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”).[i]
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….”[ii]
The Howey test typically is described as having three prongs or elements.[iii] Virtually all of the cases recite the first two prongs exactly as they are stated in Howey,[iv] but the cases express the third prong in different ways. Some cases recite the third prong exactly as it is stated in Howey.[v] Other cases, for reasons unknown, reformulate the third prong of Howey in the following ways (among others):
- “with the reasonable expectation of profits to be derived from the entrepreneurial or managerial [or ‘‘management”[xiii]] efforts of others;”[xiv] and
Still other cases use different formulations or reformulations of the third prong in the course of the same opinion.[xvi]
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:”
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.”[xx]
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.[xxi]
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”).
“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.’”[xxiv]
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 interests in the physical assets employed in the enterprise. Such a definition necessarily underlies this Court’s decision in [Joiner] and has been enunciated and applied many times by lower federal courts. [citations omitted] It permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that, in our commercial world, fall within the ordinary concept of a security.’ H.Rep. No.85, 73rd Cong., 1st Sess., p. 11. It embodies a flexible, rather than a static, principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” [xxv]
In Tcherepnin v. Knight,[xxvi] the Supreme Court, in construing the term “security” as it is used in the Exchange Act,[xxvii] stated that “we are guided by the familiar canon of statutory construction that remedial legislation should be construed broadly to effectuate its purposes. The [Exchange Act] quite clearly falls into the category of remedial legislation. [citations omitted] One of its central purposes is to protect investors through the requirement of full disclosure by issuers of securities, and the definition of security in §3(a)(10) necessarily determines the classes of investments and investors which will receive the Act’s protections. Finally, we are reminded that, in searching for the meaning and scope of the word ‘security’ in the Act, form should be disregarded for substance and the emphasis should be on economic reality.”[xxviii]
In United Housing Foundation, Inc. v. Forman,[xxix] the Supreme Court stated that Congress broadly defined the term “security” “so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.”[xxx]
“The fundamental purpose undergirding the Securities Acts is ‘to eliminate serious abuses in a largely unregulated securities market.’ United Housing Foundation, Inc. v. Forman, 421 U. S. 837, 421 U. S. 849 (1975). In defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits, SEC v. W.J. Howey Co., 328 U. S. 293, 328 U. S. 299 (1946), and determined that the best way to achieve its goal of protecting investors was ‘to define the term “security” in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.’ … Congress therefore did not attempt precisely to cabin the scope of the Securities Acts…Rather, it enacted a definition of ‘security’ sufficiently broad to encompass virtually any instrument that might be sold as an investment.”[xxxii]
Notwithstanding the Broad Remedial Purposes of the Securities Act, Those Acts Cannot Be Invoked to Remedy Every Commercial Tort While the courts have clearly concluded that the term “investment contract” must be construed broadly in order to effectuate the purposes of the Securities Acts, they have at the same time been wary of characterizing commercial arrangements involving the sale of goods and services as “investment contracts” for the sake of affording a remedy to persons who have entered into such arrangements and lost money.
Thus, in Reves, the Supreme Court – immediately after articulating the position (quoted above) that the Securities Acts must be construed broadly in light of their remedial purposes – concluded (quoting Marine Bank v. Weaver, 455 U.S. 551, 556 (1982)) that ‘‘Congress did not…intend to provide a broad federal remedy for all fraud.”
In Rodriguez v. Banco Cent. Corp., 990 F. 2d 7, 10 (1st Cir. 1993), the First Circuit stated that “…[Howey and Forman] mark out a concept, not a precise definition. The term ‘securities,’ we are told, must be flexibly applied to capture new arrangements comprising the essence of securities, however they may be named…But not all property is a security, and fuzzy edges do not mean that the concept is unbounded.”
Other cases make the same point. See, e.g., Long v. Shultz Cattle Co., Inc., 896 F. 2d 85, 88 (5th Cir. 1990) (en banc) (recognizing “the importance of a workable definition of the term ‘investment contract,’ one that fully implements the remedial purposes of the Securities Acts without unduly burdening commercial enterprises that Congress never intended to be covered under the federal securities laws.”); Garcia v. Santa Maria Resort, Inc., 528 F. Supp. 2d 1283, 1292 (S.D. Fla. 2007) (“Count I seeks relief under the federal securities laws; therefore, only if the transactions before the Court fall within the ambit of those laws could Plaintiffs have a federal securities claim. These laws are not a panacea for every alleged transactional wrong, however, because ‘federal securities laws were not intended to provide a federal remedy for all fraud or misconduct arising out of a commercial transaction.’”) [quotations omitted]; Haddad v. Rav Bahamas, Ltd., 431 F. Supp. 2d 1278, 1284 (S.D. Fla. 2006) (the definition of “investment contract” requires courts “to examine the economic substance of the transaction and is broadly applied to ‘encompass virtually any instrument that might be sold as an investment.’ Mutual Benefits Corp., 408 F.3d at 742 (citations omitted). Nevertheless, courts recognize that the federal securities laws were not intended to provide a federal remedy for all fraud or misconduct arising out of a commercial transaction. Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982). Thus, ‘[e]ach transaction must be analyzed and evaluated on the basis of the content of the instruments in question, the purposes intended to be served, and the factual setting as a whole.’ Id. at 561 n. 11, 102 S. Ct. 1220.”).
“Interpretation of the securities laws is governed by two conflicting judicial concerns. Since the [Securities] Acts were devised to protect the public from speculative or fraudulent schemes advanced by promoters, they must be construed liberally as remedial statutes. S.E.C. v. Glenn W. Turner Ent., Inc., 474 F.2d 476 (9th Cir. 1973).
“The Supreme Court has held that the term ‘investment contract’ ‘embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” S.E.C. v. Howey Co., 328 U.S. 293, 299, 66 S. Ct. 1100, 1103, 90 L. Ed. 1244 (1946).
“The Court had earlier stressed that ‘(n)ovel, uncommon, or irregular devices, whatever they may appear to be, are also reached [under this definition]’. S.E.C. v. Joiner Corp., 320 U.S. 344, 351, 64 S. Ct. 120, 124, 88 L. Ed. 88 (1943). In essence, ‘form should be disregarded for substance and the emphasis should be on economic reality.’ Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S. Ct. 548, 553, 19 L. Ed. 2d 564 (1967). Most recently the Court in United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 851, 95 S. Ct. 2051, 44 L. Ed. 2d 621 (1975), again emphasized that trial courts must look to the ‘substance’ of the transaction.
“But while the securities laws must be utilized with flexibility to remedy the protean forms of investment fraud, the court is also mindful that these laws cannot be utilized as catch-all solution for business fraud and other economic torts. Previously this court has commented that ‘the word “security” is not a judicial philosopher’s stone for the conjuration of federal cases.’ Lincoln National Bank v. Lampe, 414 F. Supp. 1270, 1280 (N.D. Ill. 1976).
“Thus, the court must carefully match the allegations of the instant complaint against the well-established standard for investment contracts first articulated by the Supreme Court in Howey, supra, and recently reiterated in Forman, supra, 421 U.S. at 852, 95 S. Ct. 2051....
“In analyzing the pleadings and exhibits presently before the court...the court of course recognizes that ‘land as such is not a security and that a land purchase contract, simply because the purchaser expects or hopes that the value of the land purchased will increase, does not fall automatically within the confines of the Securities Acts.’ McCown v. Heidler...[527 F.2d 204, 208 (10th Cir. 1975).]…
“But in a variety of circumstances the courts have found that real estate deals were in fact investment contracts. S.E.C. v. Howey, supra; S.E.C. v. Joiner Corp., supra; McCown v. Heidler, supra.
“As noted, there is an investment aspect in every land transaction arising from the hope of increased property values... But, as the Supreme Court recently stressed, there is frequently also a strong motivation to purchase real estate for purposes of ‘consumption’, that is to occupy the land or develop it by one’s own effort. Forman, 421 U.S. at 853, 95 S.Ct. 2051.
“The court must therefore consider the nature of the promotion to determine whether the emphasis of the developers and their sales agents was on the ‘investment’ or the ‘consumption’ side of the real estate duality.
“For example, in Forman the Supreme Court contrasted those attracted solely by the prospects of a return on investment from those attracted solely by the prospect of acquiring a place to live. It was clear that Coop-City, the property in question, attracted its owners on the latter basis.
“It is apparent that the same considerations justified the court's dismissal of the complaint in Davis v. Rio Rancho Estates, Inc., 401 F. Supp. 1045 (S.D.N.Y.1975), a case cited by the defendants. Judge Brieant noted that the defendants promoted their project by brochures which "fairly read, place more emphasis on development of a residential community than on purchase as an investment." 401 F. Supp. at 1049….
“Using a similar analysis the Tenth Circuit found a factual question as to the existence of a possible investment contract sufficient to compel a remand of McCown, supra, to the district court. The court of appeals analyzed the brochures which laid extremely heavy stress on the investment nature of the recreational property in question.
“It is thus also apparent that the court cannot determine the relative emphasis given to the profit-seeking and the ‘consumption’ sides of this project without an analysis of the representations and promises made by the defendants.”[xxxiv]
As I will discuss in my next post, other courts have adopted the same analysis regarding the difference between “investment contracts” involving consumptive items, on the one hand, and commercial arrangements involving such items, on the other. While the cases have often struggled to draw the line clearly based on the particular facts and circumstances before them,[xxxv] the basic principles that have guided them in this context are these:
- Application of the Howey test to a contract, transaction or scheme involving the offer and sale of a consumptive item involves an “objective” inquiry into whether the issuer/promoter has led potential purchasers to expect profits resulting from the managerial or entrepreneurial efforts of others. Put somewhat differently, the test 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. The test is an objective, rather than a subjective test. The fact that a person believes he or she is making an “investment” is not sufficient to prove the existence of an “investment contract.” What matters is whether the efforts utilized by the promoter would lead a reasonable person to believe he or she is making an investment.
- Central to this test is the “promotional emphasis” of the seller of the product.
- Characterization of the inducement cannot be accomplished without a thorough examination of the representations made by the seller as the basis of the sale.
- Promotional materials, merchandising approaches, oral assurances and contractual agreements must be considered in applying the test.
- If, from an objective standpoint, the promoter does not offer and sell the item primarily as an investment, the offer and sale of the item will not constitute an “investment contract.”
- Without a promoter’s actual promise or agreement to take actions expressly designed to add value to an otherwise consumptive item, the contracts, transactions or schemes pursuant to which such items are offered and sold will not be considered “investment contracts,” even though the promoter takes actions that in fact increase the use and enjoyment, and thus the potential value, of the item.