It’s Solely An Issue of Being Reasonable
The US Securities & Exchange Commission (SEC) has been all hot under the collar over Initial Coin Offerings (ICOs) since its somewhat wonky verdict on the DAO in July 2017. In section B of that verdict, titled “The DAO Tokens Are securities”, the SEC attempts to paraphrase a ruling against J. Howey to determine whether or not his olive grove was a security or not (turns out the courts said it was). The SEC states:
An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
The only problem with this is that it’s incorrect. The Howey ruling actually resulted in the following conclusion:
The test of whether there is an “investment contract” under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.
If you are having a hard time spotting the difference between the two paragraphs, let’s help out the SEC too while we are at it and rewrite their conclusion in correct English:
An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits solely to be derived from the entrepreneurial or managerial efforts of others.
The Howey ruling helps clarify the definition of others for us too, conveniently enough, in Section 2 of the Syllabus:
For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party
Let’s look up the definition of the missing word now (we will use the Cambridge American dictionary so as to be fair here):
solely adverb / UK /ˈsəʊl.li/ US /ˈsoʊl.li/ C1 only and not involving anyone or anything else
Now let’s rewrite the Howey sentence, spelling out for the Commission their omitted use of the English word “solely:
An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits only and not involving anyone or anything else to be derived from the entrepreneurial or managerial efforts of the token’s promoter or a third party
Before we examine this more closely, let’s make one further analysis of the Howey ruling and examine the word reasonable:
B2 based on or using good judgment and therefore fair and practical; B1 acceptable;
Finally, let’s look at the Howey ruling one more time:
An investment contract is an investment of money in a common enterprise with an expectation that is based on or using good judgment and therefore fair and practical of profits only and not involving anyone or anything else to be derived from the entrepreneurial or managerial efforts of the token’s promoter or a third party.
So, the expectation of profits must be solely derived from the entrepreneurial or managerial efforts of others, those being not you in any way, shape or form. That is pretty clear. Perfect!
You are not expected to do anything. Ever. You are never expected to even say the name of the token to anyone — it will magically rise all on its own without you doing a thing! (ed: Ain’t that great!)
If you haven’t yet worked out why this is yet critical to the SEC’s currently quite possibly unconstitutional bashing of the tokenized world, then let’s go through the average Initial Coin Offering process: 1) gather a community 2) award bounties to any interested parties who spread the word about the token 3) incentivize token holders to take part by offering some sort of alternate utility for the token (e.g. it can buy discounted goods at xyz department store / restaurant) 4) sell the token and 5) get as many YouTubers, Tweeters and other social and if possible, mainstream media contacts as possible to pump the collective message that this token is the next Bitcoin through the airwaves.
To be clear, I am not endorsing or condemning the standard ICO marketing fare. There are many things childish and wrong-minded about it, and there are many positives in it. I am merely focused here on whether or not this marketing process, which can be applied to almost every ICO that has ever been held, constitutes a reasonable expectation of profits to be derived only and not involving anyone or anything else on the part of the token issuer.
First of all, the gathering of a community to me seems to nullify the role of management as being expected to produce a profit for the investor only and not involving anyone or anything else unless all the community members attending whatever community forum is in place are required to invest. The reason I mention this requirement is it seems to me logical that if, just like an annual general meeting, your investors are the only ones who are specifically allowed to attend the communal get-together, that such a gathering is in fact not a marketing exercise to the wider world (i.e. no recruitment) but rather, an event to inform investors how their investments are faring.
When it comes to equities, this AGM stuff can be pretty big business: Berkshire Hathaway, after all, offers a much discounted B-share to potential investors so that every citizen can turn up what is annually billed as the stock market’s Woodstock (music festival) event. I am not sure whether or not ICOs have or have not such exclusion provisions in their Discord or Telegram communities, but I have never been in one that requires you to be a token holder first.
Usually, the information is just out there for all and anyone to see and use, in fact, in the case of ICOs. Further, users are often encouraged, from what I can tell, to go out and spread the word multi-level marketing style about the project. These actions would seemingly disqualify the project’s investors from reasonably assuming that management was only and not involving anyone or anything else responsible for making them a capital gain profit on their token.
If 1) creates circumspect ideas about the questionable nature of whether a token is a security or not, 2) surely kills the issue by any stretch of the imagination however. If an ICO instigates a bounty, and this bounty is somehow fundamental in producing a token price increase and thereby a capital gain on the part of the investor, and the non-management bounty hunters are therefore partly responsible for this, then surely, this excludes this provision expressly from being so?
One could harp on about similar incongruities with respect to tokens being securities in light of 3), 4) and 5), surely? Aren’t you, the token buyer, being asked to actively participate in the propagation of the token? Then, if so, you can’t be reasonably expecting someone else to do all the heavy lifting for you, surely?
In summary, this is a complex question, but the result is actually very clear: most, if not all, tokens are expressly not securities as provided for in the Howey ruling upon which the SEC claims to have made such rulings judicially and fairly.
How The SEC Got It Wrong was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.