SEC: How to Use the Howey Test to Determine Whether a Cryptographic Asset Is a Security?
TechFlow Selected TechFlow Selected
SEC: How to Use the Howey Test to Determine Whether a Cryptographic Asset Is a Security?
These factors are not intended to be an exhaustive assessment of whether a digital asset is an investment contract or any other type of security, and no single factor is decisive.
Navigating Web3 tides with focused insightsCompiled by Wu Shuo Blockchain
Original Source: SEC
This article compiles the key content from the SEC's publication titled "Framework for 'Investment Contract' Analysis of Digital Assets," which primarily outlines how to apply the Howey Test to determine whether a digital asset constitutes a security. The SEC also notes in its conclusion that "these factors are not intended to be an exhaustive evaluation of whether a digital asset is an investment contract or any other type of security, and no single factor is determinative." The original document was last modified on March 8, 2023.
A. Investment of Money
The first prong of the Howey Test is typically satisfied when digital assets are offered or sold because they are purchased or otherwise acquired with something of value—whether fiat (or real) currency, another digital asset, or some other form of consideration.
(SEC Note: Cash is not the only form of contribution or investment; an investment contract can exist even without cash. For digital assets distributed through so-called "airdrops," the absence of monetary consideration does not necessarily mean the investment of money condition is unmet. Therefore, airdrops may constitute the sale or distribution of a security. In such "airdrops," digital assets are distributed to holders of digital assets, often to promote their circulation.)
B. Common Enterprise
Courts often treat a "common enterprise" as a distinct element of an investment contract. In evaluating digital assets, we generally find that a "common enterprise" exists.
(SEC Note: Based on our experience to date, investments in digital assets constitute investments in a common enterprise because the fortunes of digital asset purchasers are either interlinked with one another or tied to the success of the efforts of the promoter or sponsor.)
C. Expectation of Profit Solely from the Efforts of Others
Typically, when analyzing digital assets under the Howey Test, the central question is whether purchasers have a reasonable expectation of profits (or other financial returns) derived solely from the efforts of others. Returns may come through participation in distributions or through appreciation in the value of the asset (e.g., selling at a higher price in a secondary market). This prong is satisfied when promoters, sponsors, or other third parties (or groups of related third parties)—each referred to as an "Active Participant" (AP)—provide significant managerial efforts that are critical to the success of the enterprise, and investors reasonably expect to profit from those efforts. For this inquiry, "the economic realities of the transaction" and "the characteristics of the instrument as used in the marketplace under the proposed terms, distribution plan, and economic inducements" are relevant. Thus, this inquiry is objective and focuses on the transaction itself and how the digital asset is offered and sold.
The following characteristics are particularly relevant when assessing whether the third prong of the Howey Test is satisfied.
1. Reliance on the Efforts of Others
Determining whether purchasers rely on the efforts of others primarily involves two key questions:
● Do purchasers reasonably expect to rely on the efforts of Active Participants (APs)?
● Are those efforts "undeniably significant" and do they constitute critical managerial efforts that affect the failure or success of the enterprise, as opposed to more routine efforts?
While none of the following characteristics alone is necessarily determinative, the more prominently they are present, the more likely it is that purchasers rely on “the efforts of others”:
● APs are responsible for the development, improvement (or enhancement), operation, or promotion of the network, especially when purchasers of the digital asset expect the AP to perform or oversee tasks necessary for the network or digital asset to achieve or maintain its intended purpose or functionality.
● When the network or digital asset is still under development and is not yet fully functional at the time of offering or sale, purchasers reasonably expect the AP to further develop the network or digital asset’s functionality (directly or indirectly), particularly if the AP has committed to additional development work that would increase the value of the digital asset.
● Essential tasks or responsibilities are carried out by APs and are expected to continue being performed by APs rather than by an unrelated, decentralized community of network users (often described as a “decentralized” network).
● APs create or support markets for the digital asset or influence the price of the digital asset. For example, an AP may: (1) control the creation and issuance of the digital asset; or (2) take other actions to support the digital asset’s market price, such as limiting supply or ensuring scarcity through buybacks, “burning,” or other activities.
● APs play a dominant or central role in guiding the ongoing development of the network or digital asset. In particular, APs play a leading or central role in decisions regarding governance issues, code updates, or how third parties participate in validating transactions involving the digital asset.
● APs retain an ongoing managerial role in decisions concerning the characteristics or rights represented by the network or digital asset, such as:
● Deciding whether and how to compensate individuals or entities providing services to or overseeing the network.
● Determining where the digital asset will trade. For example, purchasers may reasonably rely on the AP to ensure liquidity, such as if the AP has arranged or committed to arrange for the digital asset to trade on a secondary market or platform.
● Deciding who will receive additional digital assets and under what conditions.
● Making or contributing to management decisions, such as how funds raised from the sale of digital assets will be deployed.
● Playing a leading role in validating network transactions or ensuring the ongoing security of the network, or otherwise being responsible for the network’s continued security.
● Making other managerial judgments or decisions that directly or indirectly affect the success of the network or the value of the digital asset.
● Purchasers reasonably expect the AP to act in its own interest and enhance the value of the network or digital asset, for example:
-
The AP has the ability to realize capital appreciation from the value of the digital asset. For instance, if the AP retains an equity or beneficial interest in the digital asset, purchasers may reasonably expect the AP to work to promote its own interests and increase the value of the network or digital asset.
-
The AP distributes the digital asset as compensation to management, or ties management compensation to the price of the digital asset in the secondary market. In such cases, compensated individuals would be expected to take steps to increase the value of the digital asset.
-
The AP directly or indirectly owns or controls intellectual property related to the network or digital asset.
-
The AP profits from the digital asset, especially when the digital asset has limited functionality.
Additional considerations related to “the efforts of others” arise when assessing whether a digital asset previously sold as a security requires reassessment in subsequent offerings or sales, including but not limited to:
● Whether the efforts of the AP, including any successor AP, remain important to the value of investing in the digital asset.
● Whether the manner in which the network operates means that purchasers no longer reasonably expect the AP to perform critical managerial or entrepreneurial efforts.
● Whether the efforts of the AP no longer affect the success of the enterprise.
2. Reasonable Expectation of Profit
An assessment of digital assets should also consider whether there is a reasonable expectation of profit. Profits may include capital appreciation resulting from the initial investment or business development, or a share of earnings generated from the use of purchasers’ funds. Price increases driven solely by external market forces (such as general inflation trends or the economy) affecting the supply and demand of the underlying asset are generally not considered “profits” under the Howey Test.
The more of the following characteristics that are present, the greater the likelihood of a reasonable expectation of profit:
● The digital asset grants holders rights to share in the enterprise’s revenues or profits, or to benefit from capital appreciation of the digital asset.
-
Such opportunity may stem at least partly from increases in the value of the digital asset due to operational, promotional, or developmental improvements to the network, especially if a secondary trading market exists allowing holders to sell their digital assets and realize gains.
-
This may also occur when the digital asset grants holders rights to receive dividends or distributions.
● The digital asset is transferable or tradable on a secondary market or platform, or is expected to become so in the future.
● Purchasers reasonably expect that the efforts of the AP will lead to capital appreciation of the digital asset, thereby enabling them to profit from their purchase.
● The digital asset is broadly offered to potential purchasers rather than targeted specifically at users of the underlying goods or services or those needing the network’s functionality.
-
The quantity offered and purchased suggests an investment intent rather than reflecting the number of network users. For example, quantities offered and purchased significantly exceed any plausible user need, or are too small to make practical use of the asset within the network.
● Little correlation exists between the purchase/offer price of the digital asset and the market price of the specific goods or services for which the digital asset can be exchanged.
● Little correlation exists between the typical amount of digital asset traded (or purchased) and the typical quantity a consumer would buy for actual use or consumption of the underlying goods or services.
● The AP raises more funds than needed to establish a functional network or digital asset.
● The AP benefits from its efforts by holding digital assets of the same kind distributed to the public.
● The AP continues to use revenue or operating funds to enhance the functionality or value of the network or digital asset.
● Marketing of the digital asset, directly or indirectly, includes any of the following:
-
Emphasis on the AP’s expertise or its ability to build or enhance the value of the network or digital asset.
-
Language suggesting the digital asset is an investment or that recipients are investors.
-
Stating that proceeds from the sale of the digital asset will be used to develop the network or digital asset.
-
Promoting the future (rather than current) functionality of the network or digital asset, along with the AP’s prospects for delivering such functionality.
-
Express or implied promises to build a business or operation, rather than offering currently available goods or services for use on an existing network.
-
Ease of transferability as a key selling feature.
-
Highlighting the potential profitability of network operations or the potential appreciation in value of the digital asset in marketing or promotional materials.
-
Availability of a trading market for the digital asset, especially when the AP implies or explicitly commits to creating or supporting such a market.
Additional considerations related to “a reasonable expectation of profit” arise when assessing whether a digital asset previously sold as a security requires reassessment in subsequent offerings or sales, including but not limited to:
● Purchasers no longer reasonably expect that ongoing development efforts by the AP will be a key determinant of the digital asset’s value.
● The value of the digital asset has shown a direct and stable correlation with the value of the goods or services for which it may be exchanged or redeemed.
● Trading volume of the digital asset corresponds to the level of demand for the underlying goods or services that can be redeemed.
● Holders are able to use the digital asset to achieve its intended function, such as purchasing goods and services via the network or platform.
● Any economic benefit arising from appreciation in the value of the digital asset is incidental to obtaining access to its intended utility.
● No AP possesses material non-public information or could be viewed as holding material inside information about the digital asset.
3. Other Relevant Considerations
When assessing whether there is a reasonable expectation of profit derived from the efforts of others, federal courts examine the economic substance of the transaction. In doing so, courts also consider whether the instrument was offered and sold to purchasers for use or consumption.
Although none of the following use-or-consumption characteristics is determinative on its own, the more prominently they are present, the less likely the Howey Test is satisfied:
● The distributed ledger network and digital asset are fully developed and operational.
● Holders of the digital asset can immediately use it on the network for its intended function, especially when built-in incentives encourage such usage.
● The digital asset is created and structured to meet user needs rather than to drive speculation about its value or network development. For example, the digital asset can only be used on the network and is typically held or transferred in amounts consistent with expected user needs.
● Limited potential for value appreciation of the digital asset. For example, the design specifies that the value remains constant or even decreases over time, so that a reasonable purchaser would not expect to hold the digital asset long-term as an investment.
● For digital assets classified as virtual currencies, they can be used immediately in multiple contexts as payment or as a substitute for real (fiat) currency.
-
This means the digital asset can be used to pay for goods or services without first converting it into another digital asset or fiat currency.
-
If categorized as a virtual currency, the digital asset functions practically as a store of value that can be saved, retrieved, and exchanged later for something of value.
● For digital assets representing rights to goods or services, they can now be redeemed on an established network or platform to obtain or use those goods or services. Relevant factors may include:
-
Correlation between the purchase price of the digital asset and the market price of the specific goods or services for which it may be exchanged.
-
The digital asset is offered in increments consistent with consumption intent rather than investment or speculative purposes.
-
Intent to consume the digital asset may be stronger if access to goods or services based on the digital asset is only possible or more effective through using the digital asset on the network.
● Any economic benefit potentially derived from appreciation in the digital asset’s value is incidental to gaining access to its intended utility.
● Marketing emphasizes the functional aspects of the digital asset rather than its market value.
● Potential purchasers have the ability to use the network and either use (or have already used) the digital asset to achieve its intended function.
● Restrictions on transferability align with the asset’s intended use and do not promote a speculative market.
● If the AP facilitates the creation of a secondary market, transfers of the digital asset are limited to users of the platform.
Digital assets exhibiting these types of use or consumption characteristics are less likely to constitute investment contracts. Consider, for example, a well-established online retailer that creates a digital asset for consumers to purchase products exclusively on its network, sells the digital asset in exchange for fiat currency, and allows redemption of the digital asset for products priced in that fiat currency. As part of its operations, the retailer continues to market its products to its customer base, promotes its digital asset payment method, and may reward customers with digital assets based on product purchases. After receiving the digital asset, consumers can immediately use it to purchase products on the network. The digital asset is non-transferable; instead, consumers can only use it to buy products from the retailer or resell it back to the retailer at a discount below the original purchase price. Under these facts, the digital asset would not be an investment contract.
Even if a digital asset can be used to purchase goods or services on a network and the network or digital asset functionality is still being developed or improved, a securities transaction may still exist if, among other factors: the asset is offered or sold to purchasers at a discount to the value of the goods or services; the quantity of digital assets offered or sold exceeds reasonable usage levels; and/or there are limited or no restrictions on resale—particularly if the AP continues efforts to increase the value of the digital asset or supports a secondary market.
Join TechFlow official community to stay tuned
Telegram:https://t.me/TechFlowDaily
X (Twitter):https://x.com/TechFlowPost
X (Twitter) EN:https://x.com/BlockFlow_News
@SECGov
