Do ICO’s Seek an Expectation of Profit Solely from the Efforts of Others?

This post was originally published on this site

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.

 

Series Post-Script

 

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]

jeff

What is a Common Enterprise and is Bitcoin or Ethereum one?

This post was originally published on this site

In our most recent blog post, we discussed the first prong of the Howey test – an “investment of money” – through the lens of so-called ‘airdrops’. Moving on to the second prong – a “common enterprise” – requires us to take a step back and consider multiple angles. While courts, generally, have been quick to find a common enterprise despite the U.S. Courts fragmentation on the test, new cryptocurrency based projects, as open-source, add a level of consideration that is worth exploring.

 

Not Split – Fragmented

The circuits are fragmented in evaluating the “common enterprise” element, and we are left with three approaches: (1) horizontal commonality, (2) broad vertical commonality, and (3) narrow vertical commonality.

The horizontal commonality test is relatively straightforward. The test requires a pooling of funds in a common venture and a pro rata distribution of profits. The test is not worried about any promoters (which, in this context, means the issuer and its principal(s)). Thus, an investor’s assets must be joined with other investors where each investor shares the risk of loss and profits according to their investment. To date, the U.S. Circuit Courts of Appeal that follow the horizontal commonality test include the First, Second, Third (affirmed, but no opinion by the Third Circuit Court), Fourth, Sixth, and Seventh Circuits. Note – We have only include the circuit courts because these courts are one tier below the U.S. Supreme Court regarding what decisions hold the most weight in the U.S. legal system.

Vertical commonalty focuses on the vertical relationship between the investor and the promoter. Under this test, a common enterprise exists where the investor is dependent on the promoter’s efforts or expertise for investment returns. There are two approaches the vertical commonality:  (1) broad vertical commonality, and (2) narrow vertical commonality.

The only requirement under broad vertical commonality test is that “the investors are dependent upon the expertise of efforts of the investment promotor for their returns”. This test is perhaps the easiest to satisfy because there is typically always an information asymmetry between the promoter and the investor. The key question to ask, therefore, is does the investor rely on the promoter’s expertise? Both the Fifth and Eleventh Circuits follow the broad vertical commonality test.

The narrow vertical commonality test only finds support from one circuit – the Ninth Circuit. Under this test, the court only looks at whether or not the investor’s profits are linked with the profits of the promoter. Put another way, a common enterprise exists if the investor’s success or failure is directly correlated with that of the promoter’s.

 

Where Does That Leave Us?

When we look at Bitcoin and Ethereum, we have to ask who exactly are the ‘promoters’? One of the primary concerns in regulating securities is information asymmetries that lead to investors being taken advantage of by promoters. Remember, the Securities and Exchange Commission (SEC) has a three-part mission:  (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. Therefore, companies offering securities must tell the truth about its business, what securities they are selling, and the risks involved in investing in the company’s securities.

Evaluating Bitcoin and Ethereum under the same test, a central organization, clearly, does not exist. For Bitcoin, there was no ICO and has perhaps been sufficiently decentralized since its inception according to the SEC. For Ethereum, perhaps at the ICO stage, a central entity existed that investors relied on, making it (possibly) a security. However, we are now three years removed from that, and Ethereum has been, to all intents and purposes, deemed to be not a security. In the current state, anyone can write proposals on GitHub, fork the code, contribute upstream to Ethereum, etc. In truly permissionless, decentralized systems, has everyone become a ‘promoter’? The investment of money is not in a common enterprise, but rather an investment of money for tokens to participate in the growth of a network or base protocol. Unlike the familiar examples above, however, the issue with most ICOs is that the platforms are not built and there is a core team that is developing the software pre-release in a silo. Therefore, the investor is dependent on the team for the network to be built, and the funds from the ICO are going towards the team to continue the development of the network.

Many people in cryptocurrency are expecting the next big announcement to come from the SEC or the CFTC. We believe, however, that the next large moment of legal clarity will come, rather, from the courts via the numerous civil lawsuits developing. The U.S. Supreme Court has, to date, declined to take on this circuit court fragmentation directly. Perhaps this is because the facts and circumstances of the prior cases do not warrant a novel decision around the commonality question. However, the way we have seen cryptocurrency evolving and expect it to continue evolving, the time has come to settle the issue of what is a common enterprise.


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]

jeff

Do Crypto Currency Airdrops pass the Howey Test?

This post was originally published on this site

Continuing on our journey of securities law and cryptocurrency, it’s time to start pulling apart the Howey test. In an academic paper following the Howey Test’s 64th anniversary, the test was equated to that house that the home owners have continued building new additions that are clearly additions, sometimes awkward, and “the consensus of neighbors with taste is that the house should be torn down and rebuilt from scratch.”

What better way to start than by contemplating what is an “investment of money”? In my previous post, “investment of money” is presumably an investment of anything of value. An investment is the commitment of the item of value with the expectation of receiving some additional profit. This prong seems simple enough, is rarely litigated, and not of much concern; however, of more concern to the crypto community is the concept of airdrops.

An airdrop is when a token project distributes tokens into the token recipient’s cryptocurrency wallet for no monetary contribution in exchange. Most of the time, the airdrop is for the Ethereum blockchain; however, airdrops have occurred on Stellar, NEO, Waves, and EOS (to name a few) and bitcoin holders have received airdrops via Bitcoin hard forks. Airdrops continue to be a source of token distributions for a number of reasons. For the token issuer, it is an easy way to gain a broad network of token holders. Once listed on an exchange, the token holders are free to trade thereby creating a “liquid” market and market cap for the token project as well as a source of income for the token project as an airdrop usually constitutes some minority percentage of the token supply. I say “usually” because an $8M airdrop earlier this month ran out of tokens and has since announced a token buy-back program. Airdrops, as a token generation event, appear to be a way to create demand for your token and to skirt the uncertainty around ICOs and securities laws. Unfortunately, this is not the case.

 

No Investments of Money and Securities Law

Like everything in cryptocurrency right now, it’s all new and there is nothing like it that regulators can compare it to. Well, you can continue thinking that; however, where airdrops, or free distributions of securities are concerned, the SEC has seen this movie before. On July 21, 1999, the SEC issued four cease-and-desist proceedings relating to the issuance of “free” stock. The SEC claimed in its press release, “Free stock is really a misnomer in these cases. While cash did not change hands, the companies that issued the stock received valuable benefits. Under these circumstances, the securities laws entitle investors to full and fair disclosure, which they did not receive in these cases.” The valuable benefits for these companies were “a fledgling public market for their shares, increasing their business, creating publicity, increasing traffic to their websites, and, in two cases, generating possible interest in projected public offerings.” The reason the valuable benefits to the company are mentioned is because Section 2(a)(3) of the Securities Act defines a “sale” to “include every contract of sale or disposition of a security or interest in a security, for value.” Therefore, these companies were selling unregistered securities to the public.

Given that tokens are airdropped into your cryptocurrency wallet and it is then your choice to trade them or use them as the network prescribes, is subjecting the token distribution to securities laws necessary? Yes, airdrop scams do exist taking the form of impersonating real airdrops, fake profiles and project name confusion, marketing gimmicks, requesting private keys. The SEC’s role is to protect the integrity of markets through full and fair to disclosure to prevent fraud. So, is subjecting airdrops to securities laws using the above history of free stocks necessary to achieve the SEC’s purpose or is another regulatory body like the FTC more equipped to handle such an issue?

However, as of now, when contemplating an airdrop as a token distribution model, securities law still applies. While the SEC is warming up to the notion that utility tokens can exist. However, the economic realities of the transaction must still be contemplated. An SEC review is substance over form. Unfortunately, giving away things for “free” is not so free.

 


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]

jeff

House Hits Refresh on JOBS and Investor Confidence Act of 2018

This post was originally published on this site

On July 17, 2018, the U.S. House of Representatives passed a near-unanimous bill (406-4) to update the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). The JOBS Act, passed with much fanfare in 2012, was designed to help small businesses, entrepreneurs, and investors by updating and modernizing, in a number of respects, the way that capital is formed for these stakeholders. Unfortunately, in the six years since its passage, many of those constituencies have for the JOBS Act wanted in crucial ways, and have viewed its work as unfinished. Accordingly, calls for an overhaul have been steady and growing.

Which brings us to the present, and the passage of an overwhelmingly bipartisan bill from the House of Representatives, titled the JOBS and Investor Confidence Act of 2018 (the “Act”), which seeks to further reform regulations which have been viewed as holding back investments in small businesses and start-ups.

Major Takeaways for Investors and Startups

Update to “accredited investor” definition: The $1 Million ‘net worth test’ as part of the definition of “accredited investor” in the Securities Act of 1933 is amended to be adjusted for inflation every five (5) years using the Consumer Price Index for all Urban Consumers.

The Act also expands the definition of accredited investor beyond simply the net worth and income tests to include registered brokers and investment advisers as well as natural persons who have “professional knowledge” of a subject related to a particular investment, and whose education or job experience is verified by the Financial Industry Regulatory Authority (“FINRA”) or an equivalent self-regulatory organization (“SRO”).

Reg D Modification: The Act requires the SEC, within six (6) months after the Act is enacted, to amend Reg D to exclude presentations made to angel investor groups and others from the definition of ‘general solicitation’.

Special Purpose Crowdfunding Vehicles: Crowdfunding investors can now form “crowdfunding vehicles” advised by investment advisors to invest as a group rather than as disparate, individual shareholders.

Analysis / Impact

These changes would be significant steps forward for the startup space (Note: the Act must, of course, still be passed by the Senate, signed into law and implemented). With fast-moving and highly technical investment opportunities like cryptocurrency, the definition of “professional knowledge” is changing. It is nice to see a shift toward an understanding that professional knowledge is inherently valuable and can give well-informed individuals access to early investments into start-ups, and businesses at all stages of the capital formation life cycle.

The Reg D modification seems to be an extension of the shifting view in securities regulation away from focusing on ‘offers’ and, instead, focusing on ‘sales’. The clarification that activities such as demo days and pitch events do not constitute general solicitation under Reg D would seem to be a recognition of a reality that already exists in those environments and brings lower level ‘testing the waters’ activities into the sunshine. The new exemption is provided so long as:  the event advertising does not reference or specify offerings of securities and the event sponsor is not offering investment advice to event participants nor is engaging in investment negotiations, charging fees, or receiving certain compensation; and the information provided does not extend beyond the type and amount of securities being offered, the amount of securities already subscribed for, and the issuer’s intended use of the securities offering proceeds. With the growth of incubators and accelerator programs, the ambiguity between general solicitation and pitches has been questioned numerous times. The clarity offered in the Act finally adds some guardrails to that grey area.

Finally, the Special Purpose Crowdfunding Vehicle seeks to address one of the most significant issues with equity offerings under Reg CF (although, from the author’s perspective, many more still exist!). Currently, using crowdfunding platforms like Angelist, accredited investor groups often form a special purpose vehicle using Reg D to invest jointly in a company. The obvious benefit to the issue is that there is only one shareholder on the cap table rather than thousands. The cost and difficulty in getting shareholder approval from thousands of disparate investors every time shareholder consent is required has kept many companies from utilizing Reg CF.

With respect to non-accredited investors, the Act addresses this issue by allowing small investors to form a special purpose vehicle guided by a sophisticated investor who, additionally, has a fiduciary duty to represent their interests and negotiate on the small investor groups’ behalf. Similarly to accredited investors forming special purpose vehicles under Reg D, a special purpose vehicle for crowdfunding would represent one shareholder on the issuing company’s cap table. Although it seems to be a hopeful aspect that qualified intermediaries will actually find it lucrative to act in this capacity and will wish to do so (which will remain to be seen), nevertheless, this addition provided by the Act may allow companies that are shying away from Reg CF to use it more going forward.

We will be following this Act closely as we continue advising our start-up and investor clients on these and other developments in unlocking innovation and growth in small businesses.

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]

jeff