When It Comes To Analyzing Utility Tokens, The SEC Staff's 'Framework For ‘Investment Contract' Analysis Of Digital Assets' May Be The Emperor Without Clothes (Or, Sometimes An Orange Is Just An Orange) (Part IV)

This is the fourth in a series of posts critical of the SEC's approach to analyzing so-called “utility tokens” under the federal securities laws. The first, second and third posts can be found here, here, and here. This post, like the previous three, is not intended to be, nor should it be substituted for, legal advice, which turns on specific facts. Further, the legal treatment of utility tokens is uncertain and continues to develop, and there can be no assurance that any court or regulator would agree with any of the conclusions set forth below.

Part IV: The Investment/Consumption Duality In my last post, I asserted that the central thrust of the case law surrounding the offer and sale of contracts, transactions or schemes that involve the sale of consumptive items is that the substance and economic reality of such contracts, transactions or schemes must be determined by the nature of the marketing efforts employed by the issuer. In this connection, perception is reality—not the subjective perception of the persons purchasing such items, but the objective perception that the issuer attempts to induce. If the issuer employs marketing methods that, analyzed objectively, would induce a person to view the purchase of the consumptive item as part of an investment package, then the substance and economic reality are that the issuer has engaged in the offer and sale of an “investment contract.” If, however, the issuer employs marketing methods that, analyzed objectively, would induce a person to view the purchase of the consumptive item as just that, then the substance and economic reality are that the issuer has engaged in the offer and sale of a consumptive item, not an “investment contract.”

As discussed below, at least one court has aptly referred to this duality as the investment/consumption duality. The courts have recognized this duality based on an understanding that, as broad as the remedial purposes of the federal securities laws may be, those laws cannot be read to support the assertion of liability against persons engaged in commercial, as opposed to investment, transactions - even if such transactions involve fraud.

In this post, I will explore how the courts have articulated the investment/consumption duality.

In my next post, I will explore how the courts have applied the investment/consumption duality to particular contracts, transactions or schemes involving the sale of consumptive items to determine whether such contracts, transactions or schemes constitute “investment contracts.”

Howey Revisited First, in under to have a sound understanding of the investment/consumption duality, it is important to revisit the definition of “investment contract” articulated by the Supreme Court in SEC v. W. J. Howey Co. (“Howey”).1

In Howey, the Supreme Court held that:

“…an investment contract, for purposes of the Securities 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….”2

The Howey test typically is described as having three prongs or elements.3 Virtually all of the cases recite the first two prongs exactly as they are stated in Howey,4 but the cases express the third prong in different ways. Some cases recite the third prong exactly as it is stated in Howey.5 Other cases, for reasons unknown, reformulate the third prong of Howey in the following ways (among others):

“the expectation of profits to be derived solely from the efforts of others;”6vi “with an expectation of profits produced by the efforts of others;”7 “with an expectation of profits solely from the efforts of others;8 “with the expectation of profits to be derived from the efforts of a third party;”9 “with profits to come solely from the efforts of others;”10 “with the expectation of profits to come solely from the efforts of others;”11i “a common venture premised on the reasonable expectation of profits to be derived from entrepreneurial or managerial efforts of others;”12 “with the reasonable expectation of profits to be derived from the entrepreneurial or managerial [or ''management”13] efforts of others;”14 and “with the expectation that profits will be derived solely from the efforts of individuals other than the investors.”15v Still other cases use different formulations or reformulations of the third prong in the course of the same opinion.16

Regardless of how the prongs of the Howey test are described, the cases generally address the following five factors (all of which are expressly included in Howey's definition of “investment contract” set forth above) in determining whether a contract, transaction or scheme is an “investment contract:”

an investment of money;17 in a common enterprise;18 where the investor has been led to expect; profits;xix solely from the efforts of the promoter or a third party. Case law subsequent to Howey has tended to ignore the word “solely” in the fifth factor, with courts differing on the scope or degree to which investors must rely on the efforts of others in order for there to be a finding that a particular contract, transaction or scheme constitutes an “investment contract” and therefore a “security.” Current cases generally are of the view that “the word 'solely' should not be read as a strict or literal limitation on the definition of an investment contract, but rather must be construed realistically, so as to include within the definition those schemes which involve in substance, if not form, securities,” and that the true test is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”20

While case law appears to read the word “solely” out of the Howey test, it has not abandoned the “common enterprise” test, even though the “ Framework for 'Investment Contract' Analysis of Digital Assets,” issued by the staff of the SEC's Strategic Hub for Innovation and Financial Technology on April 3, 2019, gives the “common enterprise” test what can only charitably be characterized as perfunctory treatment.21

Interpreting the Term “Investment Contract” Broadly in Light of the Remedial Purposes of the Securities Acts The courts have recognized that the term “investment contract” is to be given a broad definition in light of the remedial purposes of the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act” and, together with the Securities Act, the “Securities Acts”).

For example, in SEC v. C.M Joiner Leasing Corp.,22 a case that preceded Howey and laid the basic foundations for the Howey test,23 the Supreme Court stated that:

“the reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as 'investment contracts,' or as 'any interest or instrument commonly known as a security.'... In applying acts of this general purpose, the courts have not been guided by the nature of the assets back of a particular document or offering...The test, rather, is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect. In the enforcement of an act such as this it is not inappropriate that promoters' offerings be judged as being what they were represented to be.'”24

In Howey, the Supreme Court explained that:

“[t]he term 'investment contract' is undefined by the Securities Act or by relevant legislative reports. But the term was common in many state 'blue sky' laws in existence prior to the adoption of the federal statute, and, although the term was also undefined by the state laws, it had been broadly construed by state courts so as to afford the investing public a full measure of protection. Form was disregarded for substance, and emphasis was placed upon economic reality. An investment contract thus came to mean a contract or scheme for 'the placing of capital or laying out of money in a way intended to secure income or profit from its employment.' State v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N.W. 937, 938. This definition was uniformly applied by state courts to a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one [sic] other than themselves. [citations omitted]

By including an investment contract within the scope of §2(1) of the Securities Act, Congress was using a term the meaning of which had been crystalized by this prior judicial interpretation. It is therefore reasonable to attach that meaning to the term as used by Congress, especially since such a definition is consistent with the statutory aims. In other words, an investment contract, for purposes of the Securities 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal...