Understanding the Howey Test

howey test

The Howey Test: Tokens, Securities & Regulation

Recent declines in both Initial Coin Offerings (ICOs) and cryptocurrency prices can partly be attributed to the SEC (its noteworthy movements, opinions, investigations, and subpoenas). The SEC’s initial laissez-faire approach toward this new innovative approach to capital formation could be argued as either lazy or reactive. That is, the SEC likely wanted to see how the cryptocurrency market would facilitate and adapt to traditional securities frameworks.

As a highly innovative crowdfunding tool, initial coin and token offerings disrupt preconceived notions about capital formation. More importantly, they obliterate the traditional method for defining a security per the Howey Test.  Coin issuers and their legal counsel have opined that many a utility token did not qualify as a securities investment based on this test. However, recent SEC opinion asserts that many (if not most) utility tokens CAN be treated as securities. This assertion is already forcing token issuers to comply (at least partly) to existing securities regulation.

How do coin and token issuers comply with securities regulations?

In their effort to fit the proverbial square peg ICO into the round hole of regulation, several attorneys (in this case the likes of Marco Santori and the team at Cooley) conjured-up a complementary and often corresponding document to the Regulation D securities exemption known as the SAFT (simple agreement for future tokens). The SAFT framework has been continually employed, copied, and replicated for use in many prominent token and coin pre-sales for the past 18 months.

And while the SAFT has acted as a useful supplemental (and perhaps an interim fix) for the cryptocurrency world, regulatory challenges remain. In fact, some attorneys are calling the SAFT structure antiquated and even dead (particularly in light of recent SEC regulatory developments). However, the SAFT is more likely to serve as an interim band-aid until a more sweeping regulation is forthcoming. Until then, token issuers are advised to keep their general solicitations within the bounds of current securities regulation. Consequently, they should engage with a qualified securities attorney.

Attorneys & Broker-Dealers

Regulation is generally devised to protect the investing public against unscrupulous startups and nefarious hucksters. Unfortunately, complying with such regulation adds an additional layer of cost, including legal and investment banking fees. This is especially true for token issuers wishing to take the high road. For smaller issuers with little capital,  no readily-available ‘LegalZoom equivalent’ exists to meet these demands. This obstacle poses a serious detriment for issuing tokens or securities to the investing public.

These added regulatory costs may involve anything from document preparation to promotion processes to procedure understanding.  It also includes checking the investor box for particular regulatory requirements – like KYC (Know-Your-Customer), AML (Anti-Money Laundering), an accredited investor verification. Securities attorneys are a must for these items. If the remaining items are not outsourced to a broker-dealer, then token issuers must take special care in how they run such processes.

Legality of ICO Bounties

As an issuer of securities, token issuers typically raise capital by offering what the industry calls a “token bounty”. Bounties serve to incentivize third parties to promote the issuance through Slack, Telegram, and Facebook. Bounty promoters are often paid in liquid coins, tokens or fiat and as a percentage of the overall capital raised ( as a success fee). If utility tokens are treated as securities—like many of us believe they will —then the concept of a token bounty will directly violate securities law as it relates to paying unregistered finders or brokers.

Issuers who pay finders would be well advised to understand that such finders are registered and licensed with FINRA or other self-regulatory agencies (SRO). Otherwise, they’re paid in flat in a manner that is not directly tied to the success of the issuance (though this item gets into some gray area). Some exemptions exist for paying unregistered individuals as it relates to foreign finders soliciting foreign investors. However, token issuers are still advised to understand the laws of such foreign jurisdictions. Failure to do so can lead an issuer to encroach on other international securities laws and regulations, many of which are outside the expertise of U.S.-based securities attorneys.

As the SEC issues subpoenas, bounty programs designed to target American investors may themselves become a target. The SEC will not only be reviewing how such bounty programs are promoted but also how their promoters are being compensated (given that they’re unregistered brokers).

Liquidity and Rule 144

Initial coin and token offerings enable immediate liquidity, perhaps the greatest benefit that investors can offer.  It is the one means by which token issuers can incentivize investors to become early token and coin adopters: early investors are able to purchase tokens at a discount and sell them in subsequent artificial price hike (as the offering progresses through a pre-sale). This artificial “pump”—while effective at incentivizing investor participation, mirrors many of the reverse merger pump-and-dump schemes seen a generation ago. Unfortunately, such immediate liquidity not only hurts token velocity but in many cases it also violates Rule 144 hold restrictions.

Rule 144 includes investor hold restrictions on certain types of public and private securities. Removing the Rule 144 hold legend from a security allows the security to be sold to another qualified buyer. In the case of private securities, further restrictions based on the type of security and the potential buyer in question may still exist. In general, Rule 144 holds include periods that last from 6 to 12 months. This time period is much longer than what has historically been standard in most coin and token sales. It’s likely that future coin and token offerings will include sell-date restrictions engineered directly into the smart contract. Such a token would automatically prevent token holders from violating securities laws.


The regulation of coin and token offerings was inevitable. Those who assumed otherwise were living a fantasy.  Any new regulation does not mean the party is over, however. Rather, it simply forces the industry to mature more quickly. Moreover, it will allow blockchain startups to acquire capital in more legitimate ways. However, the industry’s relationship to regulation remains in flux and will require more time to completely gestate. Once it does, it’s expected that ICOs and other alternative methods of capital formation will combine with traditional methods to provide several new and holistic offerings,  Such offering will be favorable and compelling for both investors and issuers alike.

About the Author

Nate Nead is an investment banker and Principal Founder of InvestmentBank.com. Nate works with issuers in both buy and sell-side M&A as well as capital formation projects, including initial coin and token offerings, software & technology, real estate, and business and consumer services. He resides in Seattle, Washington. Nothing included herein should be considered as investment or legal advice. Please consult with knowledgeable professionals before making investment and business decisions, especially as it relates to initial coin offerings.

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