(Article from Securities Law Alert, September/October 2020)
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On September 30, 2020, the Southern District of New York held that digital tokens (a form of cryptocurrency) constitute “securities” for purposes of the Securities Act of 1933. SEC v. Kik Interactive, 2020 WL 5819770 (S.D.N.Y. Sept. 30, 2020) (Hellerstein, J.).
The court noted that “the definition of security includes an investment contract.” Id. (citing 15 U.S.C. § 77b(a)(1)). In SEC v. W.J. Howey Co., 328 U.S. 239 (1946), the Supreme Court held that “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person” (i) “invests his money” (ii) “in a common enterprise” and (iii) “is led to expect profits solely from the efforts of the promoter or a third party.”
The court observed that “[f]ew courts in this Circuit have had the opportunity to apply Howey in the context of cryptocurrency,” and stated that it had “to decide this case without the benefit of direct precedent in relation to cryptocurrencies.” The court explained that “the definition of investment contract is 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.”
Because there was no dispute as to the first element of the Howey test (an investment of money), the court began by considering whether the investors participated in a “common enterprise.” The court found the “economic reality” was that the company “pooled proceeds from its sales of [the digital tokens] in an effort to create an infrastructure for [those tokens], and thus boost the value of the investment.” The court held that “[t]his is the nature of a common enterprise,” because “[t]he stronger the ecosystem that [the company] built, the greater the demand for [the digital tokens], and thus the greater the value of each purchaser’s investment.”
The court rejected defendant’s contention that no common enterprise existed because the company “expressly disclaimed any ongoing obligation to [investors] after the distribution of their [digital tokens].” The court explained that “an ongoing contractual obligation is not a necessary requirement for a finding of a common enterprise.” The court also found “not dispositive” “the fact that [investors] could sell their [digital tokens] whenever they pleased.” The court noted that “the key feature is not that investors must reap their profits at the same time; it is that investors’ profits at any given time are tied to the success of the enterprise.” The court underscored that “[t]his is not a scenario where the funds of each investor were segregated and separately managed, allowing for profits to remain independent.”
The court next considered whether the investment came “with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Under Second Circuit precedent, the court explained that it was required to “consider whether, under all the circumstances, the scheme was being promoted primarily as an investment.” Id. (quoting United States v. Leonard, 529 F.3d 83 (2d Cir. 2008)).
The court noted that “[i]n public statements and at public events promoting [the cryptocurrency], [the company] extolled [the digital tokens’] profit-making potential.” The company’s CEO emphasized that “as demand increased, the value of [the digital tokens] would increase, and early purchasers would have the opportunity to earn a profit.” The court found that “[t]he demand for [the digital tokens], and thus the value of the investment, would not grow on its own.” Rather, “[g]rowth would rely heavily on [the company’s] entrepreneurial and managerial efforts.” The court concluded that the cryptocurrency therefore “satisfies this element of the Howey test.”
Finally, the court found meritless defendant’s argument that the term “investment contract” was unconstitutionally vague as applied to the digital tokens. The court explained that “Howey is an objective test that provides the flexibility necessary for the assessment of a wide range of investment vehicles.” Although the SEC had not “issue[d] guidance on securities enforcement related specifically to cryptocurrencies” or brought “enforcement actions against other issuers of digital tokens,” the court found “the law does not require the Government to reach out and warn all potential violators on an individual or industry level.”