Original | Odaily Star Daily
Author | jk
A few days ago, law professors from Yale University, the University of Chicago, the University of California, Los Angeles, Fordham University, Boston University, and Widener University submitted a friend of the court brief, which traces the history of the term “investment contract” before, during, and after the passage of the Securities Act of 1933, thoroughly refuting the SEC’s theory of “investment contract”.
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Here are the scholars’ conclusions:
- “In 1933, state courts reached a consensus on how to interpret the term ‘investment contract’, namely, it is a contractual arrangement that confers investor status and entitles the investor to a share of the proceeds, profits, or assets of the seller.”
- “After the Howey case ruling in 1946, the common characteristics of an ‘investment contract’ remained… the investor must be promised a continuing interest in the enterprise’s income, profits, or assets by reason of his investment.”
- “Every ‘investment contract’ recognized by the Supreme Court involves a commitment to give 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 secondary markets are investment contracts.
Background: Blue-Sky Laws
When Congress included the term “investment contract” in the definition of “security”, 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 governing securities transactions. In formulating a set of national standards and a federal regulatory scheme, Congress chose to base federal law on these so-called “Blue-Sky Laws”. Of particular relevance, in defining “securities” as used in the new national securities laws, Congress incorporated the term “investment contract” from these Blue-Sky Laws as a whole.
With this background, we reviewed the development of the concept of “investment contract” under the Blue-Sky Laws cited by Howey as the basis for the “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, with the prosperity of the American economy, the market for trading shares of American business giants also flourished. As the middle class and retail investors flocked to large exchanges in New York and San Francisco to buy shares in industrial behemoths from railways to heavy industry, opportunities to invest in blue-chip stocks also increased. However, at the same time, speculative or outright fraudulent investment opportunities from dubious sellers also increased, such as those “flash-in-the-pan companies, imaginary oil wells, distant gold mines, and other similar fraudulent developments”. Unlike their blue-chip stock relatives, these investment opportunities were often sold through face-to-face encounters, newspapers, or even mass mailings. Not surprisingly, the sale of these investment opportunities often involved clever “hype” and fraud.
Starting in 1910, state legislatures began responding to these developments by enacting the first securities laws at the national level. These initial legislative efforts aimed to protect the public from the harm of “dishonest salesmen selling shares under the blue sky.”
The first “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 other types or nature of securities.”
Other states attempted to provide some clarification on what was 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 evidence of indebtedness.”
Legislators quickly recognized the need to enact a second generation of securities laws. In fact, those objectionable, speculative, or fraudulent investment transactions or schemes that prompted the enactment of the first “blue sky laws” were not technically stocks or bonds. These transactions, disguised as traditional stocks, proposed giving investors an initial amount in exchange for a contractual right to share in the future value of a business, much like stocks or bonds. And since these laws focused on genuine stocks and bonds, these fake stocks and bonds were clearly 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 and oversee these new instruments or proposals that share key economic and legal characteristics with stocks and bonds, state legislatures attempted to clearly define and regulate them in the second generation of securities laws.
Minnesota added the term “investment contract” to its definition of “securities” in its 1919 “blue sky law.” This new undefined term was intended to capture those investments that, although not formal stocks or bonds, relied on and granted a contractual right to future profits. Other states quickly followed suit and included “investment contracts” in 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, courts soon provided 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 one 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 considered an “investment contract.” These rulings are regarded as 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, the investors received a “certificate” that granted them the “right” on the contract to a certain percentage of the dealer’s profits. By analyzing the definition of “securities” in the Blue Sky Law, the court ruled that these certificates were not technically or formally “stocks”. Nevertheless, the Minnesota Supreme Court still ruled that these certificates “could 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 profit-sharing arrangements were investment contracts. Here, a bus driver paid the bus company $1000 and, in return, received a “contract” that promised 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) “invested with the purpose of obtaining profits” and (ii) received a “contract” (an “operator agreement”) in exchange, which ensured an interest in the future profits of the enterprise.
In summary, early Minnesota cases revolved primarily around two statutory terms: “contract” and “investment”. If an arrangement met the following criteria, it was considered an investment contract: (i) investors obtained a contractual commitment in someone else’s business enterprise, and (ii) as an exchange for the “investment,” investors were 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 a clear 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 unified sense. As explained by Howey, this is 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 granted investors the qualification to have a contractual share in the seller’s subsequent income, profits, or assets. In fact, to our knowledge, no state court rulings have found an investment contract without these key characteristics. In some rulings, such as the Heath case, the court openly suggested that an “investment contract” required an actual contract. In other rulings, the court emphasized that the seller had an obligation to pay (and the holder had the 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 genuine investment contracts from basic asset sales.
“Investment Contracts” Since the Howey Decision
For over 75 years since the Howey decision, courts have applied the seemingly simple test from the Supreme Court to all novel and complex business arrangements, resulting in a complex network of precedents. The common thread remains – as state courts interpret state blue sky laws, as well as what Howey requires – investors must be promised a continuous contractual interest in enterprise income, profits, or assets in exchange for 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. In each application of the Howey test, the court has considered whether the transaction reflects the fundamental attributes typically considered to be securities.
In addition, the court considers the comparison between the arrangement and other instruments previously deemed “securities.” For example, in the Forman case, the court observed no distinction between an “investment contract” and “instruments commonly known as securities,” another enumerated term in the statutory definition of securities. Applying Howey, the court concluded that shares in a nonprofit housing cooperative were not “investment contracts” because investors’ motivation was “solely to obtain a place to live, not to realize a financial return on their investment.”
Marine Bank provides another example. There, a couple guaranteed a loan for a meatpacking company and exchanged deposit certificates for a portion of the company’s profits and the right to use its facilities. The court ruled that neither the deposit certificates nor the subsequent agreements between the couple and the company were “securities.”
Here, case law from the states – both prior to 1933, as discussed in Section I above, and federal courts after 1933 – emphasizes that for there to be an “investment contract,” investors must have some contractual interest in the enterprise through which they may obtain profits.
B. The Supreme Court has determined that every “investment contract” involves a commitment to the enterprise of a continuing financial interest.
In line with the rulings of state courts prior to the 1933 blue sky laws, the Supreme Court’s decisions after Howey recognized that holders of “investment contracts” must be promised a continuous 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 this Court has made with respect to what it considers a ‘security,’ the person claiming to be an investor has chosen to forgo a specific consideration to obtain a separable financial interest possessing the characteristics of a security.” The court found no “separable financial interest possessing the characteristics of a security” before it. Specifically, it concluded that non-contributory, compulsory pension plans were not “securities” because the claimed pension interests, alleged to be securities, were only a small part of overall, non-security compensation individuals received for their employment.
So far, the Supreme Court has considered that every arrangement deemed as 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, involving the offer of land leases near planned oil well test wells in exchange for investors’ “sharing in the proceeds derived from the sale of interests in the ‘exploration enterprise’ then being conducted.”
Howey itself involved the offer of small parcels of land in an orange grove, combined with a contract with the promoters to cultivate, market, and sell the oranges, with the revenue to be distributed among the “investors solely from the ‘net profits’ of the venture as determined by an audit upon the conclusion of the picking season.”
C. Other Relevant Decisions
First, two subsequent “investment contract” decisions after Howey—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 ComLianGuainy, 387 U.S. 202 (1967)—involved annuity plans under which investors paid premiums to investment funds managed by life insurance companies and were entitled to a corresponding share of the returns.
The Tcherepnin case involved the offer of “withdrawable capital shares” by a savings and loan association in Illinois, with investors who purchased these shares being entitled to become members of the association, vote their shares, and “receive dividends declared by the board of directors out of association earnings.”
Finally, the Edwards case involved an after-lease program in which a promoter supplied public telephones, along with a site lease, leaseback and management agreements, and a repurchase agreement, with investors entitled to a fixed 14% annual return from the operation of the telephones, which were leased back and managed by the promoter.
In addition, the professors found numerous examples where the Second Circuit Court of Appeals held that each “investment contract” involved a contractual promise that granted the enterprise a continuing interest.
Why is this considered a “complete refutation of the SEC’s argument”?
Based on the above content, Minnesota focuses primarily on the core concepts of “contract” and “investment” when defining an “investment contract.” Its definition emphasizes the idea that investors 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 through their investment. This definition is based on traditional notions of capital investment and profit sharing.
However, cryptocurrencies differ from this definition. First, buying cryptocurrencies does not necessarily mean 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 on profit sharing with a particular company or enterprise.
Secondly, cryptocurrency holders typically do not expect or rely on specific enterprises or individuals to generate 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.
In general, although cryptocurrencies involve “investment” to some extent, their nature, return mechanism, and relationship with the traditional concepts of “contract” and “investment contract” make it difficult to fit them into the definition of an investment contract in early Minnesota cases.
Similarly, based on the definitions argued in this article, unlike traditional securities or investment contracts, the core value of cryptocurrencies depends primarily on their characteristics as “commodities”. First of all, cryptocurrencies such as Bitcoin were originally designed as digital currencies, aiming to provide a decentralized payment method that is not constrained by traditional banking systems. This is also proven by their use as a means to pay for gas fees in major public chains. This means that they are essentially a medium of exchange and have commodity value, just like gold or other goods.
Furthermore, the value of cryptocurrencies largely depends on their scarcity, authenticity, and non-fungibility. For example, the total supply of Bitcoin is limited, similar to gold, which has 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 duplicate.
These attributes make cryptocurrencies more like physical commodities such as gold, oil, or any other form of tangible goods, rather than traditional securities or investment contracts. Although people do buy cryptocurrencies as investments, expecting their value to rise, this behavior is no different from people buying gold or artwork with the expectation of appreciation. Therefore, from this perspective, cryptocurrencies should be seen as assets with commodity value rather than traditional securities or investment contracts.
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