The Howey Test

By Christine Duhaime | January 31st, 2018

Digital currency issuers often ask about the Howey Test and its applicability to their activities. Here is our summary of the law.

In determining whether digital currencies are securities, securities regulators in Canada have expressly stated that they are evaluating digital currencies within the framework of three court decisions that considered the elements of investment contracts under securities legislation. 

The first decision, SEC v. Howey Co., 328 U.S. 293 (1946), U.S. Supreme Court (“Howey”), involved an appeal to the US Supreme Court of a decision that found that Howey Inc. had issued securities without being registered to do so or exempt from registration.  Pursuant to §2(1), §3(b) and §5(a)of the Securities Act of 1933 (the “US Securities Act”) sellers of securities (which by definition include an investment contract), are required to register pursuant to §5(a) of the US Securities Act unless exempted under §3(b) of the US Securities Act.  

Howey Inc. owned citrus groves in Florida and it sold part of its groves to investors to finance land development.  Each investor signed a land sales contract and a service contract.  The service contract gave Howey Inc. a leasehold interest, possession of the groves and authority to cultivate, harvest and market the crops.  The Securities Exchange Commission (“SEC”) took the position that Howey Inc. was issuing unregistered and non-exempt securities.  It filed an action to restrain Howey Inc. from the offer and sale of securities, alleging a violation of §5(a) of the US Securities Act.

The legal issue in Howey turned upon a determination of whether the land sales and service contracts were an “investment contract” and therefore a securities within the meaning of §2(1) of the US Securities Act.  If affirmative, Howey Inc. was required to register the securities under §5(a) of the US Securities Act, unless exempted.

The US Supreme Court held that an “investment contract” for the purposes of the US Securities Act meant a contract, transaction or scheme whereby a person: 

(a)        invests money;

(b)       in a common enterprise;

(c)        is led to expect profits;

(d)       solely from the efforts of the company or a third party

(the “Howey Test”).

The US Supreme Court held that the contracts that investors entered into with Howey Inc. were investment contracts because Howey Inc. offered the opportunity to contribute money and share in the profits of an enterprise that it managed.  The opportunity was made to persons in distant localities who lacked the equipment and experience to cultivate, harvest and market the citrus groves on their own and such persons had no desire to occupy the land or to develop it; they were attracted to the investment solely by the prospect of a return on their investment. The US Supreme Court held that a common enterprise managed by Howey Inc. or third parties on behalf of Howey Inc. with personnel and equipment to operate the groves was essential if investors were to achieve a return on their investment.

Since all four elements of the Howey Test were met – the investors provided capital with the expectation of sharing in the profits of a common enterprise while the promoters solely managed, controlled and operated the enterprise – the arrangement was an investment contract and therefore the illegal issuance of securities.

Similar issues arose in the second case, State v. Hawaii Market Center, Inc., 52 Haw. 642 (1971) which varied that part of the Howey Test that dealt with management control.  In that case, Hawaii Market Center, Inc. (“Hawaii”) intended to open a retail store which would sell merchandise to persons holding Hawaii-branded cards.  To raise money to open the retail store, Hawaii recruited founder-members who would participate in the management of the company.  The State of Hawaii filed an action against Hawaii to enjoin it from promoting its investments, arguing that the contracts were unregistered securities whose distribution was unlawful.  Hawaii argued that because investors participated in the management of the company, the fourth prong of the Howey Test was not met because the investment potential was not solelyfrom the efforts of Hawaii and therefore there were no investment contracts and securities regulation did not apply.  

The Court held that the Howey Test was too restrictive and that an investor’s participation in a company was not the relevant consideration.  What was relevant was the quality of the participation by the investor.  In order to negate the finding of a securities, an investor must have practical and actual control over the managerial decisions of a company.  In this case, although the investors could expect a profit not solely from the efforts of Hawaii but also from their own efforts, they had no actual managerial control and no power to influence how the capital raised was used.  Therefore, the Court held that the Howey Test was met and the contracts were investment contracts required to be registered before distribution.

In the third case, Pacific Coast Coin Exchange of Canada Limited v. Ontario Securities Commission, (1978), 2 S.C.R. 112, Pacific Coast Coin Exchange of Canada Limited (“Pacific Coast”) offered for sale silver coins on margin to investors for a fee of 2%. Purchasers entered into commodity agreements. The Ontario Securities Commission brought an application against Pacific Coast, alleging that the commodity agreements were investment contracts and therefore Pacific Coast was trading in securities illegally.

The Supreme Court of Canada on appeal, considered just two prongs of the Howey Test – whether there was a common enterprise and whether profits were solely from the efforts of others.  It held that the test of a common enterprise could be met in Canada when an enterprise was undertaken for the benefit of the investor and the company. In this case, the investor’s role was limited to providing money to buy silver on margin and the managerial control over the success of the enterprise was that of the company, and therefore there was a community and a common enterprise.

Since the success of the investment made by each investor was dependent upon the quality of the expertise brought to the administration of the funds by the efforts of Pacific Coast alone, the elements of the Howey Test were met, and the commodity agreements were held to be securities.

The Howey and Hawaii cases formed the material basis of the SEC’s Report of Investigation Pursuant to §21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (the “DAO Report”) published on July 25, 2017.  The DAO Report considered whether The DAO, an unincorporated organization in Canada launched by residents of Toronto which issued an initial coin offering (“ICO”), violated the US Securities Act by marketing and selling securities to US residents.  

From April 30, 2016 to May 28, 2016, The DAO offered and sold 1.15 billion DAO coins for 12 million Ether, valued at US$150 million. To promote The DAO, Ethereum launched a website, published a white paper and included a link through which DAO coins could be purchased for Ether.  DAO coin holders acquired certain voting and ownership rights.  The DAO would earn profits by funding projects that would provide DAO coin holders a return on investment.  Like all ICOs, investments in The DAO were made anonymously (i.e., the digital currency was sent from an unknown and unidentified Ether wallet of an investor to an unknown and unidentified Ether wallet address held by The DAO). 

In the DAO Report, the SEC concluded that the ICO met all four prongs of the Howey Test and DAO coins were securities. Because they were securities, The DAO was required to register to offer and sell DAO coins. The DAO Report analyzed just three of the four prongs of the Howey Test. 

With respect to the first prong of the Howey Test, an investment of money, the SEC held that the investment of “money” could take the form of Bitcoin or Ether for the Howey Test to be met under US law. 

With respect to the second prong of the Howey Test, the reasonable expectation of profit, the SEC held that investors expected to earn profit when they sent Ether to The DAO’s wallet because the promotional material from The DAO made that express representation to investors. Thus, a reasonable investor would have been motivated, at least in part, by the prospect of promised profits on their investment into The DAO.

With respect to the third aspect, profits derived from the managerial efforts of others, the SEC held that profits to investors were derived from the managerial efforts of The DAO creators who held themselves out as experts to investors. While DAO coin holders had voting rights, those rights did not give them meaningful control over the business because their ability to vote was perfunctory and they were widely dispersed and limited in their ability to communicate with one another.  The anonymity and international nature of The DAO made it impossible for them to join together to effect change or exercise meaningful control, and thus for all the foregoing reasons, The DAO was determined to be a securities.

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