Chapter Five: Avoiding the Howey Test

In the last chapters we discussed what are the relevant investment practices, who are the investors and why do they need protection, and what are considered securities (investment agreements). In this chapter we'll cover and ask how to avoid the Howey Test. 

As a general reminder, the Howey test (Sec v. Howey Co, 328 US 293 (1946))  drafts several criteria on when a contract is an investment contract. The law, however, applies to “certificates issued in series by a company, a cooperative society or any other corporation conferring a right of membership or participation in them or claim against them, and certificates conferring a right to acquire securities, all of which whether registered or bearer securities”

As the Howey test is a legal-locigal test, once you break one of its pillars, you achieve a situation where your assets, tokens, or other cryptographic files are unregulated as a security.

Generated in a series. The first issue is whether these certificates are issued in a series; meaning, that all tokens are created equal; with the same rights, prices, obligations and usage, the series part is integral. If there are five different investors, or even fifteen different investors, and each received a materially different agreement, then this will not be deemed as a security. This was the claim in the Israeli Kedem Ruling (CA 7313-14 SEC v. Kedem Building Fortification and Restoration Ltd). There, a construction company approached various investors and offered them to lend money for a housing project. The district court ruled that as the agreements were not identical, not just similar, they were not "generated in a series". The supreme court, however, rejected this claim and found sufficient grounds for a series where there was material similarity.

So, if the issuance is of different assets that hold different rights under materially different agreements, we can be more inclined to view these as non-securities.

The second pillar of the Howey test checks whether the issuance is against an investment of money. meaning, that if there's a money, or money equivalent, to be paid for the assets, then this will be a security. However, if these assets are provided free of charge, then this shall be less likely to be considered as a security. As a general rule, it does not matter whether the assets are provided against monetary payment or money equivalent (for example, writing a post on Steem is labor, which is money equivalent). 

If you're thinking to yourself, well, bitcoin or ether are not really money; then you're mistaken. In a recent case (Securities and Exchange Commission v. Shavers, Dist. Court, ED Texas 20131) the defendant set up a fund to purchase bitcoins and promised investors interest rates over their bitcoin deposits. The court found, that for the interpretation of the Howey ruling, the investment of money includes the investment of bitcoins: “It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses”.

After we concluded that the assets, or tokens, should not be issued in a series or by payment of money, we take the next pillar of the Howey test, which is that the profits are derived from the Managerial Efforts of Others. This means that the investors, the people who paid in consideration of the assets, receive their profits, or the growth of those assets worth, by the efforts made by others. It means that they are passive participants and not people who are actively involved. This, by means of example, means that while investing in a passive share of a company will be a security, investing and operating a lemonade stand with a friend will not. This means, that if you wish to issue active participants in a project a token for their reward, and the project is so successful because of their activity, then, well, this is indeed not a security. 

The next issue we need to address is the expectation of profit. In theory, if a person pays money for an asset which is issued in a series (let's say, desks?) and he can later sell these desks, but without any expectation of profit, then, well, these are not securities. This means that tradeable assets that are generated in a series but cannot be sold later on for profit, are non-securities. A good example is the git-card industry. These gift cards have a value, they are issued in a series against payment of money, but they cannot be sold at a premium and therefore are not considered a security.

[well, if people can't sell your tokens later on at a premium, why should they invest in your ICO, you ask? the answer is, well, they shouldn't].

In the Shavers ruling, which related to bitcoin interest payments, the court addressed this issue and ruled that “The Court finds that this prong is also met. At the outset, Shavers allegedly promised up to 1% interest daily, and at some point during the relevant period the interest promised was at 3.9%. Clearly any investors participating in the BTCST investments were expecting profits from the efforts of Shavers”. 

But that's not the only case. In Gordon v. Dailey, Dist. Court, D. New Jersey 2016 the court found that mining contracts; meaning contracts where people pay for the computing power which creates (mines) bitcoins, and receive a portion of their revenues, are securities for the sake of the Howey ruling: a person paid money for a contract which provided him an expectation of profit, and it was dependent on the managerial efforts of others. 

So if we look back at known investment vehicles at the cryptocurrency world, we may see that most of them are considered as a security. As we know that mining contracts are already considered securities, let's ask what's next.

Are daily interest bearing loans considered securities? If we look at the definition then they most likely are. All the prongs of the Howey test apply here. 

Are CryptoKitties Securities? Here is a very tempting question. Cryptokitties is a website where each player may buy a virtual pet, and later breed or sell these cats for money. These cats are, most likely, not securities. First thing first, they are not issued in a series; not all cats are created equal and not all cats have the same rights and responsibilities. The second thing is that people invest money, but the change in a specific cat's value is more dependent on the way a person raises his pet, takes care of it, or breeds it with others. The last thing is that in most cases, these cats do not carry an expectation of profit. These cats are just, well, virtual pets.

In our next chapter we'll discuss airdrops. Airdrops are an in

I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my blog for more info.

Previous Chapters:

Preface
Chapter One: Other People's Money, an Introduction.
Chapter Two: Scams, or why do we need investor protection?
Chapter Three: The Investors, or who doesn't need protection.
Chapter Four: What is a security, or: the Howey test, simplified.