We have heard a lot about SEC-regulation and possible security-laws violations in the past months. The SEC traditionally uses the so-called “Howey-test” to determine if an asset is considered a security or not.
But what exactly is a security?
A security is any investment product that can be exchanged for value, involves risk and is tradeable. It represents an ownership position, a creditor relationship or rights to ownership as represented in an option, for example, stocks and bonds. In contrast to tangible assets that you own, for example, a car or a house.
But what exactly is the Howey-test?
The name originates from a Supreme Court decision in 1946: SEC v W.J. Howey Co.
Howey Co was offering service contracts for producing, harvesting and marketing orange crops in Lake County, Florida. Most of these contracts were sold to tourists who stayed at a hotel that was owned by Howey Co, which sold land and land + service contracts to interested visitors.
Then the Supreme Court stepped in and asked if the purchase + the service contract created an “investment contract”?
The Supreme Court said yes and so the so-called Howey-test was born which is used to determine whether things that don’t look like securities can in fact be deemed securities:
These are the criteria:
1. there is an investment of money
2. with an expectation of profit
3. this expectation of profits derives largely from the efforts of others
Now you know.
Let’s provide an example for better understanding: You buy a finished condo with the expectation of rising real-estate prices = you bought a commodity.
You buy a condo pre-construction and the developer promises to do a bunch of work on the condo and provides ongoing services post-construction = you have entered an investment contract aka a security.