In our most recent blog post, we discussed the second prong of the Howey test – a “common enterprise” – and the US Circuit Courts’ fragmentation on the issue and lack of uniform definition. In this third and final part of our series pulling apart the Howey Test, we’re looking at the third and fourth prongs of the Test. These final two prongs, typically read together, are (collectively) “with an expectation of profits solely from the efforts of others”. The expectation of profits element focuses on the type of return that the investor seeks on their investment. This return inquiry is easily satisfied by an increase in capital or participation in earnings on invested funds. As mentioned, however, the return or profit must depend on the “efforts of others”, which goes to the passive nature of the investment return. Remember, the Howey company was selling plots of land on its citrus grove to people who had no intention of farming the land and depended on the Howey company to produce profits. These investors were expecting a passive return with no intention of consuming the oranges produced (i.e., this was not a pre-sale for the underlying future oranges which goes to consumptive use v. speculative use).
The SEC Wants to Talk About Your Control Issues
The “solely from the efforts of others” inquiry is a fact-specific analysis of the economic realities of the transaction. In sum, the more an investor controls the business operations of the project, the less likely an investment contract exists. The critical question to ask is whether the efforts of individuals other than the investor are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”. In determining an investor’s control over the profitability of the investment, a court may look at:
- the investor’s contribution of time and effort to the success of the project;
- the investor’s rights under the investment agreement;
- the investor’s access to information about the project; and
- and the investor’s level of sophistication.
This analysis brings into focus the timing of the investment. If promoters promoted the investment and then made no further efforts after the investment, it is likely that no investment contract exists.
In the modern context of security ‘token’ sales that we have been examining, an appreciation in value via secondary market trading, in theory, should not be used as weighing in favor of the token being an investment contract. Additionally, a court may consider the adequacy of financing of the investment as well as the level of speculation and the nature of the risks in the transaction.
Getting Over Control Issues
With respect to securitized token offerings, it’s fun to talk about monetary gains, decentralization, openness, lambos, etc., but more time needs to be spent around architecting the proper token governance schemes. Because this is a fact-specific analysis, each token project must think granularly in terms of why a token is necessary; what does the token do; what is a token purchaser receiving (voting rights, effectively a license to use the network, ability to contribute to the network, etc.); how is this information being communicated (i.e., Telegram, Reddit, Twitter, Slack, Medium, YouTube, Podcasts, etc.); and how knowledgeable are the pre-functional platform investors (accredited investors, professional knowledgeable investors, ordinary public investors).
Unfortunately, there is no bright-line rule, and there is likely not going to be one for some time. In the decade since cryptocurrency has existed, only two cryptocurrencies (Bitcoin and Ethereum) have been declared not securities.
Exploring the Other Side
We have talked in this series of posts, in some detail, about transparency from the team building the network, but next, we should finish by focuses on how traditional finance disclosures work for large, private investors.
Meltem Demirors, a prominent cryptocurrency investor, has openly talked about the notion of this “shitcoin waterfall”. The shitcoin waterfall is when an ICO raises a pre-pre-sale round from VCs at a very steep discount. Then, the project raises a pre-sale where the initial investors now have tokens that are valued at 50-100x more than the previous round. The white paper is likely then revised with “crypto-famous” investors listed as advisors, and the white paper reads like any other marketing brochure. Next, the project does an ICO followed by an exchange listing for the general public. Coinciding with the exchange listing, these early investors are dumping their heavily discounted tokens on the average consumer. Meanwhile, most ICOs fail within four months.
Should large, early investors in an ICO be subjected to disclosures about token exits? Such disclosures would help regulators evaluate whether or not these early investors are pumping and dumping coins on the average retail investors. The same is true with self-dealing issues in respect to projects and team members contributing back into their ICO for more of their tokens, thereby inflating the ICO raise. While we share in the enthusiasm and promises of cryptocurrency, current ICO practices are less than noble or open to everyone despite what is propagated at overpriced conferences. As more empirical data comes to light, the legal landscape will begin to adjust for these projects.
The broad variables discussed throughout this series of blog posts on the Howey test offers arguments on why some tokens are considered securities and the gaps in the legal knowledge that need to be overcome. As noted in Coin Center’s recent Framework for Securities Regulation of Cryptocurrency, “the Howey test happens to also be an effective guide for determining whether a token possess heightened risks to users. The more a given token’s software and community variables allow it to fit the definition of a security, the more need there may be to protect its users with regulation.”. In theory, the more decentralized and transparent the network, the less risky it is to hold the token as it functions more like a commodity as price fluctuation is due to the market rather than one entity behind the project.
The reason we started the blog series with the facts of Howey was because the facts are easily substitutable. However, there is a mental shift around digital things that must be explained to regulators and token issuers in order to advance the ecosystem. Sometimes, acting and failing to act can have the same consequences; a didactic that the SEC already knows very well in its views on disclosure. For now, an understanding of the past and careful self-regulation based on our understanding of prior law will have to do.
Commentary by Stan Sater & Jeffrey Bekiares, Esq. Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]