The Last Chapter in the Book of Howey

Once upon a time, William John Howey arrived in the not-too-distant picturesque central Florida region and established a verdant orange grove. Little did Howey know at the time that more legal ink would be spilled over his business model than orange juice flowing from his orange groves in the 1930s and 1940s.[1]

Not long after Howey cleared tracts of land and planted lines of orange trees in Florida, he opened up a hotel called "Howey-in-the-Hills." As snowbirds from the North arrived in their DeSotos, Packards, Plymouths and Cords, the sunseekers were welcomed to the resort and given a tour of the orange groves. Over breakfast, while sipping some of his finest orange juice, Howey explained to his guests how much money could be made in the orange business.

Once hooked on the concept of earning a profit, Howey explained to his guests how they could purchase an interest in a row or two of orange trees. Guests were quickly attracted to the prospects of earning a healthy return, but they also recognized their limitations - they had neither the time nor the ability to manage rows of citrus trees in Florida when they lived up North most of the year.

Howey - the seasoned entrepreneur - did not want to miss an opportunity to close the deal with his out-of-town guests, so he offered them a tree maintenance services contract. While some guests opted to purchase a row of orange trees without the maintenance contract, many were enticed by the convenience and expertise offered by Howey's team who could manage the orange groves for maximum profitability. With the funds raised by selling interests in the grove, Howey was able to purchase additional tracts of land for further development that could be offered to future visitors to Howey-in-the-Hills. Regardless, it was clear that the success of the business opportunity came down to the essential managerial efforts offered by Howey's specialized team.

Unfortunately for Howey, the sun suddenly set on this orange grove sales model when the Supreme Court held in its 1946 decision, SEC v. W.J. Howey Co., that the unique land and maintenance services contracts scheme represented the offer and sale of "investment contracts" and, therefore, "securities" under section 2(a)(1) of the Securities Act of 1933 (the "Securities Act").[2] Unbeknownst to Howey, his business model would give rise to the "Howey test" which to this day defines an "investment contract" as a contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits, (4) derived from the efforts of others. When this test is satisfied, the offer and sale of the securities must be registered under Section 5 of the Securities Act or fall under a valid exemption from registration.

For 80 years, the Howey test has served as the law of the land, providing a consistent standard for investment contracts. Of course, with the passage of time, innovation in the markets has moved far beyond orange groves and today is epitomized by the advent of crypto assets. The new technology has unleashed opportunity for many entrepreneurs (present-day Howeys) and investors (akin to the guests who invested funds seeking a profit through the efforts of Howey's team). Alas, this new paradigm has raised questions as to how the Howey test applies to such business ventures today.

Instead of frolicking in a bright citrus grove, it seems we've been wandering in a shadowy forest with no clear guidance on when crypto assets are or are no longer subject to an investment contract (one of the enumerated instruments in the definition of a "security"). Today, the Commission brings us back into the sunlight for some regulatory clarity. The Commission's Interpretive Release[3] provides a taxonomy that classifies which crypto assets are not securities versus those that are securities. Beyond that, it gets right to the heart of clarifying when, in the Commission's view, a crypto asset is subject to an investment contract and, importantly, when it ceases to be subject to an investment contract. A crypto asset that is not itself a security is considered subject to an investment contract when it is accompanied by representations or promises to undertake essential managerial efforts that satisfy the Howey test. The Interpretive Release also provides guidance on the nature of those representations or promises that may help form an investment contract, including the source of the representations or promises, the medium by which they are communicated and their level of detail.

The Interpretive Release represents the last chapter in the tale of Howey that brought us the landmark Supreme Court decision clarifying when an opportunity to earn a profit represents the offer of a security. Perhaps this guidance serves as a perfect storybook ending for the "investment contract" made famous by Howey and his orange groves some 80 years ago. In the Interpretive Release, the Commission clarifies when, in its view, a non-security crypto asset would no longer be subject to an investment contract. In short, the investment contract terminates either upon: (1) the fulfillment of the representations or promises of essential managerial efforts, or (2) the failure to satisfy those representations or promises. In both of those situations, the investor is no longer expecting to profit based on the essential managerial efforts of others, a key element of Howey.[4] I highly recommend that those who want to know more read the Interpretive Release in full to appreciate the examples and understand the Commission's views of the considerations that go into a determination of whether and when either of these two situations may occur in the crypto asset context.

While the Interpretive Release is published in the context of modern-day crypto assets, the framework for assessing when an investment contract terminates can easily apply to that flourishing Floridian orange grove or other non-crypto assets. Howey could have fulfilled his representations and promises as indicated at the outset. For example, the maintenance contract could have been limited to watering and caring for the orange trees for so long as they were fruit-bearing. Alternatively, the investment contract could have terminated when Howey failed to satisfy his promises. For example, if a disastrous hurricane or disease completely destroyed the groves, Howey could have publicly and unequivocally told his investors that he was abandoning his intention to water and care for the trees, ending the investment contract. Beyond the orange grove example, more creative storytellers than I will no doubt start to imagine how this guidance could apply in other contexts.

The Interpretive Release provides much-needed guidance on the application of the Howey test to crypto assets and will provide clarity to the markets even as work proceeds both inside and outside the Commission. And as modern-day William John Howeys continue to innovate and market their new ventures to prospective investors, we will continue to keep a close eye on whether additional guidance or rules may be needed to facilitate capital formation and accommodate innovation - whether it be in the orange groves or on the blockchain and beyond - without sacrificing investor protection.

For now, this closes the final chapter in the book of Howey.

The End.