- We believe the Howey Test is a three-pronged test.
- This means the expectation of profit must be from the efforts of others.
- This means common enterprises that reward someone for their efforts are not securities.
How many prongs does the Howey Test have?
There is often some debate about how many prongs the Howey Test has. It’s been cited as having both 3 or 4 prongs.
Why does this matter?
The number of prongs in the Howey Test is critical to our exploration of the legal status of securities as it dramatically changes the third clause which is either:
“3. An expectation of profit, to be derived form the efforts of others.”
Or is instead:
“3. An expectation of profit.”
“4. to be derived from the efforts of others.”
The important breakdown here is whether the matter of the “expectation of profit” alone is a problem, or if it is only when we expect profit from the effort of others.
For example, if there is a community effort but I am only being rewarded for my efforts as a part of the whole, does that change this analysis?
There is also an implication, that if “to be derived from the efforts of others” does not apply solely to the profits, then we must change our analysis of the first two prongs to include this trailing clause.
How many prongs?
In “SEC V. Paul Rubera” 1 and “SEC V. R.G. Reynolds Enterprises”2 the 9th Circuit Court notes that the Howey test is expressly a “three-pronged test.”
Given this, it is is NOT enough for a user to merely expect profit but that profit must be derived “from the efforts of others.”
Has this influenced existing case decisions?
The view of the Howey Test as a three-pronged test is not only something noted expressly in 9th Circuit Court decisions, but it has clearly influenced outcomes setting precedent in cases such as “US v. Holtzclaw”3
The Holtzclaw case raises nuanced questions about “common enterprise” during which a multi-level marketing program called “Sell America” was being reviewed as to its status as a security. In the program, individuals sold gold coin certificates on behalf of the Sell America system, that they must first buy in bulk. Their sale has a commission that is split with a regional manager who opted-in to a secondary program to earn commission from their downline.
Holtzclaw had enlisted a local church congregation to take part in this enteprise, and the aggreved party had suggested that the program was a fraud. While the court found that any reasonable party would have deemed the Sell America program and Holtzclaw’s actions to be fraudlent, they could only apply securities fraud to something that was deemed to be a security.
In the end, the court found that the local church had not purchased a security because of a lack of commonality.
While the profits of the promotor were tied to that of the investor, the investors did not have fortunes tied to one another, and the investors only profited from their own material efforts.
So while the investors had an expectation of profit and they had a strict vertical common enterprise in being tied to the promoter on redeeming the gold certificates, the profit itself was not derived from the efforts of others.
If derived from the efforts of others were its own clause and not part of the third-prong, then both prong #3 and prong #4 would have been met in the Holtzclaw case.
We believe this case gives clear grounds that the Howey test is three prongs.