How the sale of Florida Orange Groves 75 years ago established Securities Law compliance standards for Cryptocurrencies and other Digital Tokens today
Earlier this year, William Hinman, Director, Division of Corporate Finance, provided significant guidance on the applicability of U.S. Federal Securities Laws to Initial Coin Offerings (ICOs) and the sale of digital tokens. Director Hinman confirmed in detail that the SEC will continue to apply the “Howey Test” in determining whether the sale of digital tokens amount to the issuance and sale of a security.
Director Hinman (echoing several speeches by others at the SEC on the importance of the Howey Test) articulated the elements of Howey Test:
- an investment of [value];
- in a common enterprise;
- with an expectation of profit;
- that are derived from the efforts of others.
Offerings that contain these elements will be deemed the sale of a security under U.S. Securities laws and require the substantial disclosure and compliance requirements thereunder (as well as bring significant civil and criminal liability risk for failure to comply). See our Webinar “Initial Coin Offerings – Complying with U.S. Securities Laws & Tax Issues” for more information regarding the compliance requirements of an ICO and securities laws.
So what is this Howey Test – Well, pull-up a seat, have a drink and I’ll tell you:
The Origin of the Howey Test:
Howey in the Hills (just a few miles north and west of Orlando, Florida) was founded in May, 1925 by William J. Howey. Mr. Howey started to plant and develop citrus farms (adding almost 500 acres per year). Mr. Howey was very successful and built the first citrus juice plant in Florida to process the farms’ produce. By the early 1940s, as a means to produce current income into an investment cycle with a long lead time, W. J. Howey Company began to sell approximately half of the acres it developed.
In May 1943 (just over 75 years ago) W. J. Howey Company and Howey-in-the-Hills Service Inc. sold the last of their plots of orange groves (mostly to guests of a resort owned by an affiliated Howey Company). Each prospective customer was offered both a land sales contract and a service contract, after having been told that it was not feasible to invest in a grove unless service arrangements were made. While the purchaser was free to make arrangements with other service companies, the superiority of Howey-in-the-Hills Service, Inc., was stressed. Indeed, 85% of the acreage sold during the 3-year period ending May 31, 1943, was covered by service contracts with Howey-in-the-Hills Service, Inc.
The land sales contract with the Howey Company provided for a uniform purchase price per acre or fraction thereof, varying in amount only in accordance with the number of years the particular plot had been planted with citrus trees. Upon full payment of the purchase price the land would be conveyed to the purchaser by warranty deed. Purchases were usually made in narrow strips of land arranged so that an acre consists of a row of 48 trees. During the period between February 1, 1941, and May 31, 1943, 31 of the 42 persons making purchases bought less than 5 acres each. The average holding of these 31 persons was 1.33 acres and sales of as little as 0.65, 0.7 and 0.73 of an acre were made. These tracts were not separately fenced and the sole indication of several ownership was found in small land marks intelligible only through a plat book record.
The service contract, generally of a 10-year duration without option of cancellation, gave Howey-in-the-Hills Service, Inc. (“Howey”), a leasehold interest and ‘full and complete’ possession of the acreage. For a specified fee plus the cost of labor and materials, Howey was given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. Without the consent of Howey, the land owner had no right of entry to market the crop; therefore there were no rights to the specific fruit of the trees purchased. Howey was accountable only for an allocation of the net profits based upon a check made at the time of picking. All the produce of all the owners were pooled into a single group for sale.
The purchasers for the most part were non-residents of Florida. They were predominantly business and professional people who lacked the knowledge, skill and equipment necessary for the care and cultivation of citrus trees. They were attracted by the expectation of substantial profits. It was represented, for example, that profits during the 1943—1944 season amounted to 20% and that even greater profits might be expected during the 1944—1945 season, although only a 10% annual return was to be expected over a 10-year period. Many of these purchasers were patrons of the resort hotel owned and operated by the Howey Company in a scenic section adjacent to the groves. The hotel’s advertising mentioned the groves in the vicinity and the attention of the patrons was drawn to the groves as they were being escorted about the surrounding countryside. They were told that the groves were for sale and if they indicated an interest in the groves they were then given a sales pitch.
The SEC brought a claim against Howey, arguing that the bundled service contracts with the sale of the orange groves, amounted to the sale of a security and, therefore, absent compliance with securities’ laws in the offering a sale of such land and service contracts, violated U.S. Securities laws. The Supreme Court in 1946 sided with the SEC and determined that the transactions involved investment contracts (a term included in the definition of “Security” under the Securities Act of 1933). The Court determined that Howey was offering an opportunity to invest and to share in the profits of a large citrus fruit enterprise managed and partly owned by Howey. Emphasizing that the offering was mainly to persons who resided in distant localities and who lacked the equipment and experience requisite to the cultivation, harvesting and marketing of the citrus products, such investors were attracted solely by the prospects of a return on their investment. The success of this “common enterprise” relied on the personnel and equipment of Howey. The investors’ respective shares in this enterprise were evidenced by land sales contracts and warranty deeds, which served as a convenient method of determining the investors’ allocable shares of the profits. The resulting transfer of rights in land was purely incidental.
The Court went on to find that all the elements of a profit-seeking business venture were present. The investors provided the capital and shared in the earnings and profits; the promoters managed, controlled and operated the enterprise. It therefore followed that the arrangements whereby the investors’ interests were made manifest involved investment contracts, regardless of the legal terminology in which such contracts were clothed. The investment contracts in this instance took the form of land sales contracts, warranty deeds and service contracts which Howey offered to prospective investors. Howey’s failure to abide by the statutory and administrative rules in making such offerings, even though the failure result from a bona fide mistake as to the law, cannot be sanctioned under the Securities Act of 1933.
In deciding Howey, the Supreme Court created a test that looks at an investment’s substance, rather than its form, as the determining factor for whether it is a security. Even if an investment is not labeled a “stock” or “bond,” it may very well be a security under the law, meaning that registration and disclosure requirements apply. If an investment opportunity is open to many people, and if investors have little to no control or management of invested money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.
With this historical perspective, the SEC will essentially scrutinize the offering of a digital token and look at who is buying it (farmers or hotel patrons – users or investors) and will they be using the token or hoping it will rise in value (based on the efforts of others) to sell later for a profit.
Director Hinman continued his speech to describe how digital tokens will be analyzed as to whether or not their offerings are “investment contracts” and therefore securities. In advising clients in the issuance of digital tokens, it has been unknown what facts the SEC would focus on in determining if such tokens meet the Howey Test for being a security (especially in an environment where the Chairman of the SEC, John Clayton, has recently stated that “Every ICO I have seen is a security”). Director Hinman, however, stated that this does not need to be the case and listed a set of factors (while not exhaustive), that begin to provide guidance to those who wish to create and sell “tokens” without the onerous compliance required by securities laws:
“What are some of the factors to consider in assessing whether a digital asset is offered as an investment contract and is thus a security? Primarily, consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. That question will always depend on the particular facts and circumstances, and this list is illustrative, not exhaustive:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?”
Additionally, Director Hinman provided additional guidance on how to sell tokens “more like a consumer item and less like a security”:
“Again, we would look to the economic substance of the transaction, but promoters and their counsels should consider these, and other, possible features. This list is not intended to be exhaustive and by no means do I believe each and every one of these factors needs to be present to establish a case that a token is not being offered as a security. This list is meant to prompt thinking by promoters and their counsel, and start the dialogue with the staff – it is not meant to be a list of all necessary factors in a legal analysis.
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?”
Digital tokens are changing day to day and the contributions that such tokens can make to society will be immense. The analysis of what constitutes a security is “not static” and we will no doubt hear more in the future. However, no matter how advanced the technology becomes, whether or not the item being sold is a security will still depend on the elements established by the sale of orange groves more than 75 years ago.