A few days ago, law professors from Yale University, University of Chicago, University of California Los Angeles, Fordham University, Boston University, and Widener University submitted a friend of the court brief that traced the historical meaning of the term “investment contract” before, during, and after the passage of the 1933 Federal Securities Act, thoroughly refuting the SEC’s theory of “investment contract”.
Here are the scholars’ conclusions:
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“In 1933, state courts reached a consensus on how to interpret the term ‘investment contract’, which is regarded as a contractual arrangement that gives investors the qualification to hold a share in the subsequent income, profits, or assets of the seller.”
After the 1946 Howey case ruling, the common characteristic of an ‘investment contract’ remains “…that, despite being an investment, investors must be promised a continuing interest in the enterprise’s income, profits, or assets.”
“Every ‘investment contract’ recognized by the Supreme Court involves a contractual commitment to provide a continuing interest in the enterprise.”
@MetaLawMan on Twitter said, “In my opinion, this friend of the court brief deals a fatal blow to the SEC’s argument that cryptocurrencies traded on the secondary market are investment contracts.”
Background: “Blue-Sky Laws”
When Congress included the term “investment contract” in the definition of “securities”, the term had a specific meaning in Blue-Sky Laws, which required a contractual commitment to future value.
When Congress adopted the Securities Act and the Exchange Act, almost every state had already enacted state laws regulating securities transactions. In establishing a national standard and federal regulatory scheme, Congress chose to develop federal laws based on these so-called “Blue-Sky Laws”. Of particular relevance, Congress incorporated the term “investment contract” from these Blue-Sky Laws when defining “securities” in the new national securities laws.
With this background, we reviewed the development of the concept of “investment contract” under the Blue-Sky Laws, as cited by Howey, as the basis for a “uniform” definition of the term.
In the early 20th century, some states in the United States began to enact the first “Blue-Sky Laws”.
At the turn of the 19th century, as the US economy prospered, the market for trading shares of American companies also flourished. With the influx of middle-class and retail investors buying shares of industrial giants from railways to heavy industry on major exchanges in New York and San Francisco, opportunities to invest in blue-chip stocks also increased. However, at the same time, there was also an increase in speculative or outright fraudulent investment opportunities from dubious sellers, such as those “ephemeral companies, imaginary oil wells, distant gold mines, and other similar fraudulent ventures”. Unlike their blue-chip relatives, these investment opportunities were often sold face to face, through newspapers, or through mass mailings. Not surprisingly, the sale of these investment opportunities often involved clever “puffery” and fraud.
Starting from 1910, state legislatures began to respond to these developments by enacting the first batch of securities laws. These initial legislative efforts aimed to protect the public from the harm of “dishonest salesmen selling shares under the blue sky”.
The first batch of “blue sky laws” were relatively simple and did not explicitly define the instruments they covered. For example, Kansas’ 1911 securities law was hailed as the first “blue sky law”. It simply required investment companies to register before selling “any stocks, bonds, or any other kind or nature of securities”.
Other states attempted to provide some explanations of what is considered “securities”. For example, the initial regulations in California and Wisconsin explicitly defined “securities” as traditional instruments such as “stocks, stock certificates, bonds, and other evidences of debt”.
Legislators soon realized the need to enact a second generation of securities laws. In fact, those bad, speculative, or fraudulent investment transactions or schemes that triggered the issuance of the first “blue sky laws” were not technically stocks or bonds. These transactions disguised as traditional stocks proposed to give investors an initial amount in exchange for a contractual right to future value of the enterprise, just like stocks or bonds. And since these laws focused on genuine stocks and bonds, these fake stocks and bonds were obviously not bound by the first generation blue sky laws.
Subsequently, these states expanded the “blue sky laws” to include “investment contracts”, which encompassed the new forms of stocks and bonds.
In order to specifically regulate these new instruments or proposals that share key economic and legal characteristics with stocks and bonds, state legislatures attempted to explicitly regulate and supervise them in the second generation of securities laws.
Minnesota added the term “investment contract” to the definition of “securities” in its 1919 “blue sky law”. This new undefined term was intended to capture investments that, although not formal stocks or bonds, depended on and gave a contractual right to future profits. Other states quickly followed suit and added “investment contracts” to the list of instruments covered by their “blue sky laws”.
Minnesota’s interpretation of the term “investment contract” in the Gopher Tire case
Although the term “investment contract” is not defined in the law itself, the courts soon gave a definition based on the legislative intent and background of this statutory term in the blue sky laws. In several early Minnesota cases, including the case cited by the Supreme Court in Howey, 328 U.S. 298 & n.4, the state Supreme Court examined the key characteristics that a collection of instruments or rights needed to meet in order to be identified as “investment contracts”. These rulings are considered authoritative interpretations of the original meaning of this term.
In the Gopher Tire case, a local tire dealer sold “certificates” of its business to investors. Gopher Tire, 177 N.W. 937-38. Under the agreement, investors would pay $50 and agree to promote the dealer’s products to others. In exchange, investors received a “certificate” that gave them the “right” to a certain percentage of the dealer’s profits as stated in the contract. By analyzing the definition of “securities” in the Howey test, the court ruled that these certificates were not technically or formally “stocks”. Nevertheless, the Minnesota Supreme Court still ruled that these certificates “can properly be regarded as investment contracts”. In making this ruling, the court reasoned and emphasized that these certificates shared key characteristics with stocks, namely that investors provided “funds” to the dealer and, in return, investors obtained the right to “share in the profits of the enterprise” through the contract.
Other early Minnesota cases followed this early judicial test to define the statutory terms. In Bushard, the Minnesota Supreme Court faced another dispute over whether a profit-sharing arrangement was an investment contract. Here, a bus driver paid $1000 to the bus company and, in return, received a “contract” promising the driver a certain wage plus a share of the bus company’s profits (in addition to the “ultimate return” of his $1000 “investment”). Based on the ruling in Gopher Tire, the court ruled that this arrangement was an “investment contract” based on two key factors: the driver (i) made the investment with the purpose of obtaining profits and (ii) received a “contract” (the “operator’s agreement”) in exchange, which ensured an interest in the company’s future profits.
In summary, early Minnesota cases primarily revolved around two statutory terms: “contract” and “investment”. If an arrangement met the following conditions, it was considered an investment contract: (i) the investor obtained a contractual commitment in someone else’s business enterprise, and (ii) as an exchange for the “investment”, the investor was promised a share in the future income, profits, or assets of the enterprise.
By the time the Securities Act and the Exchange Act were adopted, the term “investment contract” had acquired a definite meaning.
By 1933, when the Securities Act was enacted, 47 out of the 48 states had already passed their own blue sky laws, many of which involved “investment contracts” (following in the footsteps of Minnesota). Moreover, in the decades before 1933, when state courts applied the term “investment contract” to various arrangements, they reached a consensus in a uniform sense. As explained by Howey, this was the meaning adopted by Congress.
In short, by 1933, state courts had reached a consensus on how to interpret the term “investment contract”, considering it as a contractual arrangement that conferred upon the investor the qualification to have a contractual share in the seller’s future income, profits, or assets. In fact, as far as we know, no state court decision seems to have found an investment contract without these key features. In some decisions, such as Heath, the court openly proposed that an “investment contract” required an actual contract. In other decisions, the court emphasized that the seller had an obligation to pay (and the holder had a right to receive) a portion of its future value as an exchange for the initial capital outlay. The court often relied on this requirement to distinguish true investment contracts from basic asset sales.
“Investment Contracts” since the Howey Test
In the 75 years since the Howey test, the courts have applied the seemingly simple test of the Supreme Court to all novel and complex business environments, resulting in a complex network of precedents. The common thread remains – as the state courts interpret the state blue sky laws and as Howey requires – investors must be promised a continuing contractual interest in the enterprise’s income, profits, or assets as a result of their investment. In this section, we will discuss some of these cases.
A. The Howey test requires consideration of whether a proposed transaction resembles the ordinary concept of a security.
The Supreme Court has repeatedly interpreted the term “investment contract,” including in Howey itself. Each time, in applying the Howey test, the court has considered whether the transaction reflects the fundamental attributes typically associated with securities.
In addition, the court has also considered comparisons between the arrangement and other instruments previously deemed to be “securities.” For example, in the Forman case, the court observed no distinction between an “investment contract” and an instrument “commonly known as a security,” which is another enumerated term in the statutory definition of a security. Applying Howey, the court concluded that shares in a nonprofit housing cooperative were not “investment contracts” because the investors’ motivation “was solely to obtain a place to live, not to derive a financial return from their investments.”
Marine Bank provides another example. In that case, a couple guaranteed a loan for a meat company and exchanged certificates of deposit for a portion of the company’s profits and the right to use its facilities. The court ruled that neither the certificates of deposit nor the subsequent agreements between the couple and the company were “securities.”
Here, both state case law – pre-1933 as discussed in Section I above, and federal courts post-1933 – emphasize that for there to be an “investment contract,” investors must have some contractual interest in the enterprise through which they may potentially derive profits.
B. Every “investment contract” recognized by the Supreme Court involves a contractual commitment that grants the enterprise a continuing interest.
In line with the pre-1933 state court decisions and following Howey, the post-Howey Supreme Court decisions recognize that holders of “investment contracts” must be promised a continuing participation in the enterprise’s income, profits, or assets.
In International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979), the court specifically emphasized this theme. There, the court observed that “in every decision by this Court involving what we have deemed to be a ‘security,’ the person involved in the investment choice has been offered a financial interest in the form of a separable, negotiable instrument.” The court found that there were no “separable, negotiable instruments” with securities characteristics before it. Specifically, it concluded that non-contributory, compulsory pension plans were not “securities” because the alleged securities interests were merely a small part of an overall non-securities compensation that individuals received due to their employment.
So far, the Supreme Court has considered that every arrangement deemed an “investment contract” promises investors some form of ongoing contractual interest in the future efforts of the enterprise. S.E.C. v. C. M. Joiner Leasing Corp. was a case three years before Howey that involved offering land leases near planned oil well test wells in exchange for investors’ “sharing in the proceeds from the sale of units of the ‘exploration enterprise’ then being conducted.”
Howey itself involved offering small parcels of land in an orange grove and entering into contracts with promoters to harvest, market, and sell the oranges in exchange for a “share in the profits, measured by the checks cut from the grove’s harvest.”
C. Other Relevant Decisions
First, two post-Howey “investment contract” decisions—S.E.C. v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65 (1959), and S.E.C. v. United Benefit Life Insurance Co., 387 U.S. 202 (1967)—involved annuity plans in which investors paid premiums to investment funds managed by life insurance companies and were entitled to a corresponding share in the profits.
Tcherepnin involved a proposal for “redeemable capital shares” offered by a savings and loan association in Illinois. Investors who purchased these shares were entitled to become members of the association, vote their shares, and “receive such dividends as the association’s directors declared from association earnings.”
Finally, Edwards involved an after-lease plan in which a promoter provided public telephones, along with a site lease, leaseback and management agreement, and a repurchase agreement. Investors were entitled to a fixed 14% annual return from the operation of the public telephones, which were leased back and managed by the promoter.
In addition, the professors found that each “investment contract” identified by the Second Circuit involved a contractual promise that granted the enterprise a continuing interest, and they cited a dozen examples.
Why is this considered a “complete refutation of the SEC’s argument”?
Based on the above content, Minnesota primarily focuses on the core concepts of “contract” and “investment” when defining an “investment contract.” Its definition emphasizes the investor’s ability to obtain some form of contractual commitment in a business enterprise and the right to share in the future income, profits, or assets of the enterprise due to the investment. This definition is based on traditional notions of capital investment and profit sharing.
However, existing cryptocurrencies differ from this definition. First, purchasing cryptocurrencies does not imply that investors will receive any form of contractual commitment or explicit profit-sharing rights in a specific business enterprise. The value of cryptocurrencies is typically based on market demand and supply, technological advancements, or other external factors rather than profit sharing with a particular company or enterprise.
Secondly, cryptocurrency holders typically do not expect or rely on specific enterprises or individuals to earn returns or profits. Their returns usually come from the appreciation of the currency, which is determined by market forces rather than a specific business activity or profit-driven approach.
In general, although cryptocurrency involves “investment” to some extent, its nature, return mechanism, and relationship with the traditional concepts of “contract” and “investment contract” make it difficult to fit into the definition of an investment contract in the early Minnesota cases.
Similarly, based on the relevant definitions argued in this article, unlike traditional securities or investment contracts, the core value of cryptocurrency mainly depends on its characteristics as a “commodity”. Firstly, cryptocurrencies such as Bitcoin were initially designed as digital currencies to provide a decentralized payment method not constrained by traditional banking systems, which is also proven in major public chains as a means to pay for gas fees. This means that it is essentially a medium of exchange and has commodity value, just like gold or other goods.
Furthermore, the value of cryptocurrency largely depends on its scarcity, authenticity, and non-falsifiability. For example, the total supply of Bitcoin is limited, similar to gold, both having a fixed supply. This scarcity gives it commodity value. In addition, blockchain technology ensures the authenticity and uniqueness of each unit of cryptocurrency, making it difficult to counterfeit or replicate.
These attributes make cryptocurrency more like gold, oil, or any other form of physical commodity rather than traditional securities or investment contracts. Although people do purchase cryptocurrency as an investment, expecting its value to rise, this is no different from buying gold or artwork with the expectation of appreciation. Therefore, from this perspective, cryptocurrency should be regarded as an asset with commodity value rather than a traditional security or investment contract.