Also known as “Token Sales,” ICOs enable startups to raise money for their projects by selling crypto coins as a form of equity both to sophisticated investors and the average public. This democratization of fundraising through ICOs has generated a level of excitement, some say greed, comparable to the old days of gold prospecting in the Wild West.
“Anytime you have new concepts that are disruptive to old ways of doing things,” says Paul Atkins, CEO of Patomak Global Partners, “That gets a lot of people interested and focused.”
Including at the U.S. Securities and Exchange Commission, (SEC), where Atkins once served as a commissioner. In July, the federal agency issued an investigative report warning startups that their tokens could constitute securities and subject to federal securities laws. “We seek to foster innovative and beneficial ways to raise capital,” said SEC Chairman Jay Clayton, “While ensuring – first and foremost – that investors and our markets are protected.”
But the SEC report, much of it based on an obscure 1946 Supreme Court test called the Howey test involving Florida citrus grove investments, has only raised more questions than it has answered and has token lawyers reaching for their legal tomes to see exactly how that historic case relates to modern day digital assets. As ICOs skyrocket in popularity as a viable alternate form of capital raising, and given the steep penalties for non-compliance with securities laws, there’s a growing sense of urgency around finding ironclad answers to some of these challenging questions. For instance, what constitutes a security when it comes to digital tokens? How does the Howey test apply to the different examples of tokens surfacing daily? And most importantly, how can startups issue tokens without running afoul of the law.
“Lots of tokens, especially the tokens we’ve seen over the last year, probably have passed the Howey test, which is a bad thing when you’re a token seller,” says Marco Santori, a partner and head of the fintech practice at Cooley LLP., and a noted ICO expert. “It’s the one test you don’t want to pass.”
The New Paradigm
The Howey test stems from the 71-year-old Supreme Court ruling, Securities and Exchange Commission v. W.J. Howey Co. et. al., which centered around the definition of a key term in the 1933 and 1934 federal securities laws, “investment contract.”
The Court issued the four-pronged test to define such a contract.
“They said an investment contract is an investment of money, in a common enterprise, with the expectation of profits, solely from the efforts of others,” says Lee Schneider, who is a partner at McDermott, Will & Emery and heads up the law firm’s fintech and broker-dealer practices. He has written extensively about ICO regulation.
The test poses two fundamental questions, outlined in this recent explainer video by prominent crypto lawyer Peter Van Valkenburgh, Director of Research at the Washington, D.C., based Coin Center. “First, is the thing being sold as an investment contract?” says Van Valkenburgh. “And the second, is there a person upon whom investors are relying. And you have to answer yes to both of these for it to be a security.”
Van Valkenburgh offers an example of a security by comparing gold to Apple stocks. Gold has inherent value that doesn’t ride on the continual efforts of others, he says. But the value of Apple stocks by their nature, are heavily dependent on the efforts and successes of Apple CEO, Tim Cook and his management team.
The SEC applied a similar rationale to tokens in the matter of The DAO, or Decentralized Autonomous Organization – a stateless, crowdfunded, for-profit, virtual blockchain entity – created by the German organization Slock.it – to sell “DAO Tokens” to raise capital.
The agency asserted that the tokens met the four-pronged Howey test in structure and function and were therefore deemed securities. Describing crypto tokens as “the new paradigm,” the SEC asserted that token sellers must comply with federal securities laws, “regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology.”
Hewing to the Statute
The SEC decided not to pursue enforcement actions in the DAO case. But others may not be so lucky. Schneider says he counsels new clients “in very stark terms,” to fight the temptation to skirt federal securities laws. “Look, don’t commit fraud,” Schneider tells them. “You should not commit fraud here.”
Joshua Ashley Klayman of Morrison & Foerster says she advices startups to use a simple rule of thumb when launching tokens. “No matter where you are in the world, whatever jurisdiction you are launching from, if you are marketing or selling to U.S. persons, then U.S. securities laws are going to apply to you,” says Klayman, “And if that token is a security, you need to either register or you need to find an exemption.”
Amid all this hand-wringing, many in the ICO community have complained that the SEC missed the mark with the DAO report by failing to provide a clear bright line test for digital tokens. The SEC did not respond to requests for comment. But former commissioner Atkins says the agency was right to be cautious.
“They have to hew to the statute, and things are changing all the time in the real world, so they would never want to get caught you know, saying this is the bright-line test,” Atkins says. “And then suddenly they find, a year or two down the road, that things have changed and they don’t then want to be in the position of saying, ‘Oops, never mind about that, and now we’re going to smash you in the head.’”
From Citrus to Crypto
Many legal experts say the Supreme Court ruling’s securities broad stroke has enabled it to stand the test of time for more than seven decades even as the nature of securities has morphed dramatically. Unlike today’s digital assets, the 1946 ruling had to do with a much simpler investment asset — citrus groves, owned and operated by a Florida land baron named W.J. Howey, who is widely considered the father of asset-backed securities.
And although citrus and crypto couldn’t be more different asset classes, one tangible, the other virtual, there are eerie parallels to then and now. Howey’s investment creativity took place against the backdrop of the industrial revolution, the invention of the automobile and the creation of the transcontinental railroad. Today’s ICO innovations are taking place against the backdrop of the data revolution and the evolution of the internet through blockchain technology.
Born in Odin, IL, in 1876, William John Howey was a larger-than-life character whose rise and fall was deeply tied to the boom and bust days of 1920s Florida. Raised on a farm and armed with only a limited formal education, Howey became one of the state’s most successful citrus developers, opening the first Florida citrus juice plant and building his unique sales program for selling the cultivated citrus groves as asset-backed securities investments.
Howey’s granddaughter Westa Bryant says her grandpa was a tireless entrepreneur with a golden tongue. “My grandmother said that they were developing land for groves 24 hours a day, even at night,” says Bryant. “He had offices in all the big northeastern states,” plus Chicago. And he would bring people down to Florida, put them up at the Floridan Hotel, wine ’em and dine ’em and sell groves to them.”
Luck and Timing
By 1920, Howey had amassed 60,000 acres of highly profitable citrus groves, according to the Supreme Court ruling. He would plant about 500 acres annually and keep half of it for himself. The other half, he would sell to the public as “narrow strips of land,” each acre planted with 48 trees, later doubled to 96 trees per acre, the ruling says. Howey also owned a service company called Howey-in-the-Hills Service Inc., which took care of the crops, and the two corporations jointly were listed in the investment contracts.
“The basic idea was that the owner of the citrus groves was proposing to sell an interest in the groves to various people,” says Schneider. “Those people would each contract with the current owner of the citrus grove so that the current owner would tend all the trees and do the harvesting, and whatever profit came from the fruit would be shared between the investor and the citrus grove tender.”
Howey’s enterprises prospered against the backdrop of the Florida land boom, says Peggy Beucher Clark, who has written a book about Howey-in-the-Hills, the community named after Howey.
“The stock market was rising quickly, and investors were spending more time in Florida, making it the playground for the rich and famous,” says Clark. “Taking notice of rising real estate prices, many made speculative investments, and the state’s population grew exponentially.”
And with it grew demand for Howey’s citrus grove parcels. He became wealthy, built a mansion and was living the good life.
Failure to Register
But Howey’s lucky streak didn’t last as Florida went from boom to bust, seemingly overnight and his investment scheme collapsed.
“He was very organized. He presented a plan with a promise of a secure investment. And that’s what people wanted,” says Clark. “And I think he delivered. It’s just that life happened.”
In 1938, Howey died of a heart attack. He was only 62. But his problems were far from over.
The SEC sued W.J. Howey Co. and the related service company for selling what the agency described as “unregistered and nonexempt” securities.
“The transactions in this case clearly involve investment contracts as so defined,” the Supreme Court ruled. “The respondent companies are offering something more than fee simple interests in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents.”
In essence, the court used four factors to rule that the orange and grapefruit groves were actually a security; that the owners were buying an investment contract in a common enterprise, namely the groves; that the owners had the expectation of profits; based on the efforts of others – since the owners weren’t tending the groves themselves, but were relying on Howey and his company.
With today’s digital assets, a comparable approach would be for example, Blockchain Capital’s BCAP tokens, which were issued as securities. Again, just like with the citrus groves, the profitability of those tokens would be dependent on the efforts of that company. Now, going back to Van Valkenburgh’s example of stocks vs. gold, just like gold, the price of an Ether token on the Ethereum network for example may rise and fall based on market conditions, but its value would not be solely affected by the efforts of any one group that is deemed responsible for its success. So that Ether token would not constitute a security.
A Monumental Starting Point
This issue of what constitutes an investment contract first entered the digital technology realm in 2004, when the Supreme Court reaffirmed the Howey test in a ruling involving phone company ETS Payphones, Inc. The pay phones case “was pretty much the same idea as the citrus groves,” says Schneider. Instead of plots of land, ETS was selling and managing pay phones and their upkeep and sharing the profits with the investors, and those agreements, the court said, constituted investment contracts.
Which brings us to where the Howey test stands today in the crypto token era.
The Cooley law firm’s Santori describes the test as a “monument to sound principles-based regulation,” but a starting point, rather than the end point. Santori, along with Protocol Labs, recently released a controversial alternative legal framework which they say could help ICOs navigate thorny securities, money services and tax laws. Santori proposes a two-step process to comply with Howey using a SAFT – Simple Agreement for Future Tokens.
“So instead of developers selling pre-functional tokens directly to the public, which is what we’ve seen in a typical ICO,” says Santori, “they’re selling a promise of functional tokens to accredited investors.” SAFT would be SEC-complaint, and at this initial stage, the token would be regarded as a security. But once the project goes live with a functional blockchain network, Santori says, “It’s more likely that those tokens are just some kind of product and they may act like a commodity.”
At this second stage, Santori says, the ICO could launch a public sale and sell tokens directly to the public without putting investors at risk and without having to answer to the SEC.
But other legal experts, including Schneider, take issue with this token parsing. In a recent client update titled, “Bright Lines don’t Work for Blockchain Tokens,” Schneider said that this legal theory oversimplifies the issues, “risking unwarranted and improper application of the federal securities laws to non-securities.”
Legacy Trumps Controversy
Despite all this global hand-wringing over the Howey test, few in Howey’s immediate world are even aware that he’s back in the news. Certainly not Westa Bryant, who says she thinks of W.J. Howey only as “my grandmother’s husband.”
And certainly not Orlando real estate developer Clayton Cowherd, who along with his brother, Brad, have purchased the historic Howey family mansion. Cowherd says his main dilemma regarding Howey’s legacy is whether the mansion should be retrofitted with air conditioning.
“The purest of purists would say we’re destroying the history by adding air conditioning,” says Cowherd. “But in our opinion, in order to keep it alive, really, we had to modernize just a few things. But in general, we’re trying to maintain the history as best we can.”
If only the crypto community had something so trivial to worry about, like air conditioning, as it comes to terms with W.J. Howey’s unexpected legacy. Life would be sunshine and oranges.