Howey Test: Cheating the SEC lie detector
The Howey Test was developed in 1946 by the U.S. Supreme Court for determining whether a financial asset qualifies as a promissory note or stock. It is still the main SEC instrument for securities regulation.
The Howey Test is a tough polygraph used by regulators to check cryptocurrency projects. To pass it, you have to answer 4 questions honestly and instantly.
One might ask: how is the cryptocurrency connected to the bill or bond?
But the SEC takes a different view and looks for signs of security in any token or coin that could potentially generate passive profit for the owner.
Therefore, each company offering its digital asset on the market is checked using the Howey test: does a transaction using this token contain signs of an investment transaction? Does a startup fall under the jurisdiction of the SEC with subsequent mandatory registration and taxation of income from owning or reselling shares?
Howie's Scary Questions
Let's look at these four criteria based on the SEC v. Ripple Labs court case. Remember that the Securities Commission believes that XRP Ripple tokens are a security, since investors were attracted under the promise of profit that can be obtained through the work of others.
These are 3 out of 4 criteria that the Howey test checks.
If crypto-founders answer “yes” to all 4 questions of the test, then this automatically puts their project under the SEC control. And then the regulators begin to figure out how the investor portrait complies with the law norms. Indeed, in the US, only qualified investors have the right to invest in venture and hedge funds.
According to the law, this category includes:
1. Individuals with a net annual income of at least $200,000
2. Individuals who have declared a net (after tax) capital of at least $1,000,000
The SEC vs Ripple case is a classic example of the Howey test use in litigation. Source: Cryptonews.com
First question: Did you raise funds from investors?
In this case, Ripple Labs definitely falls into the category of a securities seller, because in fact, for 3 years, they’ve been conducting an ICO (without calling it that), promising a profit from the rise of XRP price, having received direct investments in the amount of $1.3 billion.
The scandal broke out only after someone , Ryan Coffey, one of the early token buyers, sold them on the exchange, losing $551 on the sale. He filed a lawsuit against Ripple CEO Brad Garlinghouse and accused him of losing 30% of his investments.
“Not such a great loss!” - any crypto trader would say and they would be right. But the problem is that Coffey filed a lawsuit on behalf of several investors. And the SEC reacted instantly to the collective suit, and a series of courts followed.
Question two: Were investments attracted under the promise of future material profits?
This question may seem rhetorical to some. Does anyone attract investments differently? The investor is motivated by potential profit, other incentives do not work.
But there are crowdfunding platforms that promise investors the growth of their public reputation or marketing promotion of the brand. Such investment agreements are not of interest to the Securities Commission.
In the Ripple case, the situation is straight from the SEC manual: the founders promised capital gains, but unqualified investors suffered losses.
The commission ignores the fact that Coffey and the rest of the plaintiffs sold the tokens during the market drawdown, succumbing to panic. SEC is only interested in dry numbers.
Question three: Was the money invested in a joint enterprise?
This calls for clarification: what do US regulators consider a “joint enterprise”? Most federal courts define it as a horizontal system that pools money or assets from multiple investors, with profit and risk shared in proportion to contributions. That is if the founders are also investors.
But there is also a “vertical” approach. In this case, the courts believe that the profit of the founders and investors is directly dependent: if the founders do not receive income, then the investors are left on bread and water. In this case, the total income of the project is not taken into account.
In the Ripple case, this point is not transparent. Since the company refused to provide financial documents for the organization and launch of the token. And some meetings were held behind closed doors at the request of witnesses giving evidence.
We cannot say for sure how the regulator will evaluate the “joint enterprise” in the Ripple Labs case.
Question four: Is the expected profit related to the third parties’ activities?
This is the criterion for passive investment. If the success of the enterprise as a whole depends on promoters, the third parties’ involvement and organizations that take direct participation in the token promotion, and the investors themselves are only watching what is happening in anticipation of profits, then this question will have an unequivocal “yes” answer.
In the Ripple case, the court may recognize the presence of a fourth criterion. Ryan Coffey's lawsuit alleges that the founders bribed crypto exchanges Gemini and Coinbase to list XRP. And this, according to the plaintiff, led to an artificial increase in the price of the token.
Whether Garlinghouse can prove that there was no bribery involved, we will find out very soon.
A final decision on the case should be made by the end of 2022.
Note that the significance of this court and the decision made on it is higher than the Ripple proof of guilt / innocence from the SEC point of view. It is important for Brad Garlinghouse to create a precedent and prove to the regulator that the digital token acquisition is not a classic investment contract, and XRP has nothing to do with company shares.
Moreover, in a similar situation, Telegram did not dare to argue with the Securities Commission and chose not to launch the internal Gram token.
