Debunking Securities Law Myths About Tokens
holy shit, there are a lot of them!
I’ve been focusing on “cryptolaw” (*shudder*) for almost three years now.
It’s fair to say that this is an industry in which many people are eager to generate novel theories about how laws apply to their favorite technology.
At this point, I think I’ve heard ‘em all, so it seemed like a good time to collect all the crazy myths out there about how securities laws apply to tokens that I’ve run across in my time working on these issues into one handy-dandy guide.
MYTH: Tokens are “commodities” and therefore cannot be “securities”.[1]
FACT: The premise of this myth is true—most tokens are likely commodities under U.S. law. The term “commodity” under the Commodities Exchange Act (CEA) means “all goods and articles…and all services, rights and interests….in which contracts for future delivery are presently or in the future dealt in.” A token might be a “good or article” or represent a “service, right or interest,” or might be the subject of an agreement such as a “SAFT” which is a “contract for future delivery”. It is likely that even simple spot transactions with cryptocurrency exchanges to acquire a token are “contracts for future delivery.” Accordingly, most tokens are commodities.
Nevertheless, the inference is flawed because a digital asset can be both a commodity and a security. In such cases, the SEC’s authority over such commodity is reserved and the CFTC’s authority over such commodity is not exclusive. According to the CFTC, “while digital currency is a commodity, that does not resolve the question of whether the ’33 Act applies…That depends on the securities laws.”[2]
MYTH: Tokens are “currencies”; therefore, the securities laws do not apply to tokens.[3]
FACT: This myth is grounded in the fact that “the definition of ‘security’ in the Securities Act does not include the term ‘currency’, and the Exchange Act expressly excludes “currency” from the definition of a ‘security’.”[4]
However, the term “currency” as used in the federal securities laws and other U.S. federal financial regulations[5] is meant to refer to national sovereign fiat currencies, not “cryptocurrencies” or tokens.
Moreover, this myth was specifically rejected by The U.S. District Court for the Southern District of New York’s opinion in SEC v. Telegram Group. Although the court acknowledged that GRAMs were ultimately intended to be used as a “substitute currency to store and transfer value”, the court concluded that the application of the securities laws was not precluded by the potential for using GRAMs as a substitute for currency.
MYTH: If a token is not marketed as an “investment,” or is marketed as a “non-investment” (consumer good), it is not a security.
FACT: The marketing of a token as an investment can be evidence that the Howey test is met, but it is neither necessary nor sufficient for the Howey test to be met.
Token acquirers can reasonably infer the investment potential of a token from a wide variety of circumstances—such as the existence of an active participant who holds many tokens and undertakes activities to drive public demand for the token, combined with the token having limited supply. Moreover, marketing the token as an investment can be subtle and avoid obvious words like “investment” and “profit”.[6]
Conversely, the fact that a token is marketed as an investment does not necessarily make it a security. For example, BTC is widely marketed for as an investment, but BTC is not a security.
MYTH: If the token is useful for a non-investment purpose (i.e., if the token “has utility” or a “consumptive purpose”), it is not a security.
FACT: This myth was prevalent during the 2016-2017 ICO boom, when it was used to argue that “utility tokens” are not securities, but has since declined in popularity due to repeated refutation by the SEC, securities attorneys and courts. Nevertheless, the myth remains relevant today and often reappears in superficially different guises.
The myth is grounded in a kernel of truth: Under a line of cases descending from United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), “when a purchaser is motivated by a desire to use or consume the item purchased, the securities laws do not apply.” The Forman court held that the purchase of “stock of [a] cooperative housing corporation” was not a securities transaction because “[t]he sole purpose of acquiring these shares is to enable the purchaser to occupy an apartment in Co-op City.” The court reasoned “there can be no doubt that investors were attracted solely by the prospect of acquiring a place to live, and not by financial returns on their investment”. Some key facts in the case that are often ignored in superficial commentary include that:
the condos could not be acquired without purchasing the stock;
the stock could not be transferred except together with the condos;
there was a fixed ratio of shares to each condominium;
the shares did not confer separate voting rights (one resident, one vote); and
the economic upside of the shares was artificially constrained by a cap on the future sales price.
However, the mere existence of a possible consumer use is not sufficient to prove that a transaction is primarily consumption-motivated. Rather, for the Forman exception to apply, the totality of facts and circumstances must show that the transaction was objectively structured primarily for a consumer purpose. Thus, in a superficially similar case, Teague v. Bakker, 35 F.3d 978 (4th Cir. 1994), in which lifetime memberships to a religious resort entitling the purchaser to a certain number of days at the resort each year, the court held that the memberships represented investment contracts because:
“the promotional materials…represented that the value of the privileges lifetime partners would receive far exceeded the $1,000 …purchase price [because] you can actually save thousands of dollars during your lifetime with your onetime investment of $1,000”;
in stark contrast to Forman, acquiring a lifetime membership was not necessary to be able to stay at the resort—in fact, up to 50% of rooms could be reserved for non-members—and “the value of the rights to use [the resort] would be enhanced, and therefore capital appreciation might accrue, by virtue of the regular commercial operations of half of all the facilities reserved by regular patrons paying full price”;
there was evidence that the memberships or their benefits were transferable; and
the testimony of membership holders that they acquired the memberships to use them to stay at the resort was not dispositive of the issue and could be disregarded based on the objective indicia of an investment purpose.
Similar to the result in Bakker, in SEC v. Glen-Arden Commodities, Inc., 368 F. Supp. 1386 (E.D.N.Y. 1974), the court held that acquisitions of warehouse receipts evidencing ownership of casks of whisky stored in bonded warehouses in Scotland constituted investment contracts. Although whiskey is a consumable item, the acquirers were acquiring the receipts as an investment under circumstances satisfying the Howey test.
It is worth noting that not all “uses” are necessarily “consumer uses” of the kind contemplated by Forman. Cases relying on Forman relate to acquisitions of single condominiums and other goods and services that are clearly for personal or household consumer use—e.g. acquiring a condo to live in. By contrast, token uses such as governing a decentralized financial protocol or staking a token to receive more tokens are more inherently financial in nature. We are skeptical that courts will apply the Forman logic to these primarily finance-oriented “uses”. By contrast, the acquisition of an NFT like a “cryptokitty” NFT may fall under the Forman exception.
In cases where venture capital investors have purchased the tokens (or instruments convertible into the tokens), it will be particularly difficult to demonstrate that Forman’s “consumptive use” exception applies. This is illustrated by some of the reasoning in the District Court for the Southern District of New York’s recent opinion in SEC v. Telegram Inc.:
“Consumptive uses for GRAMs were not features that could reasonably be expected to the Initial Purchasers targeted by Telegram…Telegram did not focus on cryptocurrency enthusiasts, specialty digital assets firms, or even mass market individuals who had a need for an alternative to fiat currency. Instead, Telegram selected sophisticated venture capital firms…with an inherent preference (i.e., their business model) toward an investment intent rather than a consumptive use.”[7]
This type of venture capital investment demonstrates that there is an investment upside to the token. Such powerful evidence of a potential investment purpose makes it challenging to demonstrate that even non-venture-capital-investors are acquiring the token primarily for “consumption.”
UPDATE 10/7/20: This reasoning was largely accepted by the court in SEC v. Kik, see relevant excerpt below:
MYTH: If all token acquirers agree to representations and covenants providing that they are acquiring the token solely (or mostly) for a non-investment purpose, then the token is not a security.
FACT: A unique feature of the U.S. securities laws is that they are non-waivable.[8] This means that parties are not permitted to directly or indirectly agree by contract or otherwise that the securities laws do not apply when they otherwise would. In other words, an agreement among the parties that the securities laws do not apply will not be enforced or honored. In the context of the Howey test, this means that representations and covenants regarding a non-investment purpose will only be honored if they are accurate and are performed. For example, it is objectively implausible that a venture capital investor wishes to acquire hundreds of thousands or millions of dollars worth of in-app currency for a messaging platform favored by teenagers because the venture capital firm plans to buy emojis as part of its messaging activity. Therefore, if the venture capital investor represents that it is acquiring the tokens for such purpose, the representation will be viewed as an impermissible attempt to waive the securities laws and will be disregarded. Similarly, if a person who engages as a business in cryptocurrency trading buys the tokens in large amounts, it is unlikely that the cryptocurrency trader has a non-investment purpose, and any contrary representations or covenants provided by the trader in the purchase agreement would likely be disregarded.[9]
MYTH: Tokens that are “airdropped” or otherwise distributed “for free” or are rewarded pursuant to “bounty programs” or “liquidity mining” are not securities because there is no “investment of money”.
FACT: The error in this myth is interpreting the phrase “investment of money” under the Howey test to require a literal investment of money.
In reality, “an investment of money” can be any cost incurred by the purchaser or any benefit conferred upon the seller. For example, a prospective user signing up for a company’s mailing list in exchange for free shares of the company’s stock can be an “investment of money” because the person might not have signed up for the email list if not induced by the prospect of receiving free shares.[10] Furthermore, even if the security is a “gift,” such as an in an “airdrop,” there is still deemed to be an exchange of value if there is a resulting benefit to the issuer which implicates the securities laws—for example, “the creation of a public market for the issuer’s securities” can be such a benefit.[11]
Based on this reasoning, tokens rewarded to users as a reward for activities such as using the product, “liquidity mining,” finding bugs, tweeting, creating additional software, making referrals, etc., are clearly acquired with “an investment of money.” Even airdropping a token on an unwitting, unknown holder of a random Ethereum address would constitute an “investment of money” by the recipient if the purpose of the airdrop were to encourage a public market in the token or foster investment-related interest in the token.[12]
For case law authority on this subject, see generally Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991), where the court reasoned as follows:
[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract….[T]he ‘investment’ may take the form of ‘goods and services,’ or some other ‘exchange of value’.
MYTH: Because the Howey test requires that token acquirers reasonably expect profits “solely from the efforts of others,” if token profits depend in any way on a given token holder’s efforts, the token is a not a security.
FACT: Although it is true that Howey originally required “efforts solely from the efforts of others,” subsequent case law has departed from Howey.[13] Now, the law now only requires that an investor relies “predominantly” on others to supply “the undeniably significant [efforts], those essential managerial efforts which affect the failure or success of the enterprise”. This principle has been recognized in many Howey cases—for example, in a case where persons bought chinchillas and had to breed them and raise their offspring in order to achieve a profit by selling the offspring back to the sellers, the court nevertheless held that the chinchilla purchases and the buyback agreement constituted an investment contract.[14]
Even if token holders affect their own profits by timing their buys and sells, or affect the security of the network by staking in proof-of-stake, they might still be relying predominantly on the issuer for their token profits. For example,the issuer might be essential to fulfilling (via paying and coordinating developers, attracting investment, etc.) a product roadmap likely to increase the value of the token or the issuer might have business connections enabling it to enter into high-profile commercial partnerships that increase the value of the token
MYTH: Because governance tokens enable the token holders to vote on all or most decisions, they are not securities.
FACT: Like many of the other myths, this one derives from a kernel of truth—the voting and economic interests in “general partnerships” are presumed not to be securities because no partner is primarily relying on the efforts of any other partner(s) for profits. Instead, each partner is an active and potentially essential participant in the enterprise. These enterprises are co-managed by a relatively few number of people who know each other and regularly coordinate. Importantly, general partnerships are inherently un-scalable. The small-scale nature of general partnerships is reflected in rules like the IRS’s rule that partnerships having more than 100 partners are “public partnerships” and the Investment Company Act’s rule that investment funds with more than 100 equityholders are “investment companies” which need to be registered with the SEC.
The mere provision of voting rights to token holders, even if votes are held very frequently, does not mean all token holders are “general partners”. An enterprise styled as a DAO might be community-governed in theory, but large token holders (or groups of smaller token holders who coordinate with one another to achieve a large aggregate token stake) may in practice dominate the decision-making while passive and small token holders lack the same information and power to coordinate. Or “curators” might be required, as they were in the original TheDAO. The more passive or less powerful DAO members are likely relying upon the entrepreneurial efforts of others and thus the governance token is more likely to be a passive interest, and thus a security, than a general partnership interest, and thus a non-security.
MYTH: The Howey test requires ongoing reliance on the entrepreneurial efforts of others after the investment is made. Therefore, if all entrepreneurial efforts of an issuer occurred prior to the network launch, the token is not a security.
FACT: This myth is not a pure myth, but more of an “it’s complicated”. It is the subject of an ongoing “split” (disagreement) between the courts of appeals of different U.S. federal circuits. Certain cases hold that if all of the “efforts of others” made after the alleged security is sold are “ministerial,” the Howey test is not satisfied. But other cases hold that a mix of pre-sale entrepreneurial efforts and post-sale ministerial efforts can satisfy the Howey test. The SEC staff has endorsed the latter line of cases, including in discussions with the author of this report relating to DeFi tokens.
MYTH: An “investment contract” is a contract; therefore, if the issuer of a token does not enter into a contract with token holders, there is no “investment contract” and the securities laws do not apply.
FACT: This viewpoint has become popular recently due to an article by securities attorney Lewis Cohen, “Ain’t Misbehavin’: An Examination of Broadway Tickets and Blockchain Tokens”[15] and the apparent embrace of its reasoning by SEC Commissioner Hester Peirce in “Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization”[16]. The argument supporting this viewpoint goes something like this (note: this is not a quote, but a ‘gloss’ giving my best interpretation of the various arguments made):
In all or most cases holding that the parties had an “investment contract,” there also existed an ordinary contract between the alleged securities issuer and the alleged securities purchaser. Such contracts typically are ordinary commercial agreements, such as the services contract in Howey providing that the issuer would farm oranges for buyers of the orange groves.
This is not a coincidence. It is only by virtue of there being such a services contract that efforts of others can be ‘reasonably expected’. If there is no such literal contract between the token issuer and a given token acquirer, there cannot be an “investment contract.”
The existence of a services contract between an alleged securities issuer and an alleged securities acquirer is an implicit ‘fifth prong’ of the Howey test. Thus, when a token seller enters into a “SAFT” with an investor, that is a securities transaction because there is an actual contract between the seller and purchaser. However, when the SAFT converts into tokens and the investor sells the tokens to third parties, that is not a securities transaction because the tokens do not inherently connote any contractual rights and there is no services contract between the issuer or investor and the new purchaser.
While acknowledging that a few influential securities law authorities have embraced this theory, we view it as unsupported by the case law and regulators’ guidance. Judges adjudicating a Howey case clearly examine all relevant facts and circumstances and do not require every securities transaction to also involve entering into a services contract. Howey itself defines an “investment contract” as “a contract, transaction or scheme” meeting the four elements of the test. Since transactions and schemes can occur without contracts, we do not view the definition of “investment contract” as requiring that an actual contract be involved.
“Investment contracts” are not meant to be part of specific, actual contracts entered into by the parties. “Investment contracts” are a type of contract-implied-by-law that will be deemed to exist when it serves the purposes of the securities laws.
UPDATE 10/7/2020: The theory that a contract is required is now confirmed to be firmly in the “MYTH” category per the court’s holding and reasoning in U.S. Securities and Exchange Commission v. Kik Interactive Inc., No. 1:2019cv05244 - Document 88 (S.D.N.Y. 2020):
ENDNOTES:
[1]Defendants’ Response in opposition to Plaintiff’s Emergency Application for Preliminary Injunction, filed 10/16/19, in SEC v. Telegram Group, Inc., et. al, No. 1:19-cv-09439 (PKC)..“The grams themselves, as distinct from the purchase contracts, will merely be a currency or commodity (like gold, silver or sugar) — not a ‘security’ — once the TON Blockchain launches.”
[2]Letter from U.S. Commodities Futures Trading Commission to The Honorable P. Kevin Castel, United States District Judge, Southern District of New York, regarding SEC v. Telegram Group, Inc., et. al., No. 1:19-cv-09439 (PKC).
[3]Defendants’ Response in opposition to Plaintiff’s Emergency Application for Preliminary Injunction, filed 10/16/19, in SEC v. Telegram Group, Inc., et. al, No. 1:19-cv-09439 (PKC).“The grams themselves, as distinct from the purchase contracts, will merely be a currency or commodity (like gold, silver or sugar) — not a ‘security’ — once the TON Blockchain launches.”
[4]Wells Response from Counsel to Kik Interactive Inc. to SEC In re: Kik Interactive (HO-13388), p.15.
[5]See e.g. 31 CFR § 1010.100(m) (defining currency as “[t]he coin and paper money of the United States or of any other country that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange in the country of issuance. Currency includes U.S. silver certificates, U.S. notes and Federal Reserve notes. Currency also includes official foreign bank notes that are customarily used and accepted as a medium of exchange in a foreign country.”)
[7]SEC v. Telegram Group, Inc., et. al, No. 1:19-cv-09439 (PKC).
[8] See e.g. Elaine A. Welle, Freedom of Contract and the Securities Laws: Opting Out of Securities Regulation by Private Agreement, 56 Wash. & Lee L. Rev. 519 (1999)
[9]S.E.C. v. SG Ltd., 265 F.3d 42, 54 (1st Cir. 2001).[10] SEC v. Sierra Brokerage Servs., Inc., 608 F. Supp. 2d 923, 940–43 (S.D. Ohio 2009), aff’d, 712 F.3d 321 (6th Cir. 2013)
[11] Capital General, 1993 WL 285801, at *10
[12] Order Instituting Administrative and Cease-and Desist Proceedings Pursuant to Section 8a of the Securities Act of 1933 and Sections 15(B) and 21c of the Securities Exchange Act of 1934, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order In the Matter of Tomahawk Exploration LLC et. al., https://www.blockchainlegalresource.com/wp-content/uploads/sites/31/2018/08/33-10530-1.pdf.
[13] S.E.C. v. Turner, 474 F.2d 476 (9th Cir. 1973).
[14]Miller v. Central Chinchilla Group, Inc., 494 F.2d 414 (8th Cir. 1974). See also Securities & Exchange Commission v. Glenn W. Turner Enterprises Inc., 474 F.2d 476 (9th Cir. 1973) (holding that one particular investment scheme, which essentially gave a buyer the opportunity to purchase a "self-improvement" contract (Dare to be Great Adventures) and then earn a commission through his own promotional activities with respect to further sales of such improvement contracts, was a "security" under federal law).
[15] Lewis Cohen, Ain’t Misbehavin’: An Examination of Broadway Tickets and Blockchain Tokens, Wayne Law Review, Vol. 65, No. 1, 2019
[16] Hester Peirce, Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization, speech Feb 6, 2020.
This article has clarified so many things. For example, I now understand why Judge Torres ruled that selling tokens to institutional investors implicated securities laws. Such nuance.