Section 2(a)(1) of the Securities Act of 1933 defines “securities” as: “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement… investment contract… or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The seminal Supreme Court case for determining whether an instrument meets the definition of security is SEC v. Howey, 328 U.S. 293 (1946). The Supreme Court has reaffirmed the Howey analysis as recently as 2004. Howey focuses specifically on the term “investment contract” within the definition of security, noting that it has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” Not every contract or agreement is an “investment contract” and the Supreme Court developed a four-part test to determine whether an agreement constitutes an investment contract and therefore a security.
The Court articulated the test as follows: A contract constitutes an investment contract that meets the definition of “security” if there is (i) an investment of money; (ii) in a common enterprise; (iii) with an expectation of profits; (iv) solely from the efforts of others (e.g., a promoter or third party), “regardless of whether the shares in the enterprise are evidenced by formal certificates or by nominal interest in the physical assets used by the enterprise.” In order to be considered a security, all four factors must be met.
Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of a money investment the first factor will likely be satisfied in most ICO offerings.
Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (i) horizontal; (ii) narrow vertical and (iii) broad vertical. Under the horizontal approach, a common enterprise is deemed to exist where buyers pool funds into an investment and the profits of each buyer correlate with those of the other buyers. Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may be deemed not to exist.
The narrow vertical approach looks to whether the profits of an investor are tied to a promoter. The broad vertical approach considers whether the success of the investor depends on the promoter’s expertise, and both approaches may be analyzed together. If there is such reliance, then a common enterprise will be deemed to exist. Thus, depending on the level of control exerted by the issuer, the less of a reliance on the issuer’s expertise, then the less chance a given token offering would be viewed as having a common enterprise.
Given the diverging approaches, the law on the “common enterprise” element is somewhat unclear and not easily susceptible to analysis but more to the whims of a given court. Putting things in more practical terms: in one sense, it would appear that any given token utilization platform is a common enterprise if it involves the efforts of users to perpetuate the increased use and growth of a system that benefits the issuer and any investors. It would seem to be the case that where the issuer of any given token uses the funds derived from the issuance to create, support and maintain the system, a court might find the common enterprise element satisfied. Although not definitive in this regard, depending on how the presale is structured and whether the construction of the system is contingent on such funds, this type of control by the issuer may increase the likelihood that this element would be met. Therefore, the farther out from platform development an ICO occurs the more likely funds obtained from the ICO would be used to build, code and implement the platform, and hence the greater the likelihood there will be reliance on the issuer/promoter by any investors.
Under the “expectation of profits” element, profit refers to the type of return or income an investor seeks on their investment (rather than the profits that the system or issuer might earn). This could refer to any type of return or income earned as a result of being an ICO investor, which would be narrowed to the extent it is derived passively, i.e., from the efforts of others. Since courts consider this factor through the lens of the “efforts of others” factor, this prong is analyzed along with the fourth factor below. In other words, just because there is a return or profit, does not mean that the investment contract is a security. It is the essentially passive nature of the return, as determined by the “efforts of others” analysis that results in an “investment contract” and “security” as opposed to a simple contract instrument.
“Solely from the efforts of others”: typically, courts have been flexible with the word “solely,” such that, in addition to the literal meaning, it also will include significant or essential managerial or other efforts necessary to the success of the investment. The expectation of profits resulting from the purchase of ICO tokens would primarily relate to whether a token holder receives rights and/or investment interests. While non-security token holders may receive money, capital gains, or other forms of financial incentives by virtue of merely owning the token, any such incentives should be derived through their own efforts, rather than through a passive investment.
Although an issuer may have some managerial oversight over the system and the initial distribution of its tokens, if the buyers do not obtain any voting rights with respect to the management of the entire platform this would seem to militate toward relying on the “efforts of others,” in this case the issuer, and therefore toward a given token being a security. The manner in which an ICO occurs, particularly the promotion and marketing, may also affect the “expectation of profits” analysis. For example, if the language used to promote an ICO includes words like “investment,” “returns” or “profits,” the purchasers may be more likely to expect profits from the efforts of others than if the new token is promoted on the basis of the usefulness of the rights attaching to it.
Courts have also analyzed the existence of voting rights through this fourth Howey factor. Whether voting rights are determinative of a security will be based on the facts at hand. For example, where (i) the token holder is provided with rights that provide it with significant managerial control— i.e., the ability to participate in decisions that will affect the success of the enterprise; (ii) the holder has the resources and expertise to make a meaningful contribution; and (iii) the holder does, in fact, participate in management decisions, the instrument is less likely to be considered a security.
Please note the above is a general overview of the Howey analysis, and no warranty is provided with respect to any specific offering. If you have questions or concerns regarding your particular token offering, please inquire here so this Firm may provide an opinion as to its status as a security or personal property.
