the digital asset is structured in a way that would prompt purchasers to buy it for potential appreciation in value.

Original link:

https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn11

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