Recently, in some blockhain projects born mostly by the brand new teams from around the world that are going to make an ICO, it has become very fashionable to show up or rather be brazenly proud that their project token easily and freely passes such a terrible and hated by everyone The Howey Test. Lawyers and advisors of such projects, without shame and most likely manipulating the essence of the test issues, openly put in danger the project itself, its ideation and the team that believed them, thus promising to open investment shores of the USA and the world for such projects. Moreover, even skillfully inspire confidence to the project’s founders that if to show that the project token — is an utility, it increases the interest in the project and its goodwill. From the side it all looks funny and comical. After all, in addition to the Howey test, the SEC (The United States Securities and Exchange Commission) appeals even a number of other tests and legislative acts, which in principle inflict a mortal blow to the legend of your token, as an utility. But many advisors and lawyers prefer to keep silence, if for sure they are in course of these things. All these tests, including Howey test, arose from the case law and the rich fantasy of legal practice and the government monopoly to control the financial flows in the US. What is the problem, let’s figure it out.
The blockchain token is created with the help of blockchain as part of a decentralized software protocol. There are many different types of tokens, each of which has different characteristics and means of application. Some tokens, such as bitcoin and monero, function as a digital currency. Others can represent tangible assets, such as gold or real estate, anything already today. Tokens can also be used in new protocols and networks to create distributed applications. These types of tokens represent the next stage of innovation in blockchain technology, and the potential for new types of business models that are decentralized — for example, as cloud computing without Amazon, social networks without Facebook or online marketplaces without eBay. However, there are a number of complex legal issues related to tokens. The main problem of legalization of this process is not to give a legal and practical assessment of such a phenomenon as the ICO, legally substantiating it. ICO is secondary. The legal nature of the token is primary.
Nowhere in the world is today the theoretical and clear legal definition of what is a token.
There are certain guides and explanations of regulators, which mean only a recommendation character and nothing more. There are no laws yet. Nodaway problem is that it is not yet possible to define a basic asset under the law for token. Legislators still declare intentions, and regulators — as it is not strange, show their passivity in solving this issue. Even such a position of regulators has an explanation. This is their retrospective and even retrograde policy, since they are still evaluating the tokens from the point of view of comparing it with something from the past, but they are not able to apprise it from the perspective of the future. Further, even if you refer to any regulator, including the most authoritative (SEC) with a request to evaluate your project token, the probable answer will be according to their compliance policy code — it is not subject to review, in order to avoid the policy of creating precedents. So far no one regulator has given a token definitions, unlike, for example, bitcoin and other crypto currency. Everyone is waiting who will be the first in determining the legal essence, who will be responsible for this precedent. Exactly from such a retrospective position, the SEC uses those tools that are familiar to it, in order to evaluate such now how phenomena as tokens in the financial market.
Accordingly, some tokens, depending on their characteristics, may be subject to control and monitoring by US federal regulators and securities market laws. This would mean, among other things, that it is illegal to offer tokens for sale in the US without their registration or exemption from registration. Similar rules are applying in many other countries of the world. However, the global crypto community is focused on the US federal legislation, as these laws are representing the biggest threat to the crowdsale of tokens. In many jurisdictions there may be problems with AML legislation or with general consumer protection laws, however, the most real threat to the crowdsale and token is presented by the comprehensive US law giving unlimited powers to the SEC and determining what a security is. I consider it just necessary, to quote one article from Section 2(a)(1) of the Securities Act of 1933: «The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing». The bold font indicates those positions that so smoothly can fit the definition of your token as an utility, but finally, this law defines everything as just security. A similar comprehensive definition also gives Section 3(a)(10) of the Securities Exchange Act of 1934. Of course, based on these definitions of case law, as well as on the understanding of facts, we can conclude that if the token of your ICO project does not meet the definition for security, then your token is utility. It can be stressed out that this conclusion depends on the characteristics and nature of your token. But I do not see such opportunities at all, based on the above definitions. In fact, in most practical cases, your token does not have a chance of being utility under the US jurisdiction. This is my subjective opinion. Therefore, I am very cautious about such projects ICO, which waved their passed tests Howey as a red rag matador, attracting the attention of the SEC and American private investors. And I always argue with the involved lawyers in the project if they are starting to put project founders up to let them pass the Howey test easily and show up what one wants so much to see. It should be understood that tokens can have different functions depending on how they were developed and which computer systems were used. In principle, you can assume with great reserve that if the token has one or more functional rights and technical capabilities, then it can be not considered as security. To wit, if such tokens in the ecosystem of your project perform a role of mean and rights to program, develop or create features for the system or to “mine” things that are embedded in the system; to access or license the system; to charge a toll for such access or license; to contribute labor or effort to the system; to use the system and its outputs; to sell the products of the system; to vote on additions to or deletions from the system in terms of features and functionality. Not much!!!
But at the same time, you can more confidently state that if your token has one or more investment interests and rights, then it can be exactly considered as security. To wit, if such tokens in the ecosystem of your project perform a role of ownership interest in a legal entity, including a general partnership; equity interest; share of profits and/or losses, or assets and/or liabilities; status as a creditor or lender; claim in bankruptcy as equity interest holder or creditor; holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token; and feature allowing the holder to convert a non-security Blockchain Token into a Blockchain Token or instrument with one or more investment interests, or granting the holder an option to purchase one or more investment interests. Most likely, based on the SEC practice of treating the question of nature and the essence of the tokens, even a combination in the token of features and properties both security and utility, eventually such a combined token will be considered finally as security. Further, more — based on the SEC practice, the presence of a share of ownership in a fund or other legal entity that buying non security (utility) tokens of various projects, will still consider and constitute such a share of ownership as in the security tokens, even if such a fund declares its investment interest in only utility tokens (non security). Such paradoxical interpretation is explained by investment plans and the presence of investment interests among the holders of tokens, even if this interest to matchboxes and soap bubbles. Further, even more confusing from the practice of SEC interpretations. The token itself, being in fact, a planning future structure, either utility, or security, before creating and implementing a system of its operational existence in blockchain, will be considered as security. There is no clear legislative definition for this situation, but the SEC stands for this position. Therefore, the launch of the blockchain for your project and related tokens should occur as close as possible to the frame timing associated with each other. That is, it is better to run the system and tokens simultaneously, then the probability that the tokens of your blockchain system considered as security will be reduced. And this interpretation by the SEC follows from the special features of the Howey test, in part of the section “Risk of loss”. All this is just one example of the heterogeneity of the interpretation of the nature of tokens, and the profound difference between what the ICO project founders and their lawyers want to see, and what they actually able to see and how the SEC’s officers evaluate, whose instruments on the Howey test were deeply extended by the Supreme US court in 2004 in the case of SEC v. Edwards, 540 U.S. 398 (2004). The structure of the Howey test specifically focuses on the term “investment contract” within the definition whether your token is a security. It is worth noting that the test is used to classify such instruments that are “more variable character” and that can be considered as a form of “contract, transaction or scheme, whereby an investor lays out money in a way intended generating income or profits from his investments’’. Based on the SEC practice of applying the Howey test, tokens are most likely to be analyzed as an investment contract. Some of the investment interests listed above are more accurately described as traditional types of securities, so its combination with non security (utility) feature tokens is more likely to be assessed by SEC as security tokens.
The USA Supreme Court structured the Howey test in the following way: the arrangement is an investment contract that corresponds to the definition of security if the actions under the contract implying a list of the following activities and characters. Namely:
• investing / an investment of money;
• investing in a common business deal / enterprise;
• Participants in the common business / enterprise expecting a profit;
• profits are expected predominantly from the efforts and actions of others / third parties, regardless of whether the shares of the enterprise have been confirmed by official certificates or a nominal share in the physical assets used in the enterprise / for the common cause
• Is any profit received from investments largely or entirely outside the control of the investors?
Do not be so sure that you are able to bypass all the hidden pitfalls of terminology and analysis of situations in this test. Each of the above features has a number of additional definitions that complicate the answers:
Ø Investment of Money — Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. See, e.g., Int’l Bhd. Of Teamsters v. Daniel, 439 U.S. 551, 560 n.12 (1979); Hector v. Wiens, 533 F.2d 429, 432–33 (9th Cir. 1976); Sandusky Land, Ltd. V. Uniplan Groups, Inc., 400 F. Supp. 440,445 (N.D. Ohio 1975)
Ø Common Enterprise — Under the horizontal approach, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor correlate with those of the other investors. Under the vertical approach looks to whether the profits of an investor are tied to a promoter and whether the success of the investor depends on the promoter’s expertise. If there is such reliance, then a common enterprise will be deemed to exist. See, e.g., Curran v. Merrill Lynch, 622 F.2d 216 (6th Cir. 1980); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016 (7th Cir. 1994); SEC v. Continental Commodities Corp., 497 F.2d 516 (5th Cir. 1974) and other cases.
Ø Expectation of Profits — Under this element, profit refers to the type of return or income an investor seeks on their investment. Thus, for purposes of tokens, this could refer to any type of return or income earned as a result of being a Blockchain Token holder, which would be narrowed to the extent it is derived passively, i.e., from the efforts of others. More specifically, profits may include all manner of returns, such as dividends, other periodic payments or the increased value of the investment — whether it is a variable or fixed return. See, e.g., SEC v Edwards, 540 U.S. 390 (2004) and other cases as well.
Ø Solely from the efforts of Others — Typically, USA courts have been flexible with the word “solely,” such that, in addition to the literal meaning, it also will include significant or essential managerial or other efforts necessary to the success of the investment. See e.g., SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482–83 (9th Cir. 1973); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir.1974), Hirsch v. Dupont, 396 F. Supp. 1214, 1218–20 (S.D.N.Y. 1975), aff’d, 553 F.2d 750 (2d Cir. 1977)
I think that even my easy explanation is enough to understand how serious and professional your lawyers in ICO projects should be when they start juggling with the capabilities of the Howey test. And how deep you can run into trouble. Always keep in mind the case with the MUNCHEE start up, and the fact that the Howey test through the power of SEC officers at their glance can become a guillotine for your ICO project. The US regards its legislation as extraterritorial, so in addition to Howey Test, you ought to be aware of the dangers of other tests that are less popular in the press and mass media, but this no make it less popular with the SEC. Namely:
· Reves’s Family Resemblance Test, 1990, US Supreme Court decision in Reves v.Ernst & Young (in fact, a test of investment expectations — if during negotiations and discussions you manipulate with investment income expectations or promises — then your token is a security, and the legal explanation of the nature of the “manipulation” is unlimited)
· Risk Capital Test, California Supreme Court Silver Hills Country Club v. Sobieski (1961) (even club membership falls under risky capital investments — a membership card is a security)
Here — all your tokens are SECURITY. Almost any token, when is passing the above tests, receives points and is in danger of being recognized as a security. But we must remember that before you begin ICO, you have to answer questions related to your project token:
· Who is the issuer of the token?
· What rights are given to the owners of the token?
· What is the economy behind the token?
It is the question of the economy of the token that will help you to understand and not to do stupidities with the lawyers. But usually, based on practice, it is the economy issue that is mostly lame and is a risk factor for the token in the dilemma — either security, or utility!!!
Sergiy Golubyev
EU structural funds, ICO projects, NGO & investment projects, project management, comprehensive support for business, expert with AgroChallenge foundation