Chapter Four: What is a security, or: the Howey test, simplified.

What is a security? A security falls under different definitions in different jurisdictions, where most of these have similar criterion. Under the Israeli Securities Act, a securities are:

“certificates issued in series by a company, a cooperative society or any other corporation conferring a right of membership or participation in them or claim against them, and certificates conferring a right to acquire securities, all of which whether registered or bearer securities”

The Israeli law has several requirements in order to deem a specific contract a security. The first is the series requirement. Meaning, that the participation rights shall be provided to more than 35 offerees (section 15 of the ISA).

In the Kedem (CA 7313-14 SEC v. Kedem Building Fortification and Restoration Ltd ) ruling, the Israeli Supreme Court ruled that any agreement, even if it had some changes in the specific language for different participants, may be considered as a series for the interpretation of the ISA. In that case, a loan agreement, where each lender had similar terms but different guarantees and interest rates, and all of them were represented by counsel, had been deemed as a security, as the company raising the debt entered into an agreement with more than 35 parties and, de facto, offered itself to the “public”.

According to the Kedem ruling, the Israeli law incorporated the US method for securities, and therefore we’ll inspect what are considered rights there.

Under Section 2 of the US Securities Act, 1933 a security is:

“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 term of “profit-sharing agreement” or “investment contract” is used to interpret what is considered a right, and all in light of the Howey ruling.

The Howey case. In Sec v. Howey Co, 328 US 293 (1946) the US Supreme court addressed the question of an investment contract. Howey was a Florida corporation who offered investors the option to purchase lands from it, where orange trees were already planted in said lands, and also offered a management agreement to take care of the orange trees and sell them, where the profits would be shared. The Supreme Court addressed whether this is an “investment agreement”; and decided that in order to decide whether this is an “investment agreement” two questions have to be addressed: whether there is an investment of money in a common enterprise, and whether such investment creates profits based on the managerial efforts of others. According to the Supreme Court: “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“.

To sum up, there are four prongs. The first is investment of money, the second is an expectation of profit, the third is a common enterprise, and the fourth is that profits are generated by the managerial efforts of others*.

The Glen Turner Case (Securities & Exchange Com'n v. Glenn W. Turner Ent., Inc., 474 F. 2d 476 - Court of Appeals, 9th Circuit 1973) involved a pyramid scheme and defining it as a security under the act. Glen Turner Enterprises offered people a participation right in a “game” where they paid US$1,000 in order to receive tape cassettes and the right to resell these cassettes to others, where each resale would issue a reward; the court ruled that such participation is deemed as a security, as “The purchaser is sold the idea that he will get a fixed part of the proceeds of the sales. In essence, to get that share, he invests three things: his money, his efforts to find prospects and bring them to the meetings, and whatever it costs him to create an illusion of his own affluence. He invests them in Dare's get-rich-quick scheme. What he buys is a share in the proceeds of the selling efforts of Dare”. What we can learn from the Glen Turner case is that even if a person invests efforts in the company, those efforts cannot be targeted for the sale of additional units, but only to actual profits.

In United Housing Foundation, Inc. v. Forman 421 U.S. 837 (1975) the US Supreme Court ruled that buying a participation unit in a housing project, even if such unit may result in some profits, is not a security, because of specific limitations in the housing agreement: “To acquire a Co-op City apartment, a prospective purchaser must buy 18 shares of Riverbay stock for each room desired at $25 per share. The shares cannot be transferred to a nontenant, pledged, encumbered, or bequeathed (except to a surviving spouse), and do not convey voting rights based on the number owned (each apartment having one vote). On termination of occupancy, a tenant must offer his stock to Riverbay at $25 per share, and, in the unlikely event that Riverbay does not repurchase, the tenant cannot sell his shares for more than their original price, plus a fraction of the mortgage amortization that he has paid during his tenancy, and then only to a prospective tenant satisfying the statutory income eligibility requirements. Under the Co-op City Lease arrangement, the resident is committed to make monthly rental payments in accordance with the size, nature, and location of the apartment”; the court ruled that the benefits derived from the shares purchased are not considered securities because “This benefit cannot be liquidated into cash; nor does it result from the managerial efforts of others. In a real sense, it no more embodies the attributes of income or profits than do welfare benefits, food stamps, or other government subsidies”. Meaning, that a joint venture in order to set up a housing project, where each participant provides capital to build a house where he resides may not be considered a security or an investment agreement under these terms.

During the last few years, the securities and exchange commission has taken action against several cryptocurrency enterprises, which all resulted in specific actions and conclusions that might effect what is considered a security under law.

The first is the Shavers ruling (Securities and Exchange Commission v. Shavers, Dist. Court, ED Texas 2013). In Shavers, the defendant set up a fund to purchase bitcoins and promised investors interest rates over their bitcoin deposits. The court found, that for the interpretation of the Howey ruling, the investment of money includes the investment of bitcoins: “It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses”.

As Shavers offered a 1% daily interest on bitcoin deposits. “The Court finds that this prong is also met. At the outset, Shavers allegedly promised up to 1% interest daily, and at some point during the relevant period the interest promised was at 3.9%. Clearly any investors participating in the BTCST investments were expecting profits from the efforts of Shavers”.

Therefore, an enterprise where the investment and payment in cryptocurrency still does not exempt it from being as security just because it's cryptocurrency and not money.

The second ruling is the Gordon ruling (Gordon v. Dailey, Dist. Court, D. New Jersey 2016); In Gordon, the court found that mining contracts; meaning contracts where people pay for the computing power which creates (mines) bitcoins, and receive a portion of their revenues, are securities for the sake of the Howey ruling.

The third decision is the SEC decision in relation to Erik Vorhees (Administrative Proceeding 3-15902); Vorhees oferred others the option to participate in the profits of SatoshiDice.com, a gambling website, based on the sale of “shares” via an online exchange. The SEC deemed these “shares”, which allowed buyers to participate in profits, but not vote on the operation of the site, as securities and fined Vorhees.

The fourth decision is the DAO decision by the SEC. In that decision, the SEC reviewed the DAO, the Decentralized Autonomous organization which raised capital via an Ethereum token. This DAO was meant to invest in other cryptocurrency projects according to the decision of the project’s curators and the votes of the DAO token holders.

DAO Tokens were made available for purchase to anyone holding an Ethereum token via a public crowdsale. This, according to the SEC meant that a public offer was made. The DAO Tokens were provided against a specific payment; where the investors paid for the tokens with their actual value.

The DAO tokens did not provide full discretion about the decision of whether to invest in a specific project or not; as the SEC stated: “The voting rights afforded DAO Token holders did not provide them with meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote for contracts was a largely perfunctory one; and (2) DAO Token holders were widely dispersed and limited in their ability to communicate with one another”.
Due to these considerations, the SEC deemed the tokens as securities; and stated that the Howey test was met.

The conclusion is that no matter what your investment offer is, if it is offered to the public, with expectation of profit and where the profits derive from your (or other people's) action, and not from the offerees' actions, it will be considered an "investment agreement" under securities law. In this chapter we discussed the Howey test, and what is considered a security. In the next chapter, we'll see how to avoid the Howey test.

I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my blog for more info.

Previous Chapters:
Preface
Chapter One: Other People's Money, an Introduction.
Chapter Two: Scams, or why do we need investor protection?
Chapter Three: The Investors, or who doesn't need protection.