Howey Test Basics
Let’s say you’re creating a crypto token. It’s an ERC20 coin and you’re planning your ICO. But then you’re googling some stuff about what you need to do and you hear: Howey Test. What in the heck is a Howey Test? And suddenly you need an attorney? Or the SEC will be coming after you? And it’s going to cost you like ten million dollars or something because attorneys are expensive??
So, you think: do you really need a Howey Test?
And my answer is: Yes (probably). And also, you’re spiraling; it’s not that bad.
There are a couple of reasons why you’ll need to do a Howey Test, but first, you need to understand what a Howey Test is and the entire point of this whole thing.
To put it simply: the Howey Test is how the SEC and lawyers determine if something is a security or not. If it’s a security, the SEC is going to regulate it because that’s what the SEC does. If it’s not a security, the SEC doesn’t regulate it and you can keep doing whatever it is you’re doing.
A Little Bit of Background Info
Howey Tests are derived from a really important legal case called SEC v. W.J. Howey Co (328 U.S. 293 (1946)). The SEC defined securities as an “investment contract.” The Supreme Court decided that an “investment contract” exists if “there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” This means there’s 3 parts that have to exist for something to be a security:
An investment of money
A common enterprise
A reasonable expectation of profits derived from the efforts of others (sometimes this is broken up into two parts: expectation of profits and profits derived from the efforts of others)
There are other cases that further define securities, like United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman”), Tcherepnin v. Knight, 389 U.S. 332 (1967) ("Tcherepnin"), and SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) ("Joiner"), but Howey is the originator and so the test is named after it. More importantly, the SEC has issued guidance on how Howey (and the others) should be applied to tokens, to determine if a token is a utility token (not a security) or a security. Generally, the focus of the SEC guidance is on the third prong: the expectation of profits derived from the efforts of others.
What is a Howey Test?
A Howey Test, performed by a lawyer or team of lawyers, is a gigantic document that goes through all of the details of the token being offered to see if it meets the definition of a security or not. Sometimes Howey Tests are opinions, meant to be persuasive and get the tokens listed on exchanges, and other times they’re neutral memos. As time has gone on, the requirements of the SEC and big exchanges have gotten more stringent and Howey Tests have accordingly gotten more detailed.
That’s also why they take so long and cost so much money; the lawyer writing this (because a lot of exchanges require that it’s performed by a lawyer) has to do a lot of work and spend a lot of time on it to make sure you’re getting accurate, up to date guidance and it’s meeting the ever-changing requirements of exchanges and the SEC. And it’s not just the lawyer doing the work; you have to provide a lot of detailed information, too. A half-baked Howey Test is a bad Howey Test.
Do I need a Howey Test?
Almost all new coins and tokens will need a Howey Test performed to get listed on an exchange. Even if it’s not being listed on an exchange, a lawyer should still look at the details to make sure it’s not a security so you don’t have to worry about the SEC later down the line. Only if the token isn’t going to be listed on any US-based exchanges and it’s not being offered by a US company can you safely assume the SEC won’t look into it. But even then, some foreign-based exchanges still require Howey Tests for listings and you’ll need to make sure the token isn’t a security based on local regulations.
You might not even need a copy of the Howey Test right away; sometimes it just sits on your computer in PDF form, unused and unneeded. That’s great, if that’s what happens. But if the SEC issues a notice that they’re investigating you, you can digitally dust off that Howey Test, ready to go. It may need some updating and revising, but it’s a good starting point because most of the work is already done.
What do I need, how long will it take, and how much will it cost?
Everything, you need everything. Sometimes the whitepaper, a business plan, and website give enough detail, but most of the time, there’s very thorough follow-up questions. A lot of technical details, a lot of business details, and sometimes even personal details; basically, just expect to be an open book. Your lawyer is bound by confidentiality, so it’s not like they’re going to spread information unless it’s necessary and relevant. It’s better to give too much information than not enough because more information means a more accurate Howey Test.
Sometimes a Howey Test can be done really quickly, if the information is good enough and the token isn’t incredibly complicated. Even then, “quickly” means on the order of weeks, not days. Larger firms take longer than smaller ones, but the average turnaround time for an expert is about a month or two. The faster the information requests are responded to, the quicker the Howey Test can be written.
As for cost, it primarily depends on the complexity of the token and size of the law firm. Bigger law firms cost more than smaller ones, but even a solo practitioner expert like Meghan takes 15-30 hours to write a Howey Test. That’s essentially a minimum of $3000 for someone who knows what they’re talking about to do your Howey Test. And most law firms aren’t clear about their fee structure, so expect to pay at least $10,000, probably more.
Conclusion
A Howey Test is a big deal and huge investment, but it’s also a necessary one. All token issuers, big and small, need to have a lawyer look at their token to make sure they’re compliant – and usually that means doing a Howey Test. Avoiding SEC regulation and getting listed on exchanges tends to be pretty convincing.
If you think you’re ready to get a Howey Test, Meghan can help.
