Embroker Team August 7, 2023 9 min read

What Is the Howey Test & Does Crypto Pass? (The 4 Elements)

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A little more than a decade ago, cryptocurrencies were essentially an academic concept. The idea seemed far-fetched to most people. But that all changed in 2009 with the creation of Bitcoin.  

Fast forward to today, and the world’s cryptocurrency market is worth more than $3 trillion.

There’s no question that crypto is here to stay, and it will undoubtedly continue to disrupt countless industries.

But along with the technological advancements, the cryptocurrency era has ushered in a host of confusing and complicated regulatory challenges. The rapid expansion of digital assets has seen ample debate about whether these assets should be classified as currencies or securities, which would subject them to regulations.

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So how is the classification determined? It comes down to a particular test: the Howey Test, which determines whether a transaction is an “investment contract.” 

Let’s look at the Howey Test and how it applies to crypto. You may have heard the phrase before, but do you know what the Howey Test means?

What Is the Howey Test?

The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract.” If a transaction is found to be an investment contract, it’s considered a security. It’s then subject to registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.

According to the U.S. Securities and Exchange Commission (SEC), an “‘ investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The so-called ‘Howey Test’ applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.”

What Is a Security?

howey test securities iluustration

Before we dive into the origins of the Howey Test, it’s worth clarifying the term ‘security’ since it’s so intrinsic to the test’s premise.

A security is a financial instrument that holds some type of monetary value and can be sold or traded in a financial market. The most common types of securities are stocks, bonds, EFTs (exchange-traded funds), options, and mutual funds.

There are four main types of securities:

  1. Equity securities: These securities represent a share of ownership in a company, trust, or partnership (think capital stock). As a result, holders of equity securities can benefit from earnings in the form of dividends, which fluctuate based on the market, and capital gains when they sell the securities.
  2. Debt securities: With debt securities, companies can borrow funds from investors and repay the loan with interest. Examples of debt securities are bonds and promissory notes.
  3. Hybrid securities: These securities are just as the name suggests – a combination of debt and equity securities. An example of a hybrid security is a convertible bond, which can be converted into shares of stock for the company issuing the bond.
  4. Derivative securities: These are contracts between two or more parties. Their value depends on the price of an underlying asset.

In the U.S., all offered securities must register with the SEC. And companies that violate SEC regulations can face severe penalties.

So, where do cryptocurrencies fall with securities? It’s a bit complicated.

Kristin Smith, head of the Blockchain Association, told CNBC: “These decentralized networks don’t fit neatly within the existing regulatory structure.”

The rise in cryptocurrencies and blockchain technology has muddied the waters with securities regulation, leading to some gray areas, which we’ll get into more in just a bit.

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What year was the Howey Test created?

The origins of the Howey Test date back to 1946 when SEC v. W.J. Howey Co. reached the Supreme Court.

The case concerned the sale of land with citrus groves to investors in Florida. The Howey Company’s business model revolved around an arrangement with the investors, who would buy the groves and then turn around and immediately lease the land back to Howey. The company would then tend to the land and sell the harvested citrus fruit, sharing profits with the investors. 

Since many of the investors who bought the land didn’t have experience in agriculture and wouldn’t tend to the groves themselves, the arrangement suited them.

But the Howey Company didn’t register the transactions as securities. And that led to intervention from the SEC. 

In its final ruling of Howey, the Supreme Court determined that the leaseback arrangements were investment contracts under the Securities Act of 1933. 

That decision, in turn, led to the Supreme Court establishing landmark criteria for identifying securities.

What Are the Four Elements of the Howey Test?

As you probably guessed, the criteria established by the Supreme Court in Howey became what is known as the Howey Test. Since its creation, the Howey Test has been the legal doctrine for determining whether transactions are investment contracts.

Under the Howey Test, a transaction qualifies as a security if it involves the following four elements: 

  1. An investment of money
  2. In a common enterprise
  3. A reasonable expectation of profit
  4. Derived from the efforts of others

To be considered a security, a transaction must meet all four prongs of the Howey Test.

It’s worth pointing out that while the test references “money,” that has since expanded to include assets other than money. Additionally, the term “common enterprise” doesn’t have a clear definition. While many federal courts consider a common enterprise as one that is horizontal, where investors pool their assets together to invest in an endeavor, various courts have used different interpretations.

The final factor of the test concerns whether the profit from an investment is mainly or entirely outside of an investor’s control. If investors have little or no control over the investment’s management, there’s a good chance it’s a security. But if an investor has a notable influence on the handling of an investment, it’s likely not a security.

Of course, since the creation of the Howey Test more than half a century ago, many have attempted to disguise investments to avoid regulations. That’s why the Howey Test emphasizes substance over form. To combat deceptions, courts examine the “economic realities” of a transaction, rather than simply the name or label it’s given, to determine if it passes the Howey Test. If you’re a business owner of a blockchain or crypto, learn more about commercial insurance for crypto companies.

What Is an ICO?

To understand how the Howey Test applies to crypto, it’s important to understand a term crucial to the debate surrounding cryptocurrencies and securities: initial coin offering (ICO)

The simplest explanation is that an ICO is like a type of crowdfunding. To raise money for their cryptocurrency projects, companies create tokens, which people can purchase. 

Here’s how the ICO process works. First, a company creates a white paper, a document outlining the company’s pitch to potential investors, and a website dedicated to the new token. Then, after piquing people’s interest, the company asks for financial contributions (usually via a well-established cryptocurrency like Bitcoin) in exchange for some of the project’s crypto tokens. These tokens can serve various purposes, ranging from access to future goods or services to entitling the investor to a share of profits generated by the venture.

So who can launch an ICO? Anyone. ICOs are largely unregulated in the U.S., meaning anyone with the tech know-how can create one. But that lack of regulation also makes ICOs extremely high-risk, and investors have no protection if an ICO isn’t successful or turns out to be fraudulent. A 2018 study by the Wall Street Journal of 1,450 ICOs found that one in five showed “red flags” of being a scam.

Speaking about crypto assets during a September 2021 testimony before the Senate Committee on Banking, Housing, and Urban Affairs, Gary Gensler, chair of the SEC, said:

“Currently, we just don’t have enough investor protection in crypto finance, issuance, trading, or lending. Frankly, at this time, it’s more like the Wild West or the old world of ‘buyer beware’ that existed before the securities laws were enacted. This asset class is rife with fraud, scams, and abuse in certain applications.”

Does Crypto Pass the Howey Test? 


So does crypto meet the Howey Test? Well, it depends.

In a 2018 interview with CNBC, Jay Clayton, who was then chair of the SEC, made a firm statement about the debate into whether cryptocurrencies fall under the purview of the SEC: 

“Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin. That type of currency is not a security.”

A cryptocurrency like Bitcoin doesn’t pass the Howey Test. While Bitcoin meets the test’s first prong, it doesn’t satisfy the second and third elements. With Bitcoin, there is no common enterprise where investors are pooling their funds, there’s no promoter or issuer, and an investor’s success isn’t reliant on the efforts of others. 

As opposed to being a security, Bitcoin, which has never sought public funds to help develop its technology, is considered an asset in a similar vein as gold or diamonds.

But ICOs are an entirely different matter. In 2018, Clayton made a now-famous statement when he declared during a Senate hearing that “every ICO I’ve seen is a security.”

“A token, a digital asset, where I give you money, and you go off and make a venture, and in return for giving you my money, I say ‘you can get a return’ that is a security, and we regulate that,” Clayton told CNBC.

So how do ICOs factor under the Howey Test? According to the SEC, the test’s first prong is usually satisfied in offering and selling a digital asset because the asset is acquired in exchange for some form of value. For the second element, courts have generally found that a “common enterprise” exists. This means that when determining whether a digital asset meets the Howey Test, the key determination comes down to if any profits were expected from the investment and if those profits came from the efforts of others. If a digital asset meets these final elements of the Howey Test, it is a security and must adhere to SEC regulations. 

When a token doesn’t pass the Howey Test, it’s classified as a utility token. Utility tokens, known as user tokens or app coins, are more like digital coupons that give investors access to a future product or service or can be redeemed for discounted fees. Filecoin and Siacoin are examples of utility tokens. 

However, the SEC has indicated that just because a project has a utility token framework doesn’t automatically exclude it from being a security. 

The bottom line: There’s no one-size-fits-all regulation when it comes to digital assets.

What’s Next With Crypto Regulations?

The SEC has made it well-known that it’s cracking down on unregistered digital assets that qualify as securities. Take, for example, the SEC’s recent lawsuit against Ripple.

And with the crypto industry attracting more developers and investors, the SEC’s interest in regulating the use of cryptocurrencies isn’t about to let up anytime soon. Undoubtedly, the Howey Test will continue to play a pivotal role in the classification and regulation of digital assets.

But it’s worth noting that by not painting all digital assets with the same brush, the SEC has largely put the onus on developers to prove that they aren’t operating as a security.

Entrepreneurs interested in utilizing digital assets like ICOs as part of their startup venture need to be diligent. Given the numerous regulations and potential for severe penalties, entrepreneurs interested in creating a digital asset should first consult legal counsel to avoid costly violations of SEC requirements.

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