The following 2001 Appeals Court decision should be more convincing about what I have been warning about Altcoin developers and communities primarily marketing their coins to investors for the purpose of investment gains, thus creating an implied "investment contract" criteria for a security under the durable 1946 SEC vs. Howey Supreme Court test.
" because one has to invest in mining (for PoW) and shares (PoS) in order to participate in mining:
SECURITIES AND EXCHANGE COMMISSION, Plaintiff, Appellant,
v.
SG LTD. et al., Defendants, Appellees.
Nos. 01-1176, 01-1332.
United States Court of Appeals, First Circuit.
Heard August 2, 2001.
Decided September 13, 2001.
Relying upon a dictum from Howey discussing "the many types of instruments that in our commercial world fall within the ordinary concept of a security,", the district court drew a distinction between what it termed "commercial dealings" and what it termed "games." Characterizing purchases of the privileged company's shares as a "clearly marked and defined game," the court concluded that since that activity was not part of the commercial world, it fell beyond the jurisdictional reach of the federal securities laws. Id. In so ruling, the court differentiated SG's operations from a classic Ponzi or pyramid scheme on the ground that those types of chicanery involved commercial dealings within a business context. Id.
We do not gainsay the obvious correctness of the district court's observation that investment contracts lie within the commercial world. Contrary to the district court's view, however, this locution does not translate into a dichotomy between business dealings, on the one hand, and games, on the other hand, as a failsafe way for determining whether a particular financial arrangement should (or should not) be characterized as an investment contract. Howey remains the touchstone for ascertaining whether an investment contract exists — and the test that it prescribes must be administered without regard to nomenclature.
A fairly recent Supreme Court opinion demonstrates that the "commercial world" to which the Howey Court alluded actually encompasses the total universe of financial instruments available to investors, rather than the subset of financial instruments envisioned by the district court (i.e., "commerce" as opposed to "games"). In that case, Justice Marshall wrote:
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," 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.
The Howey Court established a tripartite test to determine whether a particular financial instrument constitutes an investment contract (and, hence, a security). This test has proven durable.
substance governs form, and the substance of an investment contract is a security-like interest in a "common enterprise" that, through the efforts of the promoter or others, is expected to generate profits for the security holder, either for direct distribution or as an increase in the value of the investment.
The Supreme Court has long espoused a broad construction of what constitutes an investment contract, aspiring "to afford the investing public a full measure of protection." The investment contract taxonomy thus "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."
The Howey test has proven to be versatile in practice. Over time, courts have classified as investment contracts a kaleidoscopic assortment of pecuniary arrangements that defy categorization in conventional financial terms, yet nonetheless satisfy the Howey Court's three criteria.
A. Investment of Money.The first component of the Howey test focuses on the investment of money. The determining factor is whether an investor "chose to give up a specific consideration in return for a separable financial interest with the characteristics of a security."
B. Common Enterprise.The second component of the Howey test involves the existence of a common enterprise. Before diving headlong into the sea of facts, we must dispel the miasma that surrounds the appropriate legal standard.
1. The Legal Standard. Courts are in some disarray as to the legal rules associated with the ascertainment of a common enterprise. See generally II Louis Loss & Joel Seligman, Securities Regulation 989-97 (3d ed. rev.1999). Many courts require a showing of horizontal commonality — a type of commonality that involves the pooling of assets from multiple investors so that all share in the profits and risks of the enterprise.
Other courts have modeled the concept of common enterprise around fact patterns in which an investor's fortunes are tied to the promoter's success rather than to the fortunes of his or her fellow investors. This doctrine, known as vertical commonality, has two variants. Broad vertical commonality requires that the well-being of all investors be dependent upon the promoter's expertise.
In contrast, narrow vertical commonality requires that the investors' fortunes be "interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties."
We hold that a showing of horizontal commonality — the pooling of assets from multiple investors in such a manner that all share in the profits and risks of the enterprise — satisfies the [Howey] test. Adopting this rule also aligns us with the majority view and confirms the intimation of Rodriguez. Last, but surely not least, the horizontal commonality standard places easily ascertainable and predictable limits on the types of financial instruments that will qualify as securities.
C. Expectation of Profits Solely From the Efforts of Others.The final component of the Howey test — the expectation of profits solely from the efforts of others — is itself divisible. We address each sub-element separately.
1. Expectation of Profits. The Supreme Court has recognized an expectation of profits in two situations, namely, (1) capital appreciation from the original investment, and (2) participation in earnings resulting from the use of investors' funds. These situations are to be contrasted with transactions in which an individual purchases a commodity for personal use or consumption. The SEC posits that SG's guarantees created a reasonable expectancy of profit from investments in the privileged company, whereas SG maintains that participants paid money not to make money, but, rather, to acquire an entertainment commodity for personal consumption.
In Forman, apartment dwellers who desired to reside in a New York City cooperative were required to buy shares of stock in the nonprofit cooperative housing corporation that owned and operated the complex. Based on its determination that "investors were attracted solely by the prospect of acquiring a place to live, and not by financial returns on their investments," the Forman Court held that the cooperative housing arrangement did not qualify as a security under either the "stock" or "investment contract" rubrics. The Court's conclusion rested in large part upon an Information Bulletin distributed to prospective residents which stressed the nonprofit nature of the cooperative housing endeavor.
We think it noteworthy that the Forman Court contrasted the case before it with Joiner. In that case, economic inducements made by promoters in conjunction with the assignment of oil well leases transformed the financial instrument under consideration from a naked leasehold right to an investment contract. The Joiner Court found dispositive advertising literature circulated by the promoters which emphasized the benefits to be reaped from the exploratory drilling of a test well. Id. ("Had the offer mailed by defendants omitted the economic inducements of the proposed and promised exploration well, it would have been a quite different proposition.").
The way in which these cases fit together is instructive. In Forman, the apartment was the principal attraction for prospective buyers, the purchase of shares was merely incidental, and the combination of the two did not add up to an investment contract. In Joiner, the prospect of exploratory drilling gave the investments "most of their value and all of their lure," the leasehold interests themselves were no more than an incidental consideration in the transaction, and the combination of the two added up to an investment contract.
Seen in this light, SG's persistent representations of substantial pecuniary gains for privileged company shareholders distinguish its StockGeneration website from the Information Bulletin circulated to prospective purchasers in Forman. While SG's use of gaming language is roughly analogous to the cooperative's emphasis on the nonprofit nature of the housing endeavor, SG made additional representations on its website that played upon greed and fueled expectations of profit.
This is not to say that SG's gaming language and repeated disclaimers are irrelevant. SG has a plausible argument, forcefully advanced by able counsel, that no participant in his or her right mind should have expected guaranteed profits from purchases of privileged company shares. But this argument, though plausible, is not inevitable. In the end, it merely gives rise to an issue of fact (or, perhaps, multiple issues of fact) regarding whether SG's representations satisfy Howey's expectation-of-profit requirement.
2. Solely from the Efforts of Others. We turn now to the question of whether the expected profits can be said to result solely from the efforts of others. The courts of appeals have been unanimous in declining to give literal meaning to the word "solely" in this context, instead holding the requirement satisfied as long as "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." This liberal interpretation of the requirement seemingly comports with the Supreme Court's restatement of the Howey test. (explaining that "the touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others").
We need not reach the issue of whether a lesser degree of control by a promoter or third party suffices to give rise to an investment contract because SG's alleged scheme meets the literal definition of "solely." According to the SEC's allegations, SG represented to its customers the lack of investor effort required to make guaranteed profits on purchases of the privileged company's shares, noting, for example, that "playing with [the] privileged shares practically requires no time at all." SG was responsible for all the important efforts that undergirded the 10% guaranteed monthly return. As the sole proprietor of the StockGeneration website, SG enjoyed direct operational control over all aspects of the virtual stock exchange. And SG's marketing efforts generated direct capital investment and commissions on the transactions (which it pledged to earmark to support the privileged company's shares).
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