The Howey Test: The Supreme Court Ruling that Defined Investments
What do oranges have to do with cryptocurrency? According to the SEC, quite a lot. Their answer gives us the definition of an investment contract and shaped what we consider a modern-day security.
On May 27, 1946, the Supreme Court ruled on SEC v. W.J. Howey, a case that determined that the sale of units of a citrus grove, alongside a contract for cultivating and marketing the fruit, was an “investment contract,” as defined by the Securities Act of 1933. According to the Act, an investment contract is a monetary investment in a common enterprise meant to generate profit from the efforts of others.
The History of Howey
W.J. Howey managed a huge tract of citrus groves in Lake County, Florida, through his company, The Howey Company. The Howey Company cultivated about half of the 500 acres, offering the other half for sale. The Howey Company also ran a hotel on a pastoral plot of land near the orange grove. As guests toured the countryside, Howey Company employees would point out the groves and mention they were for sale. Sales presentations were ready for any visitor who seemed interested in owning a citrus grove.
These guests weren’t going to become citrus farmers themselves, but would simply buy a plot of land, and then pay to have someone else do the grunt work of cultivation. Customers were encouraged to use The Howey Company’s service company, Howey-in-the-Hills Service, Inc. They were technically free to choose another company to maintain the land if they wanted, but since most of the buyers lived outside of Florida, it’s easy to see how having the arrangements settled along with the land purchase may have seemed like an attractive option.
The service contract spanned 10 years, and typically did not come with the option to cancel. It gave Howey-in-the-Hills full authority over the cultivation of the groves, the harvest, and the marketing of the fruit. With this contract, the purchaser had no right to market the fruit on their own. Again, that may have seemed just as well, as most of the people making these orange grove purchases also had no experience in the fruit-growing business. Basically, this contract meant that purchasers simply had to sit back and wait to see what kind of profits their purchase would generate. The Howey Company made representations that the 1943 to 1944 growing season had seen profits of 20%, and that the upcoming season looked even more promising, even though “only a 10% annual return was to be expected over a 10-year period.”
The Supreme Court case boiled down to whether the land sales contract, the deed, and the service contract constitute an investment contract. Ultimately, the Supreme Court rejected a previous ruling from the lower courts that found that because the orange groves have intrinsic value, independent of the success of Howey-on-the-Hills, that the purchase could not be considered an investment. Instead, the Supreme Court ruled that “The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
As a result of this ruling, the Howey Test was born. It established that the orange grove investments had all of the markers of a profit-seeking business, namely that the investors provided the capital and hoped to share in the profits.
To satisfy the Howey Test, an investment contract must meet the following criteria:
1. An investment of money;
2. In a common enterprise;
3. With an expectation of profits; and
4. Solely from the efforts of others.
Crypto-Assets and the Fight to End Howey
Thanks to 21st century debates around the nature of digital assets, the Howey Test is once again a hot-button issue. Crypto-assets, like Bitcoin, present an interesting conundrum. Not many people fully understand this new type of asset, and it’s highly debated if digital assets match the Supreme Court’s understanding of an investment contract.
Nevertheless, in 2019, the SEC sued Kik, a social media platform, for failing to register its tokens as securities. Buyers purchased Kik tokens before Kik’s promised digital ecosystem existed, and buyers therefore expected a return on an investment “from the efforts of others.” As of publication, Kik and the SEC are still arguing in court over whether the customers who bought Kik tokens had a reasonable expectation of profits.
The SEC further alleged that Kik needed funds when they started advertising their tokens, which customers may not have known. Under the Securities Act of 1933, companies that want to offer a security, or an investment, must register that security with the SEC. In order to obtain registration, the company provides a prospectus that includes financial information about the company. The SEC argues that if Kik had registered as a security and provided a prospectus disclosing information, Kik’s lack of funds may have scared off some buyers from purchasing the now nearly worthless tokens.
Proponents of blockchain argue that the Howey Test is based on a 74-year-old ruling, and that the language needs an update that reflects digital financial products. Many of these digital assets can’t become competitive and build their networks without first raising funds. SEC regulations stymie this process, making it impossible for the cryptocurrency to get off the ground. Some cryptocurrencies have attempted, without much success, to label the purchases of their tokens as simple contracts that give the buyer the right to tokens, which will be distributed once the network is built.
This cryptocurrency debate is only the latest controversy around the Howey Test. As one article from the William & Mary Business Law Review states, “The intentional breadth and adaptability of the definition of investment contract necessarily leads to complex and fact-intensive judicial inquiries in the application thereof, and allows for inconsistent results…creating the possibility of similarly situated litigants winding up with dissimilar outcomes.”
While the Howey Test is creating plenty of questions and trouble for cryptocurrencies today, its days may be numbered. SEC commissioner Hester Pierce told Forekast that she believes there’s a chance Congress might one day say, ‘Hey, we want you to think about tokens in some other way than through the Howey lens’.”
Until then, cryptocurrencies have an uphill battle to raise capital without raising concerns with the SEC.