Digital Assets—Investment Contracts or Howey Test Unicorns? (Part 5 of 6)
In the fifth piece of his six-part series, Professor Ari Gabinet analyzes the role of Kin’s contract in determining whether it is a security. Professor Gabinet draws on his expertise in securities law, accrued through experience as a private practice litigator, a private sector in-house counsel, and as a district administrator of the SEC.
Kin Itself Is Not the Security; It’s the Contract That Might Make It One
Confusion arose in the Kik case because Kik offered the same token to the buyers in the private offering and in the TDE. But the fact that the token was the same does not mean that the token was a security in both offerings. Kik conducted an exempt offering of Kin precisely because the proceeds were being used to build the Kin ecosystem—Kik’s managerial efforts were to bring utility and value to Kin, making that offering arguably a securities offering under Howey. But in the TDE, there were no such managerial efforts to be employed; the contracts under which the tokens were issued in the TDE must be examined to determine if it was an investment contract—it is the CONTRACT, not the property being sold, that is the security.
An investment contract is not the same as a share of stock, but for purposes of its integration analysis, the Kik court treated the tokens as if they were equity securities— the same thing was sold in both offerings—Kin.
Purchasers in the two sales received the same class of securities, fungible Kin that were equal in value. It is true that they received them via different instruments with different rights. However the ultimate result was distribution of identical assets.
Kik Interactive, supra, at 24.
Are Third Party Efforts Before the Contract is Entered Into Relevant If the Contract Does Not Promise Third Party Efforts After the Contract is Made?
To the court it made no difference that the entrepreneurial work was complete by the time of the TDE. In the court’s view the value of Kin to the TDE buyers depended on the entrepreneurial work that had already been done with the money raised from the sale of Kin in the private offering. This reasoning is seductively simple, but may be too simplistic. The question is whether the contract pursuant to which Kin was sold is an investment contract, not whether the token by itself is a security. Citrus grove plus management contract is not the same as citrus gove with no management contract, even though the subject matter of both is a fungible citrus grove.
The fact that the terms of the private offering and the TDE contracts were different requires the court to examine those differences; if it glosses over them because the digital asset was the same, it has NOT performed its Howey analysis. For purposes of the Howey test, the “thing” being tested is not just the physical (or digital) subject of the contract—it is the combination of that subject matter with the terms and conditions of the contract. Even though the token offered was the same, the expectations and attendant rights were not. In the private offering Kik sold digital assets to raise money with which to build an autonomous network hosting applications in which Kin could be used and thereby become valuable. In the TDE it sold Kin pursuant to a contract that specified that Kik undertook no obligations, and that Kin’s value would only increase as a result of the use of the existing network by third parties under no obligation to do so.
The issue is important because many assets appreciate and are purchased primarily for that reason, but not all such assets are securities. For a contract to purchase an asset to be an investment contract, the expectation of profit must be predicated on the entrepreneurial activities of the promoter or other third parties; third parties, moreover, whose activities are not wholly independent of the promoter’s activities.
Like a condominium or real estate development whose value may increase if the surrounding area is developed by independent parties, the purchase of such a bare asset is not a security, even in the presence of some incidental development by the promoter. Courts have held that the work a developer does before offering the property to buyers does suffice to make the contract for sale a security where the developer does not undertake to do anything after the sale to enhance the property’s value. In Rodriguez v. Banco Central Corp., et al, 990 F.2d 7 (1st Cir. 1993), the First Circuit wrote:
In our view, even if every buyer bought for investment, what was purchased in this case was not a share of a business enterprise and so not a security. Taking the evidence most favorably to the buyers, they were sold land in individual parcels with strong and repeated suggestions that the surrounding area would develop into a thriving residential community. But apart from the promise of an existing lodge or a new country club, the evidence did not show that the promoter or any other obligated person or entity was promising the buyers to build or provide anything. A few scraps of evidence, usually ambiguous, may point the other way but we do not think that a reasonable jury could conclude on this record that the defendants were promising to construct a community.
A security might exist if the defendants had promised, along with the land sales, to develop the community themselves. Then each buyer might be acquiring an interest not only in land but in a package of commitments that, taken together, could comprise a business venture harnessing the entrepreneurship of the promoter. Each parcel of land would still have a different value, unlike the typical share of stock, but most of the potential gain might depend on the development of the community as a whole. Cf. Joiner, 320 U.S. 344 at 348-49, 88 L. Ed. 88, 64 S. Ct. 120 (promised oil well gave mineral leases "most of their value and all of their lure"). The promoter's commitment to build the community, in turn, could constitute the "common enterprise" financed jointly by the buyers. Howey, 328 U.S. at 299. Several decisions have taken this view, and we think they may be correct in principle. (E.g., McCown v. Heidler, 527 F.2d 204 (10th Cir. 1975); Miller v. Woodmoor, CCH Fed. Secur. L. Rep. P 96,109, 91,998-999 (D.C. Colo. 1976); Aldrich, 627 F.2d at 1038-1040).
In this case, however, the most that can be said is that the promoter left the distinct, and distinctly false, impression that a community was going to develop through natural forces. Many buyers were told that Disney World's presence nearby would spur growth. Others were shown pictures of specific sports facilities already existing at specific distances. But aside from the lodge or country club, there was little testimony that specific promises were made by anyone to do specific things. Accordingly, what we have is sales of property based on false representations as to its prospects, but there is no pretence of a "common enterprise" managed by the promoter and hence no "security." (See, e.g., Woodward v. Terracor, 574 F.2d 1023, 1025 (10th Cir. 1978); Happy Investment Group v. Lakewood Properties, Inc., 396 F. Supp. 175, 180-81 (N.D. Cal. 1975)).
Rodriguez, supra, at 13.
Arguably Kik too sold property (Kin) with the strong and repeated suggestions that the Kin ecosystem would develop into a thriving blockchain community, but with no promises of specific things that Kik would do beyond the substratum that was already in existence at the time of the TDE. It is not only in the context of real estate that courts have refused to find expectation of profits based on the efforts of third parties where entrepreneurial efforts are complete by the time the parties make their contract. Courts have held that where the efforts of a promoter that precede, in their entirety, the sale of the asset, the third prong of the Howey test has not been satisfied. The D.C. Circuit Court of Appeals rejected the finding of a security in the sale of viaticals (insurance contracts on the lives of third parties). In Securities and Exchange Commission v. Life Partners, Inc., 87 F.3d 356 (DC Cir. 1996), the Court rejected the SEC’s argument that sales of viaticals constituted investment contracts. The Court refused to find profits based on the efforts of third parties based on the defendant’s “pre-purchase expertise in identifying existing policyholders” and performing ministerial services post-purchase, including potentially arranging resales of the viatical contract for purchasers. The Court rejected the SEC’s argument that the difference between pre- and post-sale activities was artificial and irrelevant to the Howey analysis:
Absent compelling legal support for the Commission's theory—and the Commission actually furnishes no support at all—we cannot agree that the time of sale is an artificial dividing line. It is a legal construct but a significant one. If the investor's profits depend predominantly upon the promoter's efforts, then the investor may benefit from the disclosure and other requirements of the federal securities laws. But if the value of the promoter's efforts has already been impounded into the promoter's fees or into the purchase price of the investment, and if neither the promoter nor anyone else is expected to make further efforts that will affect the outcome of the investment, then the need for federal securities regulation is greatly diminished.
SEC v. Life Partners, Inc., 87 F.3d at 547. Even those cases where the courts have noted that the efforts of third parties analysis may include pre- and post-sale efforts have found some element of post-sale activity by the promoter to be part of the expected value. (See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 , 240-41 (2d Cir. 1985); SEC v. Mutual Benefits Corp., 408 F3d 737, 743 (11th Cir. 2005)(ongoing market-making for viaticals)).
For an analogy, consider a hypothetical Dave & Buster’s entertainment business. The founders want to build the shell of an arcade for other vendors to occupy and offer token operated amusements. First Dave and Buster’s creates a fixed number of tokens. It conducts a portion of the tokens to people with the promises to use the proceeds to build a building where vendors can come and install games in which the tokens can be used. It fulfills its promise and builds a self-sufficient building with all the infrastructure necessary for third parties to come and install and operate games that accept D&B tokens.
Then Dave & Buster's sells the remaining D&B tokens to the public, telling them only that the building has been built and is awaiting third parties to install games in which the tokens can be used. The fixed number of tokens means that they may have either commercial utility or speculative value as collectibles. Dave and Buster's does not make any representation of how it will use the proceeds of the second sale of tokens; what it plans to do with them is therefore irrelevant because the buyers’ expectations of the value of the tokens is not dependent on any further entrepreneurial effort by Dave and Buster’s. From the point of view of the Howey test, Dave and Buster's uses the proceeds for is irrelevant; it could distribute the proceeds to its principals; it could use it for any project it is working on—even, theoretically, a game that will operate in the Dave & Buster’s building—from which Dave Buster’s, not the token holder, will keep the profits—derived from token holders using them there.
The second sale of the D&B tokens—like the sale of Kin—are of assets accompanied by no promise of further entrepreneurial efforts of anyone. They are conceptually indistinguishable from the sale of real estate in a development whose value depends on unrelated third parties building amenities in the area. They are conceptually indistinguishable from citrus groves prepared by Howey, but sold without any management contract.
The Kik court rejected the analogy of Kin to the purchase of real estate, noting that real estate has inherent value independent of the buildout of the neighborhood or the rest of the development. But the question is not whether the asset has independent value; the question is whether the expectation of profit comes from the promised efforts of the promoter or third parties. The Court noted that Kin’s value was dependent on Kik being “the primary driver of [the Kin] ecosystem.” Given Kik’s argument that it did not promise and was not obligated to provide post-TDE promotional effort, the court either did not credit Kik’s evidence; relied solely on the pre-TDE development of the Kin ecosystem; or made the circular conclusion that Kin was a security by integrating it with the private offering which according to Kik, paid for the development of the Kin ecosystem.
The “pre-sale/post-sale” differentiation with respect to third party efforts has its critics. But the important question is why it should matter in each case. The purpose of the ‘33 Act’s registration requirements is to provide investors with information about what proposes to be an ongoing enterprise to which their prospective returns are tied. But as the Court stated in SEC v. Life Partners:
While, to be sure, coverage under the 1933 Act might increase the quantity (and perhaps the quality) of information available to the investor prior to the closing, "the securities laws [are not] a broad federal remedy for all fraud." Marine Bank v. Weaver, 455 U.S. 551, 556, 71 L. Ed. 2d 409, 102 S. Ct. 1220 (1982).
Life Partners, supra, loc. cit. Many things that are not considered securities derive their value from future events and from the actions of persons unconnected with the curation and sale of a particular group of assets. The numerous decisions interpreting Howey’s requirement of expectation of profits from the entrepreneurial or managerial efforts confirm that curatorial efforts in the selection of assets for purchase, without more, do not turn ordinary, appreciable assets into securities.
From a simple outsiders’ perspective, the purchase of Kin looks an awful lot like an equity investment—providing operating capital to a company to build out a business that will make the investment more valuable. The court’s reliance on Kik’s pre-TDE entrepreneurial activities appears to either extend the reach of Howey to situations devoid of post-sale third party efforts, or makes a circular argument—integrating the two offerings together allows it to conclude that the TDE was a securities offering—which conclusion is itself necessary for integrating the two offerings.
Perhaps, though, the Kik decision evidences a lack of appreciation for, or oversimplification of the nuanced digital currency environment. Not all cryptocurrency sales are simple substitutions of tokens of coins for equity securities. Blockchain businesses are widely variable, and regulatory approaches must take that variety, as well as the fundamental technological reality into account: blockchain-based systems can create autonomous infrastructures with algorithms that dictate all future activity on the blockchain—without further support or activity from the programmers who create them. If the native digital assets sold after the system is initiated, in what sense are they expecting future returns from the efforts of the promoter? If Howey had cleared citrus acreage and put up a sign offering “buy land, suitable for fruit trees,” how would the case have come out?
Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review is grateful for his support as our Faculty Advisor.