15 Feb 2025

light mode

Howey Test: Cheating the SEC lie detector

Howey Test: Cheating the SEC lie detector

The Howey Test was developed in 1946 by the U.S. Supreme Court for determining whether a financial asset qualifies as a promissory note or stock. It is still the main SEC instrument for securities regulation.

On this page

The Howey Test is a tough polygraph used by regulators to check cryptocurrency projects. To pass it, you have to answer 4 questions honestly and instantly.

One might ask: how is the cryptocurrency connected to the bill or bond?

But the SEC takes a different view and looks for signs of security in any token or coin that could potentially generate passive profit for the owner.

Therefore, each company offering its digital asset on the market is checked using the Howey test: does a transaction using this token contain signs of an investment transaction? Does a startup fall under the jurisdiction of the SEC with subsequent mandatory registration and taxation of income from owning or reselling shares?

Howie's Scary Questions

Let's look at these four criteria based on the SEC v. Ripple Labs court case. Remember that the Securities Commission believes that XRP Ripple tokens are a security, since investors were attracted under the promise of profit that can be obtained through the work of others.

These are 3 out of 4 criteria that the Howey test checks.

If crypto-founders answer “yes” to all 4 questions of the test, then this automatically puts their project under the SEC control. And then the regulators begin to figure out how the investor portrait complies with the law norms. Indeed, in the US, only qualified investors have the right to invest in venture and hedge funds.

According to the law, this category includes:

1. Individuals with a net annual income of at least $200,000

2. Individuals who have declared a net (after tax) capital of at least $1,000,000

The SEC vs Ripple case is a classic example of the Howey test use in litigation. Source: Cryptonews.com

The SEC vs Ripple case is a classic example of the Howey test use in litigation. Source: Cryptonews.com

First question: Did you raise funds from investors?

In this case, Ripple Labs definitely falls into the category of a securities seller, because in fact, for 3 years, they’ve been conducting an ICO (without calling it that), promising a profit from the rise of XRP price, having received direct investments in the amount of $1.3 billion.

The scandal broke out only after someone , Ryan Coffey, one of the early token buyers, sold them on the exchange, losing $551 on the sale. He filed a lawsuit against Ripple CEO Brad Garlinghouse and accused him of losing 30% of his investments.

“Not such a great loss!” – any crypto trader would say and they would be right. But the problem is that Coffey filed a lawsuit on behalf of several investors. And the SEC reacted instantly to the collective suit, and a series of courts followed.

Question two: Were investments attracted under the promise of future material profits?

This question may seem rhetorical to some. Does anyone attract investments differently? The investor is motivated by potential profit, other incentives do not work.

But there are crowdfunding platforms that promise investors the growth of their public reputation or marketing promotion of the brand. Such investment agreements are not of interest to the Securities Commission.

In the Ripple case, the situation is straight from the SEC manual: the founders promised capital gains, but unqualified investors suffered losses.

The commission ignores the fact that Coffey and the rest of the plaintiffs sold the tokens during the market drawdown, succumbing to panic. SEC is only interested in dry numbers.

Question three: Was the money invested in a joint enterprise?

This calls for clarification: what do US regulators consider a “joint enterprise”? Most federal courts define it as a horizontal system that pools money or assets from multiple investors, with profit and risk shared in proportion to contributions. That is if the founders are also investors.

But there is also a “vertical” approach. In this case, the courts believe that the profit of the founders and investors is directly dependent: if the founders do not receive income, then the investors are left on bread and water. In this case, the total income of the project is not taken into account.

 

In the Ripple case, this point is not transparent. Since the company refused to provide financial documents for the organization and launch of the token. And some meetings were held behind closed doors at the request of witnesses giving evidence.

We cannot say for sure how the regulator will evaluate the “joint enterprise” in the Ripple Labs case.

This is the criterion for passive investment. If the success of the enterprise as a whole depends on promoters, the third parties’ involvement and organizations that take direct participation in the token promotion, and the investors themselves are only watching what is happening in anticipation of profits, then this question will have an unequivocal “yes” answer.

In the Ripple case, the court may recognize the presence of a fourth criterion. Ryan Coffey's lawsuit alleges that the founders bribed crypto exchanges Gemini and Coinbase to list XRP. And this, according to the plaintiff, led to an artificial increase in the price of the token.

Whether Garlinghouse can prove that there was no bribery involved, we will find out very soon.

A final decision on the case should be made by the end of 2022.

Note that the significance of this court and the decision made on it is higher than the Ripple proof of guilt / innocence from the SEC point of view. It is important for Brad Garlinghouse to create a precedent and prove to the regulator that the digital token acquisition is not a classic investment contract, and XRP has nothing to do with company shares.

Moreover, in a similar situation, Telegram did not dare to argue with the Securities Commission and chose not to launch the internal Gram token.

The content on The Coinomist is for informational purposes only and should not be interpreted as financial advice. While we strive to provide accurate and up-to-date information, we do not guarantee the accuracy, completeness, or reliability of any content. Neither we accept liability for any errors or omissions in the information provided or for any financial losses incurred as a result of relying on this information. Actions based on this content are at your own risk. Always do your own research and consult a professional. See our Terms, Privacy Policy, and Disclaimers for more details.

Articles by this author
AI Is Making Crypto Scams Smarter—Insights from Chainalysis 2024

AI Is Making Crypto Scams Smarter—Insights from Chainalysis 2024

The 2024 Chainalysis report confirms that AI-driven fraud is on the rise, with crypto scammers cashing in at least $9.9 billion through advanced deception tactics.

The Coinomist
North Korean Hackers Infiltrate GitHub & NPM to Steal Crypto

North Korean Hackers Infiltrate GitHub & NPM to Steal Crypto

Lazarus Group, a North Korean hacking unit responsible for numerous cyber attacks, has launched a new campaign targeting software developers and crypto wallets.

Anahit Avetisyan
Solana Outpaces Rivals as App Revenues Surge in Crypto Revival

Solana Outpaces Rivals as App Revenues Surge in Crypto Revival

Messari reports that Solana-based apps saw an unbelievable 213% revenue spike, making Solana the top blockchain for app-generated earnings.

Anton Kryshtal
HashFlare Founders Admit to $575M Crypto Fraud Scheme

HashFlare Founders Admit to $575M Crypto Fraud Scheme

A long-anticipated court hearing in the U.S. has concluded with HashFlare co-founders Sergei Potapenko and Ivan Turogin admitting to charges of wire fraud.

The Coinomist
Weekly Analysis of BTC, ETH, and the Stock Market (Feb 10, 2025)

Weekly Analysis of BTC, ETH, and the Stock Market (Feb 10, 2025)

An overview of BTC, ETH, XAUT, and S&P500 charts, and the current cryptocurrency market dynamics.

Artem Khomenko
Weekly Analysis of BTC, ETH, and the Stock Market (Feb 3, 2025)

Weekly Analysis of BTC, ETH, and the Stock Market (Feb 3, 2025)

An overview of BTC, ETH, XAUT, and S&P500 charts, and the current cryptocurrency market dynamics.

Artem Khomenko
Weekly Analysis of BTC, ETH, and the Stock Market (Jan 27, 2025)

Weekly Analysis of BTC, ETH, and the Stock Market (Jan 27, 2025)

An overview of BTC, ETH, XAUT, and S&P500 charts, and the current cryptocurrency market dynamics.

Artem Khomenko
How to Bump a Transaction in the Bitcoin Network

How to Bump a Transaction in the Bitcoin Network

Sometimes, Bitcoin transactions can get “stuck,” especially if a low fee was set. In such cases, you might wonder: Why is my Bitcoin transaction stuck?

bitOn
Inside Cryptocurrency Farms: How Digital Coins Are Mined

Inside Cryptocurrency Farms: How Digital Coins Are Mined

Cryptocurrency farms and mining have evolved significantly since Bitcoin launched in 2009. To understand their growth, it helps to look at the broader history of resource extraction.

The Coinomist
From Bulls to Ballers — Why Celebrities Are Flocking to Crypto

From Bulls to Ballers — Why Celebrities Are Flocking to Crypto

Trump’s meme coin isn’t an outlier—it’s part of a broader trend. Back in 2021, celebrities were minting NFTs, and by 2024, they had moved on to personal token launches. The connection between fame and crypto has been growing for years, even if many failed to see it.

Vlad Vovk
Which Macroeconomic Factors Make Crypto Rise or Fall? 

Which Macroeconomic Factors Make Crypto Rise or Fall? 

It happens when you check the market and crypto prices are up or down for no obvious reason. Then you do some research and find out that there are actually reasons outside the crypto space.

Anahit Avetisyan
How Blockchain Helps Combat Disinformation

How Blockchain Helps Combat Disinformation

Fake news has become a global issue, shaping public opinion, fueling social tensions, and even influencing political decisions. With the rise of social media, the spread of misinformation has accelerated, making it increasingly difficult to regulate. However, blockchain technology offers a promising solution in the fight against fake news.

Daryna Nesterenko
Trading Psychology: How to Avoid Falling Victim to Your Own Biases

Trading Psychology: How to Avoid Falling Victim to Your Own Biases

The most successful traders aren’t always the smartest. More often, those who excel are the ones who understand psychological traps, manage their emotions, and maintain rationality under pressure.

Vlad Vovk
SBF’s Prosecutor Quits – What It Means for Crypto Crime

SBF’s Prosecutor Quits – What It Means for Crypto Crime

Danielle Sassoon, Acting U.S. Attorney for the Southern District of New York, has resigned, making headlines this week. And you’ve definitely heard of one of her biggest “client” names.

Anahit Avetisyan
Trump’s Crypto Summits: Pragmatic Move or Regulatory Mess?

Trump’s Crypto Summits: Pragmatic Move or Regulatory Mess?

What’s the best way to figure out how the crypto industry needs to be regulated in the U.S.? Donald Trump is considering different options.

Anahit Avetisyan
MORE
«Mass Adoption Isn’t About Tech – It’s About Perception». Bitmedia Founder Matvii Diadkov – About RWA, Web3, And Marketing

«Mass Adoption Isn’t About Tech – It’s About Perception». Bitmedia Founder Matvii Diadkov – About RWA, Web3, And Marketing

Matvii Diadkov, founder of Bitmedia, shared with us in an exclusive interview his expert insights on Web3 adoption, impact of GameFi and community-centering tendencies in the market.

The Coinomist
“Satoshi is CIA”: Swedish crypto bro opens up about his Bitcoin journey

“Satoshi is CIA”: Swedish crypto bro opens up about his Bitcoin journey

The first crypto craze took place almost a decade ago. Overnight, many people found out about Bitcoin and its underlying technology, blockchain.

Lesia Dubenko
MORE