US SEC: How to use the Howey test to determine whether an encrypted asset is a security

This article is a compilation of the main content of the article "Framework for "Investment Contract" Analysis of Digital Assets" published by the SEC. It mainly outlines how to use the Howey test to determine whether an encrypted asset is a security. The SEC also stated in its conclusion that “these factors are not intended to be exhaustive in assessing whether a crypto asset is an investment contract or any other type of security, and no single factor is conclusive.” The original revision date is March 8, 2023.

A Investment Fund

When offering and selling cryptoassets, the first leg of the Howey test is generally met because the cryptoasset is purchased or otherwise acquired for value, whether it is physical (or fiat) currency, another cryptoasset, or Other types of consideration.

(SEC Note: Cash is not the only form of contribution or investment, investment contracts can be formed without cash; for encrypted assets distributed through so-called "airdrops", even if there is no monetary consideration, it does not mean that the conditions for investing money are not met ; thus, an airdrop may constitute a sale or distribution of securities. In so-called "airdrops," cryptoassets are distributed to holders of cryptographic digital assets, usually to facilitate their circulation.)

B joint venture

Courts generally regard the "joint enterprise" as a separate element of the investment contract. When evaluating crypto assets, we find that there is often a "common enterprise".

(SEC note: Based on our experience to date, investments in cryptoassets constitute investments in joint ventures because the fortunes of cryptoasset buyers are tied to one another or to the success of the originator’s efforts)

C Anticipation of profit through the efforts of others

In general, when analyzing cryptoassets according to the Howey test, the main question is whether the purchaser has a reasonable expectation of profit (or other financial return) from the efforts of others. Buyers may expect to be rewarded by participating in distributions or by otherwise appreciating the value of the asset, such as selling it at a premium in the secondary market. When promoters, sponsors or other third parties (or related groups of third parties) (each referred to as "Active Participants" or "APs") provide key management efforts that are This test is satisfied when there is a reasonable expectation of profit from these efforts. For this inquiry, the "economic reality of the transaction" and the "instrumental characteristics conferred in commerce based on the proposed terms, distribution plan, and economic incentives for the prospect" are relevant. As such, this query is objective and focuses on the transactions themselves and the way cryptoassets are offered and sold.

The following properties are particularly relevant when analyzing whether the third leg of the Howey test is satisfied.

1 Rely on the efforts of others

Determining whether a buyer is dependent on the efforts of others focuses on two key questions:

● Do buyers reasonably expect to rely on the efforts of active participants (APs)?

● Are these efforts “key management efforts of undeniable importance that have an impact on the failure or success of the business,” as opposed to efforts that are more routine in nature?

While none of the following characteristics are necessarily determinative, the stronger their presence, the more likely the buyer is to rely on "the efforts of others":

● Active Participants (APs) are responsible for the development, improvement (or enhancement), operation or promotion of the network, especially when the purchaser of the cryptoasset expects the AP to perform or oversee what is necessary for the network or cryptoasset to achieve or maintain its intended purpose or function task.

○ When the network or encrypted asset is still under development, and the network or encrypted asset is not fully functional when offered or sold, the purchaser would reasonably expect the AP to further develop the functionality of the network or encrypted asset (directly or indirectly). Especially if the AP commits to further development work in order for the crypto asset to gain value or increase in value.

● There are some fundamental tasks or responsibilities that are and are expected to be performed by the AP, rather than by an unconnected, decentralized community of network users (often referred to as a “decentralized” network).

● AP creates or supports markets for encrypted assets, or prices for encrypted assets. For example, APs can: (1) control the creation and issuance of cryptoassets; or (2) take other actions to support the market price of cryptoassets, such as by limiting supply or ensuring scarcity, such as through buybacks, “burns” or other Activity.

● AP has a leading or central role in the continuous development of the network or encrypted assets. In particular, APs play a leading or central role in deciding governance issues, code updates, or how to involve third parties in validating transactions on cryptoassets.

● The AP has an ongoing management role in decisions about the characteristics or rights represented by the network or encrypted assets, such as:

○ Decide whether and how to pay those who provide services to the network or the entity or entities responsible for overseeing the network.

○ Decide where crypto assets will be traded. For example, buyers may reasonably rely on AP to provide guarantees for liquidity, such as AP has arranged, or promised to arrange, that encrypted assets are traded on the secondary market or platform.

○ Decide who will receive additional crypto assets and under what conditions.

○ Make or do business to management

○ Contribute to decisions, such as how to deploy funds raised by selling crypto assets.

○ Play a leading role in, among other things, verifying network transactions or ensuring the ongoing security of the network, or otherwise be responsible for the ongoing security of the network.

○ Make other management judgments or decisions that directly or indirectly affect the success of the network or the value of cryptoassets.

● Purchasers would reasonably expect APs to work hard to promote their own interests and increase the value of the network or encrypted asset, for example:

○ AP has the ability to achieve capital appreciation from the value of crypto assets. For example, if the AP retains a stake or interest in the cryptoasset, the purchaser would reasonably expect the AP to work hard to promote its own interests, increasing the value of the network or the cryptoasset.

○ AP distributes encrypted assets as compensation to management, or AP’s compensation is linked to the price of encrypted assets in the secondary market. In these cases, compensated individuals can expect to take steps to increase the value of the cryptoasset.

○ AP directly or indirectly owns or controls the intellectual property rights of the network or encrypted assets.

○ APs profit from cryptoassets, especially if cryptoassets have limited functionality.

In assessing whether a cryptoasset previously sold as a security needs to be reassessed upon subsequent offering or sale, there are additional considerations related to “efforts of others” including, but not limited to:

● Whether the efforts of the AP, including the efforts of any successor AP, are still important to the value of investing in encrypted assets.

• Whether the network operates in such a way that buyers no longer reasonably expect the AP to perform key management or entrepreneurial endeavors.

● Whether the AP's efforts no longer affect the success of the enterprise.

2. Reasonable profit expectations

Valuing cryptoassets should also consider whether there is a reasonable expectation of profit. Profit can be capital appreciation due to the initial investment or development of the business enterprise, or a share of earnings due to the use of the purchaser's funds. Price increases resulting solely from 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 are present, the more likely it is that reasonable profit expectations exist:

● Encrypted assets give holders the right to share in corporate income or profits, or to realize gains through capital appreciation of encrypted assets.

○ Such opportunities may arise, at least in part, from increases in the value of cryptoassets resulting from the operation, promotion, improvement, or other positive development of the network, especially if there is a secondary trading market that enables cryptoasset holders to sell their cryptoassets and Realize benefits.

○ This may also occur where the cryptoasset entitles the holder to receive dividends or distributions.

● Cryptoassets can be transferred or traded on secondary markets or platforms, or are expected to do so in the future.

● Purchasers reasonably expect that AP's efforts will result in capital appreciation of the crypto-asset and thus be able to earn a return on their purchase.

● Cryptoassets are broadly offered to potential purchasers rather than intended users of goods or services, or those requiring network functionality.

○ The number of offers and purchases of crypto assets indicates investment intentions, not the number of network users. For example, offering and buying in quantities significantly larger than any potential user would reasonably require, or in quantities so small that actual use of the asset in the network becomes impractical.

● There is little correlation between the purchase/offer price of a crypto-asset and the market price of a specific good or service that can be exchanged for the crypto-asset.

● There is little correlation between the amount of cryptoassets typically traded (or the amount buyers typically buy) and the amount of the underlying good or service that a typical consumer would buy for use or consumption.

● APs raise funds in excess of the amount required to build a functional network or crypto asset.

● APs can benefit from their efforts by holding cryptoassets of the same class as those distributed to the public.

● AP continues to use revenue or operating funds to enhance the functionality or value of the network or encrypted assets.

● Marketing of encrypted assets, directly or indirectly using any of the following:

○ An AP's expertise or its ability to build or increase the value of a network or cryptoasset.

○ The cryptoasset is marketed in terms that suggest it is an investment, or that the solicited holders are investors.

○ The intended use of the proceeds from the sale of crypto assets is to develop the network or crypto assets.

○ Future (rather than current) functionality of the network or cryptoasset, and the prospect that the AP will deliver that functionality.

○ A promise (implied or express) to establish a business or operation other than to offer a currently available good or service for use on an existing network.

○ The ease of transferability of crypto assets is a key selling feature.

○ Emphasize in marketing or other promotional materials the potential profitability of network operations, or the potential appreciation in the value of cryptoassets.

○ Availability of a market for trading cryptoassets, especially when the AP implicitly or explicitly undertakes to create or otherwise support a market for trading cryptoassets.

In assessing whether a cryptoasset previously sold as a security needs to be reassessed when it is subsequently offered or sold, there are additional considerations related to "reasonable expectations of profit", including but not limited to:

● People who buy crypto assets can no longer reasonably expect that the continuous development efforts of AP will be a key factor in determining the value of crypto assets.

● The value of a crypto-asset has shown a direct and stable correlation with the value of the goods or services for which it may be exchanged or redeemed.

● The trading volume of encrypted assets corresponds to the level of demand for goods or services that may be exchanged or redeemed.

● Whether holders can use encrypted assets to achieve their expected functions, such as purchasing goods and services through the network or platform.

● Whether any economic benefit that may arise from the appreciation in the value of the encrypted asset is a by-product of obtaining the right to use it for its intended function.

● No AP can obtain important, non-public information, or can be considered to hold important inside information about encrypted assets.

3. Other relevant considerations

In assessing whether there is a reasonable expectation of profit from the efforts of others, federal courts look at the economic substance of the transaction. In doing so, the court also considers whether the tool was offered and sold to the purchaser for use or consumption.

While none of the following characteristics with respect to use or consumption are conclusive, the more strongly they are present, the less likely it is that the Howey test will be satisfied:

● The distributed ledger network and encrypted assets are fully developed and operational.

● Holders of a crypto asset can immediately use it on the network for its intended function, especially when there are built-in incentives to encourage such use.

● Cryptoassets are created and structured to be designed and implemented to meet the needs of their users, not to drive speculation on their value or network development. For example, cryptoassets can only be used on the network and generally only be held or transferred in amounts consistent with the purchaser's intended use.

● The possibility of appreciation in the value of encrypted assets is limited. For example, the design of cryptoassets provides that their value will remain constant or even decrease over time, so reasonable purchasers would not expect to hold cryptoassets as investments for the long term.

● With regard to encrypted assets known as virtual currencies, it can be used for payment in a variety of situations immediately, or as a substitute for real (or fiat) money.

○ This means that crypto assets can be used to pay for goods or services without first converting them to other crypto assets or real money.

○ If it is classified as a virtual currency, then a crypto asset actually acts as a store of value that can be saved, retrieved, and exchanged for something of value at a later time.

● With respect to encrypted assets representing rights to goods or services, it can now be redeemed on an already developed network or platform to acquire or use those goods or services. Related factors may include:

○ The correlation between the purchase price of a crypto-asset and the market price of a particular good or service it may be redeemed or exchanged for.

○ Cryptoassets are offered in increments consistent with consumption intent, not investment or speculative purposes.

○ The intent to consume cryptoassets may be more pronounced if cryptoasset-based goods or services can only be acquired or more efficiently acquired through their use on the network.

● Any economic benefit that may be gained from appreciation in the value of a crypto asset is a by-product of obtaining the right to use its intended function.

● The marketing method of encrypted assets emphasizes the functionality of encrypted assets rather than the market value of encrypted assets.

● Potential purchasers have the ability to use the network and use (or have used) the cryptoasset for its intended function.

● Restrictions on the transferability of encrypted assets are consistent with the purpose of the assets and do not promote speculative markets.

● If the AP facilitates the creation of a secondary market, the transfer of encrypted assets can only be carried out by users of the platform.

Cryptoassets with these types of usage or consumption characteristics are unlikely to be investment contracts. Take the example of an online retailer with a thriving business. Retailers create crypto assets for consumers to purchase products only on the retailer's network, offer the crypto assets in exchange for real money for sale, and the crypto assets are redeemable for products priced in that real money. As part of these efforts, the retailer continues to market its products to its existing customer base, touting its crypto-asset payment methods and potentially “rewarding” customers with crypto-assets based on product purchases. After receiving the encrypted asset, the consumer can immediately use the encrypted asset to purchase products on the network. Crypto assets are not transferable; instead, consumers can only use them to buy products from retailers or sell them back to retailers at a discount to the original purchase price. Based on these facts, cryptoassets would not be investment contracts.

Even if a crypto-asset can be used to purchase goods or services on a network, and the functionality of that network or crypto-asset is being developed or improved, there may be a transaction in securities if, among other factors: The purchaser offers or sells the asset; the amount of cryptographic asset offered or sold to the purchaser exceeds fair use; and/or there are limited or no restrictions on the resale of these cryptographic assets, especially in the context of AP’s continued efforts to increase the value of the cryptographic asset or promote in the secondary market.