What Is the Howey Test?
The "Howey Test" is a test created by the Supreme Court for determining whether certain transactions qualify as "investment contracts." If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
This article covers the meaning of the Howey Test in securities law. See FindLaw's Securities Law section for additional articles and resources, including Securities Law: An Overview and Basic Terms for Shareholders and Investors.
What Is a Security?
The Securities Act and Securities Exchange Act have broad definitions of the term "security." Under these Acts, a security includes many familiar investment instruments such as notes, stocks, bonds, and investment contracts.
Whether a certain investment is considered a security is important, because designation as a security means that the investment is subject to certain registration requirements. In general, all securities offered in the U.S. must be registered with the Securities and Exchange Commission (SEC), although there are some exceptions. A company offering securities that are not exempt must register them, a process that also involves disclosure of certain information, including:
- A description of the company's properties and business purpose
- A description of the security being offered
- Information about the company's management
- Financial statements about the company, certified by independent accountants
Background of the Howey Test
In 1946, the Supreme Court heard a case (SEC v. Howey) that concerned whether a leaseback agreement was legally an investment contract (one of the types of investments that is listed as a "security" under the Acts). In Howey, two Florida-based corporate defendants offered real estate contracts for tracts of land with citrus groves. The defendants offered buyers the option of leasing any purchased land back to the defendants, who would then tend to the land, and harvest, pool, and market the citrus. As most of the buyers were not farmers and did not have agricultural expertise, they were happy to lease the land back to the defendants.
The SEC sued the defendants over these transactions, claiming that they broke the law by not filing a securities registration statement. The Supreme Court, in issuing its decision finding that the defendants' leaseback agreement is a form of security, developed a landmark test for determining whether certain transactions are investment contracts (and thus subject to securities registration requirements). Under the Howey Test, a transaction is an investment contract if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Although the Howey 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 is 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 Howey 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.
Substance Over Form
In deciding Howey, the Supreme Court created a test that looks at an investment's substance, rather than its form, as the determining factor for whether it is a security. Even if an investment is not labeled a "stock" or "bond," it may very well be a security under the law, meaning that registration and disclosure requirements apply. After the creation of the Howey Test, some promoters masqueraded securities to try and escape registration requirements (such as by calling an offer of securities an interest in a general partnership). To deal with these charades, courts look at the economic realities behind an investment scheme, rather than at its name or form, to determine whether it is a security.
If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.
The Howey Test is not the only test that courts have used for determining whether an investment is a security. For example, in 1990, the Supreme Court created the "family resemblance test." This test provides a way for issuers of a note to show that the note should not be considered a security, by showing that the note has a "family resemblance" to other investments that are not considered securities.
States have their own securities registration requirements, which are often referred to as "Blue Sky" laws. Some states, such as California, use what is known as the risk capital test that focuses mainly on the reasons why money or assets are being invested and what risks the investment poses for any investors, to determine whether an investment is a security.
Securities laws are complex and often confusing. Terms such as "common enterprise" are imperfectly defined, and different courts may apply different tests for determining whether an investment is a security. If you have questions such as whether a particular investment must be registered as a security or questions about your state's securities laws, it's a good idea to consult with an attorney who specializes in securities law through FindLaw.