We’re not talking about the goddamned Howey Test. Not again.
Oh yeah we are.
Before we continue, disclaimer: I’m not your lawyer, I’m not an American lawyer either, and this is a blog post, not legal advice.
Also, this is the second piece I’ve written on the SAFT structure. The first may be found here.
So, the SAFT Whitepaper came out today, and the market is reacting like it’s a pretty big deal. As they should. Published by Cooley LLP and Protocol Labs, the report’s authors include Cooley’s Marco Santori and Patrick Murck, both of whom understand blockchain technology and cryptocurrency business about as well as lawyers can.
Of course, I sounded off on the SAFT a few months ago after reviewing the first private placement memorandum published by Protocol Labs for their SAFT raise.
I am not going to do a belt-and-braces review of the SAFT whitepaper here, as (a) I have rather a lot of work to do this week and (b) it covers a lot of ground, much of which I agree with, and some of which is not really the subject of major dispute (e.g. tax issues).
1. Short version of this blog post
I will confine my comment here to the SAFT whitepaper’s arguments on page 9 of the report, where Cooley argues that
“Already-functional utility tokens are unlikely to pass the Howey test.”
That is to say, freely traded crypto-tokens that perform some useful function on a software platform will not satisfy the requirements of, and be deemed securities according to, the four-part test in SEC v W.J. Howey Co.
The Howey test, we should recall, holds that a arrangement or scheme which is not clearly a security (e.g. a share) is capable of being regulated as a security, a so-called “investment contract,” if four key elements are satisfied. These are if there is:
- an investment of money
- with the expectation of profits
- into a common enterprise
- with those profits arising solely from the efforts of a promoter or third party.
I believe the SAFT White Paper’s conclusion on this point is incomplete.
2. Long version of this blog post: introducing the Already-Functional Utility Token (AFUT)
Writing two months ago, I divided the world of tokens into two categories: the “investment token,” which is very obviously a security, and the “utility token,” which is designed to perform some software function, although it may also have value in exchange.
The SAFT Whitepaper divides one limb of this taxonomy further, into
- the “pre-functional utility token,” i.e. the promise to deliver a utility token, and
- the “already-functional utility token,” i.e. a cryptographic token which exists today and is usable today as part of a fully functional software application.
The SAFT Whitepaper and I are in total agreement that prefunctional utility tokens likely satisfy the four limbs of Howey and are therefore securities.
There are, of course, things in this world that are pre-sold without constituting securities for the purposes of the 1933 Act (see e.g. anything properly crowdfunded, or physical goods). Cryptographic tokens, on the other hand, when pre-sold ahead of the creation of the software platform that is meant to consume them frequently adopt the trappings of an investment contract – exchange-trading, marketing encouraging people to “invest,” attracting the attention of the “crypto hedge funds” – which looks an awful lot like behavior which would normally be associated with the sale of investment securities in the real world. While it is theoretically possible to structure a pre-sold crypto-token in such a way as to not constitute an investment security, this is not a conclusion I have ever reached when I’ve sat down and done an analysis of a pre-sold scheme. Examples of pre-sold tokens which might fall into this category include presale Eth, Protoshares and Eos tokens.
Where I differ from the paper most is on the AFUT. The SAFT Whitepaper says that “critics of sales in this category” (i.e. @palleylaw and I):
“might argue that the expectation of profit from resale on a secondary market is just speculative activity seeking capital appreciation. These critics might cite myriad federal court decisions holding that an expectation of mere ‘capital appreciation’ on a secondary market is sufficient to satisfy the Howey test.
Indeed that is exactly what we argue, at least insofar as it pertains to the day-to-day experience of cryptographic token origination and trading. The report then points out that
the criticism collapses the ‘efforts of others’ prong into the ‘expectation of profit’ prong… by relying on decisions which do not actually turn on the secondary market appreciation issue, and do not analyze it in much depth. Decisions that do so repeatedly hold that an expectation of profit from the mere increase in value on a secondary market is not from the ‘efforts of others.’
The SAFT Whitepaper has a point here. Cryptocurrencies are designed to run themselves and in theory can do so forever without any human administration. Stephen and I can be forgiven for making the assumption that the efforts of others leg was satisfied in situations where a development company was incorporated, raised money, created a coin in relation to which that company made representations and assumed some legal responsibility (see e.g. the Ethereum offering documents), and actively continued developing it over a length of years post-launch, as often (but not always) occurs.
When assessing whether the “efforts of others” leg of the Howey test has been satisfied, the rule is that mere hodling of an asset for “possible enhancement in value at resale is not within the Securities Act, where the essential element of reliance on the managerial, operational or developmental efforts of others is not present.” (McConathy v Dal Mac Commercial Real Estate, Inc., 545 S.W.2d 871 (1977))
The SAFT whitepaper introduces three cases illustrating the application of this principle, being Noa v Key Futures, SEC v Belmont Reid and Sinva v Merrill Lynch, where purchasers of various forward contracts for underlying assets (silver, gold, and sugar, respectively) were held not to be investment contracts as “the profits to the investor depended primarily upon the fluctuations of the silver market, not the managerial efforts” of the company issuing the paper.
The Saft Whitepaper continues by saying
Because there is no central authority to exert “monetary policy,” the secondary market price of a decentralized token system is driven exclusively by supply and demand. …One of those factors could be the efforts of the development team creating the token’s functionality; but once that functionality is created, an “essential” efforts have by definition already been applied.
This is an interesting interpretation, and one with which I disagree.
While I agree that we cannot collapse the ‘efforts of others’ prong into the ‘expectation of profit’ prong, we cannot ignore the factual matrix around the development, marketing and promotion of cryptocurrency schemes, either. Considering these facts and circumstances in their totality is what led critics such as myself to conclude that the efforts of others limb of the test could be taken as read.
Because I need to be brief, I will make three points and then conclude.
a. Code is garbage
First, “blockchain” as such is a new field. Accordingly blockchain code is often accused of being, or found to be, garbage (see the Ethereum recursive call exploit that led to the DAO fiasco, or more recently the back and forth over alleged vulnerabilities in the multi-billion-dollar IOTA token). It is therefore unrealistic to suppose that “essential” efforts end on the first day of a token’s existence.
Cryptocurrencies do have and should be expected to have ongoing and highly intensive human involvement throughout their lifecycles. See, e.g,. the go-Ethereum repo, which has nearly 9,000 commits and was last updated (as of time of writing) one hour ago. People may call Bitcoin “digital gold,” but gold does not require periodic bug fixes and is not subject to backwards-incompatible upgrades. The commodities authorities in Noa et al. aren’t perfectly applicable.
b. Speculation is a hell of a drug
Second, while cryptocurrencies are often treated by those who hold and sell them as commodities and profits arise, at least superficially, through movements in the markets (Noa et al.), I would argue that most of this value is not generated from pure utility but rather from speculation of a very particular kind. That speculation is being driven by extremely aggressive marketing and evangelisation by its holders, and often it is factually incorrect or misleading. In some cases entire companies, who shall remain nameless at this juncture, exist seemingly for the sole purpose to drive hype in this cryptocurrency or that one. Given the spectacular results, who can blame them?
Silicon Valley calls this phenomenon “bootstrapping.” I call it multi-level marketing, with identifiable human administrators whose efforts are indeed required in order for the cryptocurrency in question to both function and have value.
Where we are left is that we have to consider, in addition to the commodities authorities, the impact of other authorities with fact patterns similar to the day-to-day we encounter in cryptocurrency, namely the franchise and MLM cases.
Let us consider SEC v Glenn W. Turner, a case concerning the sale of motivational courses. Students could purchase the courses, which allowed them to attend seminars and receive audiovisual material to “improve self-motivation and sales ability.” If students spent enough money on the courses, they would also receive a licence to sell the courses to others. They could invite new recruits to meet-ups where former students would show up in fancy clothes, driving expensive cars, and generally showing how the program (known as “Dare to be Great”) was making their lives better.
This could be any cryptocurrency conference these days (some are more guilty than others). In exchange,
The purchaser is sold the idea that he will get a fixed part of the proceeds of the sales. In essence, to get that share, he invests three things: his money, his efforts to find prospects and bring them to the meetings, and whatever it costs him to create an illusion of his own affluence. He invests them in Dare’s get-rich-quick scheme. What he buys is a share in the proceeds of the selling efforts of Dare. Those efforts are the sine qua non of the scheme; those efforts are what keeps it going; those efforts are what produces the money which is to make him rich. In essence, it is the right to share in the proceeds of those efforts that he buys. In our view, the scheme is no less an investment contract merely because he contributes some effort as well as money to get into it.
Put differently, in Turner the court demonstrated a willingness to depart from the strict confines of the Howey Test – and in particular the efforts of others leg – to adopt a “flexible approach” and look to the “essential nature of the scheme” in order to circumvent
the requirement that profits come “solely” from the efforts of others [which] would, in circumstances such as these, lead to unrealistic results if applied dogmatically[.]
c. Because of the above, in practice, finding “others” should not be that hard
In Turner, of course, the issue was almost the reverse of what we face with a cryptocurrency. There, the Court had to consider whether the involvement of scheme participants themselves was enough to knock out the “efforts of others” limb of the Howey test (spoiler alert: it wasn’t, so the Court found that it was a security).
By contrast, crypto-tokens, which automate many of the functions which a scheme promoter used to perform, challenge us to find the “others” who are making the required “efforts.”
I don’t think we’ll need to look very far. Even if we completely ignore the fact that many of these schemes have Zug-based non-profits supervising their development, cryptocurrencies must be staked or mined; that is effort, with commonality between miners and holders, and that continued effort is essential for the continued existence of the enterprise. Equally, if we want to apply Turner it is probably not entirely off-base to ask whether the efforts of cryptocurrency promoters/boosters alone, viewed in tandem with the doctrine of vertical commonality, are sufficient to constitute “efforts of others” for the purposes of the Howey test, and (by extension) whether “viral” investment schemes should or could be regulated in the same way as the get-rich-quick seminars of yesteryear.
Furthermore, an affinity scam/MLM situation strikes me as being closer to the essence of cryptocurrency’s community than a bunch of commodities traders. To illustrate how short a leap of logic is required between Turner and crypto, let’s be creative and do the legal equivalent of thinking with portals. With Turner as a baseline, let’s rewrite the Court’s judgment pretty minimally and see where we come out:
The purchaser is sold the idea that he will get a fixed part of the appreciation in the price of the coin. In essence, to get that share, he invests three things: his money, his efforts to find prospects and get them to purchase coins, and whatever it costs him to create an illusion of his own affluence. He invests them in the coin. What he buys is a share in the proceeds of the uplift in value of the coin. Those efforts are the sine qua non of the scheme; those efforts are what keeps it going; those efforts are what produces the money which is to make him rich. In essence, it is the right to share in the proceeds of those efforts that he buys. In our view, the scheme is no less an investment contract merely because he contributes some effort as well as money to get into it.
Interesting thought experiment, right?
As Turner very clearly shows, the danger here to ICO token issuers lies in that old chestnut, the Duck Test. Which holds that if something looks like a duck, waddles around, and quacks, it’s probably a duck.
For this reason I conclude that AFUTs are still more likely than not to constitute investment contracts requiring registration or an exemption to registration prior to sale.
3. Summing up
Crypto-tokens defy easy identification within the acknowledged classes of property. This is only partially due to the fact that they are technologically novel, information-based and decentralized. It is mostly because those issuing crypto-tokens would rather not contract into an existing category of property, and choose not to do so despite the fact that this would make everyone’s lives a lot easier, because doing so would allow us (and the regulator) to run a proper compliance analysis.
We are left with an amorphous thing which looks an awful lot like a garden-variety investment, even if it has practical uses. People buy the things as a commodity, even though there’s an awful lot of managerial and third party development, in any case more than would be involved with a lump of gold. And the things market themselves in a fashion which a kale-eating Bay Area tech bro might call “viral,” even as a cantankerous, British-educated Connecticut Yankee like me might call it “pyramidal.”
There is plenty of room for reasonable and learned lawyers to disagree on this issue. Ultimately the only entity capable of deciding the U.S. position is a federal court. What might happen there is anybody’s guess. The courts may indeed find these things to be “digital commodities.” Or they might use the discretion they exercised in Turner to broaden the “efforts of others” test to include open-source development and viral marketing. Or they might throw out Howey completely and go with a different definition, such as the “risk capital” test adopted by the State of California in Sobieski v Silver Hills.
My money is on billions more being raised and not finding out out the legal answer until a very well-funded ICO blows up and decides to go toe-to-toe with some angry investors when they bring an action for rescission under 15 U.S. C. § 77l. Following which I am also betting logic similar to Turner will be employed in a finding that these things are, in fact, investment contracts per Howey and subject to the Securities Act.
In the meantime, consider moving to England.
Oh. And here’s a picture of a yellow-bellied marmot hanging out on a rock.