Global Trustee and Fiduciary Services News and Views Issue 50

Prime, Futures and Securities Services | Financial Innovation 70 THE HOWEY TEST A transaction’s an investment contract if . . . 1. It’s an investment of money. 2. There’s an expectation of profits from the investment. 3. The investment of money is in a common enterprise. 4. Any profit comes from the efforts of a promoter or third party. Although the test uses the term “money”, later cases have expanded this to include investments of assets other than money. The term “common enterprise” isn’t precisely defined, and courts have used different interpretations. Most federal courts define a common enterprise as one that’s horizontal, meaning that investors pool their money or assets together to invest in a project. However, other courts use different definitions. The final factor of the test concerns whether any profit that comes from the investment is largely or wholly outside of the investor’s control. If so, then the investment might be a security. If, however, the investor’s own actions largely dictate whether an investment will be profitable, then that investment is probably not a security. This has resulted in regulators issuing warnings to investors. The US Commodity Futures Trading Commission issued a customer advisory on 16 July 2018, alerting customers to exercise caution and conduct extensive research before purchasing digital coins or tokens, even stating that many ICOs end in fraud or failure. The UK Financial Conduct Authority issued a similar warning on 15 September 2017. And the US Securities and Exchange Commission has gone so far as to set up a fake ICO website, HoweyCoins, demonstrating how fraudsters recycle white papers, steal imagery and promise unrealistic returns in an attempt to part investors from their money. 14 If you click on the “Buy Coins Now!” link, you’ll end up on the SEC’s Investor.gov website where it explains all the red flags you should have spotted. Even those ICOs that prove to be a little more above board can run into trouble with regulators. As previously noted, ICOs can be used to raise funds for new ventures. Promoters will sell coins/tokens rather than sell shares or notes or obtain bank financing. However, regulators believe the economic substance of issuing coins or tokens is the same as a securities offering. Investors will expect a return on their investment usually through selling their tokens in a secondary market once the venture begins to generate a return or value. When regulators see this kind of activity, they’ll apply some kind of test to see if a security offering is being made and, if so, that all the relevant restrictions on promotion, authorisation of the promotor, listing, etc., are being applied. An example of a regulatory authority’s methodology is the US Howey Test, which states that, depending on the features of any given instrument and the surrounding facts, it may also need to be evaluated as a possible security under the general definition of security and the case law interpreting it. In other words, just because the promoter of an ICO doesn’t think it’s a securities issue, caution should still be exercised.