Derived from a Supreme Court case – SEC v. W.J. Howey Co., 328 U.S. 293 (1946) – the SEC’s Framework for digital asset analysis elaborates upon four factors: (1) an investment of money; (2) in a joint enterprise; (3) with a reasonable expectation of profits; and (4) derived from the efforts of others. Through this analysis—published in April 2019—interested parties can determine whether they may need to register their digital asset as a “security” with the SEC.
The Framework’s Background
Security must be registered with the SEC or exempted as such. While there are many types of protection – such as stocks and bonds – the most relevant for purposes of the SEC’s Framework is an “investment contract.” In its purest form, an “investment contract” involves an investment of money or other value in exchange for an asset that leads a reasonable investor to expect profit or capital appreciation executed by the issuing company.
Understanding Howey’s Four Factors
The Howey Test is important because it is applied to assets – including digital assets – regardless of whether they resemble specific securities. Further, its analysis focuses “not only on the form and terms of the instrument itself . . but also on the circumstances surrounding the digital asset and how it is offered, sold, or resold . . . .”
In the Framework, the SEC provides a list of features and circumstances under each Howey factor to help the public assess whether their asset may meet the definition of an investment contract. That said, the Framework is geared toward offering and selling digital assets—tokens.
Step-By-Step Analysis of the Framework
Each of the below factors from Howey must be satisfied for an “investment contract.” If all aspects are met, the digital asset is an investment contract and must register with the Commission as security. If one or more factors are not satisfied, then the Howey Test is not met, and the digital asset is not an investment contract. In these latter cases, the asset need not register as security.
- 1. The Investment of Money
This factor is easy to satisfy. Generally, when an individual gives money or other value in exchange for a digital asset, money is invested. This includes cash in fiat, crypto, or even airdrops.
- 2. Common Enterprise
This factor is also satisfied in most cases since there is usually a pooling of investor fortunes for a common purpose linked to each other or linked to the promoter’s efforts as well as a single issuer behind the project.
- 3. Reasonable Expectation of Profits
This factor has two aspects: (1) what profit is? and (2) is the individual’s expectation reasonable? Courts have indicated that “capital appreciation” from an initial investment or “participation in earnings” from one’s funds counts as profit. Still, increases in price due to “external market forces” such as inflation or supply/demand factors are not profitable. The facts and circumstances of each case would need to be evaluated when determining whether the expectation is reasonable.
Also necessary is a review of the “economic reality” of the situation—an objective review of what is occurring in reality.
- 4. Derived from Efforts of Others
This factor is a bit nuanced and asks several essential questions according to the Framework: (1) do the purchasers rely on the efforts of the “active participant”—referring to the “promoter, sponsor, or another third party”—and to what extent is such reliance? and (2) are the efforts of the active participant significant and involve organizational measures such that they can affect the enterprise’s failure or success? Or are those efforts more “ministerial”?
Case law demonstrates that the more the individual relies on the efforts of others and the more those efforts involve managerial duties, the more likely it is that this factor is satisfied.
Conclusion
The SEC’s Framework for investment contracts regarding digital assets is increasingly being used to ascertain whether novel digital asset projects may need to register with the Commission as a “security.” The SEC believes that this Framework – via the Howey Test – is necessary to give market participants the tools they need to make informed decisions about unique financial technologies, novel methods of capital formation, and new market structures.
