The Howey test uses three elements to determine whether a contract is a security, and therefore subject to SEC jurisdiction for reporting and other requirements.
An investment contract is a security when it is purchased with
1) an expectation of profits arising from 2) a common enterprise that 3) depends on the efforts of others.
328 U.S. 293 (1946)1
MR. JUSTICE MURPHY delivered the opinion of the Court.
This case involves the application of § 2 (1) of the Securities Act of 1933[1] to an offering of units of a citrus grove development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor.
The Securities and Exchange Commission instituted this action to restrain the respondents from using the mails and instrumentalities of interstate commerce in the offer and sale of unregistered and non-exempt securities in violation of § 5 (a) of the Act. The District Court denied the injunction, 60 F. Supp. 440, and the Fifth Circuit Court of Appeals affirmed the judgment, 151 F.2d 714. We granted certiorari on a petition alleging that the ruling of the Circuit Court of Appeals conflicted with other federal and state decisions and that it introduced a novel and unwarranted test under the statute which the Commission regarded as administratively impractical.
Most of the facts are stipulated. The respondents, W.J. Howey Company and Howey-in-the-Hills Service, 295*295 Inc., are Florida corporations under direct common control and management. The Howey Company owns large tracts of citrus acreage in Lake County, Florida. During the past several years it has planted about 500 acres annually, keeping half of the groves itself and offering the other half to the public “to help us finance additional development.” Howey-in-the-Hills Service, Inc., is a service company engaged in cultivating and developing many of these groves, including the harvesting and marketing of the crops.
Each prospective customer is offered both a land sales contract and a service contract, after having been told that it is not feasible to invest in a grove unless service arrangements are made. While the purchaser is free to make arrangements with other service companies, the superiority of Howey-in-the-Hills Service, Inc., is stressed. Indeed, 85% of the acreage sold during the 3-year period ending May 31, 1943, was covered by service contracts with Howey-in-the-Hills Service, Inc.
The land sales contract with the Howey Company provides for a uniform purchase price per acre or fraction thereof, varying in amount only in accordance with the number of years the particular plot has been planted with citrus trees. Upon full payment of the purchase price the land is conveyed to the purchaser by warranty deed. Purchases are usually made in narrow strips of land arranged so that an acre consists of a row of 48 trees. During the period between February 1, 1941, and May 31, 1943, 31 of the 42 persons making purchases bought less than 5 acres each. The average holding of these 31 persons was 1.33 acres and sales of as little as 0.65, 0.7 and 0.73 of an acre were made. These tracts are not separately fenced and the sole indication of several ownership is found in small land marks intelligible only through a plat book record.
296*296 The service contract, generally of a 10-year duration without option of cancellation, gives Howey-in-the-Hills Service, Inc., a leasehold interest and “full and complete” possession of the acreage. For a specified fee plus the cost of labor and materials, the company is given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. The company is well established in the citrus business and maintains a large force of skilled personnel and a great deal of equipment, including 75 tractors, sprayer wagons, fertilizer trucks and the like. Without the consent of the company, the land owner or purchaser has no right of entry to market the crop;[2] thus there is ordinarily no right to specific fruit. The company is accountable only for an allocation of the net profits based upon a check made at the time of picking. All the produce is pooled by the respondent companies, which do business under their own names.
The purchasers for the most part are non-residents of Florida. They are predominantly business and professional people who lack the knowledge, skill and equipment necessary for the care and cultivation of citrus trees. They are attracted by the expectation of substantial profits. It was represented, for example, that profits during the 1943-1944 season amounted to 20% and that even greater profits might be expected during the 1944-1945 season, although only a 10% annual return was to be expected over a 10-year period. Many of these purchasers are patrons of a resort hotel owned and operated by the Howey Company in a scenic section adjacent to the groves. The hotel’s advertising mentions the fine groves in the vicinity and the attention of the patrons is drawn to the 297*297 groves as they are being escorted about the surrounding countryside. They are told that the groves are for sale; if they indicate an interest in the matter they are then given a sales talk.
It is admitted that the mails and instrumentalities of interstate commerce are used in the sale of the land and service contracts and that no registration statement or letter of notification has ever been filed with the Commission in accordance with the Securities Act of 1933 and the rules and regulations thereunder.
Section 2 (1) of the Act defines the term “security” to include the commonly known documents traded for speculation or investment.[3] This definition also includes “securities” of a more variable character, designated by such descriptive terms as “certificate of interest or participation in any profit-sharing agreement,” “investment contract” and “in general, any interest or instrument commonly known as a `security.’” The legal issue in this case turns upon a determination of whether, under the circumstances, the land sales contract, the warranty deed and the service contract together constitute an “investment contract” within the meaning of § 2 (1). An affirmative answer brings into operation the registration requirements of § 5 (a), unless the security is granted an exemption under § 3 (b). The lower courts, in reaching a negative answer to this problem, treated the contracts and deeds 298*298 as separate transactions involving no more than an ordinary real estate sale and an agreement by the seller to manage the property for the buyer.
The 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 other than themselves.[4]
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 crystallized 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 299*299 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 S.E.C. v. Joiner Corp., 320 U.S. 344, and has been enunciated and applied many times by lower federal courts.[5] 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, 73d 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.
The transactions in this case clearly involve investment contracts as so defined. The respondent companies are offering something more than fee simple interests in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents. They are offering this opportunity to persons who reside in distant localities and who lack the equipment 300*300 and experience requisite to the cultivation, harvesting and marketing of the citrus products. Such persons have no desire to occupy the land or to develop it themselves; they are attracted solely by the prospects of a return on their investment. Indeed, individual development of the plots of land that are offered and sold would seldom be economically feasible due to their small size. Such tracts gain utility as citrus groves only wlen cultivated and developed as component parts of a larger area. A common enterprise managed by respondents or third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments. Their respective shares in this enterprise are evidenced by land sales contracts and warranty deeds, which serve as a convenient method of determining the investors’ allocable shares of the profits. The resulting transfer of rights in land is purely incidental.
Thus all the elements of a profit-seeking business venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise. It follows that the arrangements whereby the investors’ interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed. The investment contracts in this instance take the form of land sales contracts, warranty deeds and service contracts which respondents offer to prospective investors. And respondents’ failure to abide by the statutory and administrative rules in making such offerings, even though the failure result from a bona fide mistake as to the law, cannot be sanctioned under the Act.
This conclusion is unaffected by the fact that some purchasers choose not to accept the full offer of an investment contract by declining to enter into a service contract with 301*301 the respondents. The Securities Act prohibits the offer as well as the sale of unregistered, non-exempt securities.[6] Hence it is enough that the respondents merely offer the essential ingredients of an investment contract.
We reject the suggestion of the Circuit Court of Appeals, 151 F.2d at 717, that an investment contract is necessarily missing where the enterprise is not speculative or promotional in character and where the tangible interest which is sold has intrinsic value independent of the success of the enterprise as a whole. The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value. See S.E.C. v. Joiner Corp., supra, 352. The statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae.
Is there a common enterprise? Common to who?
Does the value of the smart contract depend on the efforts of others? Which others? The original coder, the forker, the marketer, or the similarly situated purchasers?
Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946), available at https://scholar.google.com/scholar_case?case=12975052269830471754 ↩
87 F.3d 536 (D.C.Cir. 1996)1
A viatical settlement is an investment contract pursuant to which an investor acquires an interest in the life insurance policy of a terminally ill person — typically an AIDS victim — at a discount of 20 to 40 percent, depending upon the insured’s life expectancy. When the insured dies, the investor receives the benefit of the insurance. The investor’s profit is the difference between the discounted purchase price paid to the insured and the death benefit collected from the insurer, less transaction costs, premiums paid, and other administrative expenses.
Life Partners, Inc., under the direction of its former president and current chairman 538*538 Brian Pardo, arranges these transactions and performs certain post-transaction administrative services. The SEC contends that the fractional interests marketed by LPI are securities, and that LPI violated the Securities Act of 1933 and the Securities Exchange Act of 1934 by selling them without first complying with the registration and other requirements of those Acts. The district court agreed and preliminarily enjoined LPI from making further sales.
LPI argues that […] the fractional interests sold by LPI are not in any event securities within the meaning of the 1933 and 1934 Acts. LPI asserts alternatively that it could modify its program so as to come within a safe harbor exemption for private offerings under SEC Rule 506, 17 C.F.R. § 230.506.
[…] Contrary to the district court, however, we conclude that LPI’s contracts are not securities subject to the federal securities laws because the profits from their purchase do not derive predominantly from the efforts of a party or parties other than the investors [..]
I. Background
[…]
Although some promoters of viatical settlements do register them as securities under the federal securities laws, LPI observes that registration means higher costs for investors and correspondingly lower prices for terminally ill policyholders, and objects that any significant administrative delay — even if the Commission were, for example, to permit the offeror to use one master registration and to make only a supplemental filing pertaining to each policy in which it proposes to sell fractional interests—might be fatal in this time-sensitive context. The Commission concedes that some policy-by-policy disclosure of risk factors would be required but ventures that the burden would not be prohibitive. The Commission also notes that some firms have sought and obtained an exemption from the federal securities laws for their viatical contracts; presumably a firm might also buy insurance policies for its own account or act as an agent, matching a single investor with a terminally ill insured, without running afoul of the securities laws.
That is not how LPI does business, however. LPI sells fractional interests in insurance policies to retail investors, who may pay as little as $650 and buy as little as 3% of the benefits of a policy. In order to reach its customers, LPI uses some 500 commissioned “licensees,” mostly independent financial planners. For its efforts, LPI’s net compensation is roughly 10% of the purchase price after payment of referral and other fees. Pardo claims that LPI is by far the largest of about 60 firms serving the rapidly growing market for viatical settlements; in 1994 the company accounted for more than half of the industry’s estimated annual revenues of $300 million. The company is 95% beneficially owned by Pardo through a trust, and 5% owned by Dr. Jack Kelly, who performs medical evaluations of policyholders on LPI’s behalf.
LPI was also the first company to develop a plan by which an investor could participate in a viatical settlement through an Individual Retirement Account. In order to circumvent the Internal Revenue Code prohibition upon IRAs investing in life insurance contracts, LPI structures the purchase through a separate trust established for that purpose. The IRA lends money to the trust, for which it receives a non-recourse note; the trust then uses the loan proceeds to purchase an interest in a life insurance policy, the death benefits of which collateralize the note. When the insured dies and the benefits are paid, the proceeds go to pay off the note held by the IRA.
[…] Also, once an investor acquired an interest in a policy he could avail himself of LPI’s on-going administrative services, which included monitoring the insured’s health, assuring that the policy did not lapse, converting a group policy into an individual policy where required, and arranging for resale of the investor’s interest when so requested and feasible.
Sterling Trust Company, an independent escrow agent acting for LPI, actually performed most of these post-purchase administrative functions. When the purchase closed, Sterling collected its own fee and that of LPI, escrowed funds for expected premium payments, and delivered the balance to the seller. Thereafter Sterling held the policy, held and disbursed all funds, ensured that all paperwork was in order, and filed the death claim. If an investor designated Sterling as the beneficiary, then Sterling also collected and distributed the death benefits. LPI had no continuing economic interest in the transaction after receipt of its fee upon the sale to the investor.
[…]
II. Analysis […] We proceed to consider whether the fractional interests promoted by LPI are “securities” within the meaning of that Act using the three-part test prescribed in SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), in which each investor acquired an individual parcel of citrus fruit acreage together with a portion of the profits arising from the promoter’s management of the citrus grove, id. at 295-96, 66 S.Ct. at 1101-02. The Supreme Court held in Howey that an investment contract is a security if the investors (1) expect profits from (2) a common enterprise that (3) depends upon the efforts of others. Id. at 298-99, 66 S.Ct. at 1102-03. Because LPI’s contracts fail the third element of this test, we hold that they are not securities. Finally, we go on to address LPI’s program for the sale of viatical settlements to IRAs; the issue there is whether the notes used to facilitate such purchases are themselves securities even though the underlying viatical settlements are not. We conclude that because the notes 541*541 do not change the economic substance of the transaction they are not securities.
These are all questions of law and we review them all de novo. See Delaware and Hudson Ry. Co. v. United Transp. Union, 450 F.2d 603, 620 (D.C.Cir.1971) (“Insofar as the action of the trial judge on a request for preliminary injunction rests on a premise as to the pertinent rule of law, that premise is reviewable fully and de novo”).
[…]
B. The Three-Part Test of Howey We turn next to the question whether the LPI contracts are properly characterized as securities within the terms of the 1933 Act. That determination is controlled by the Supreme Court’s decision in Howey which, as stated above, holds that an investment contract is a security subject to the Act if investors purchase with (1) an expectation of profits arising from (2) a common enterprise that (3) depends upon the efforts of others. 328 U.S. at 298-99, 66 S.Ct. at 1102-03. To the extent practical we examine each component of the test separately.
The SEC argues that the profits test requires only that “the investor could lose his investment, or that the value of his return could fluctuate,” quoting Guidry v. Bank of LaPlace, 954 F.2d 278, 284 (5th Cir.1992), and that, although the death benefit that an investor gets from a viatical settlement is in a fixed dollar amount, the profitability of the investment can vary because of the uncertain interval of time between the date of investment and the date of the insured’s death. The insured’s life span affects profitability in two ways: First, the annualized rate of return depends upon the length of the investment. Second, unless there has been a waiver of premiums pursuant to the terms of the insurance policy, the amount of the investor’s outlay for premiums depends upon the insured’s life span.
Arguing against the profits test as set forth in Guidry — which, by the way, is unclear about whether possible loss and fluctuating return are sufficient or merely necessary conditions — LPI maintains that under United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 95 S.Ct. 2051, 2060, 44 L.Ed.2d 621 (1975), profits must be derived from “either capital appreciation resulting from the development of the initial investment … or a participation in earnings resulting from the use of the investors’ 543*543 funds,” neither of which obtains with respect to viatical contracts. At oral argument the SEC asserted that even under this formulation viatical settlements satisfy the profits test of Howey because they appreciate in value — presumably because the insured’s death draws nearer with the passage of time, thus increasing the present value of the death benefit. The Commission’s reading of Forman, however, starkly omits the requirement that the capital appreciation result “from the development of the initial investment.” Id. The increased value of a viatical contract requires no “development” at all; it depends entirely upon the inexorable passage of time and the inevitable death of the insured.
On the other hand, the definition in Forman was apparently intended only to summarize the cases that had by then come before the Court — not, as LPI implies, to preempt future development upon the basis of further experience. In full context, this is what the Court said:
By profits, the Court has meant either capital appreciation resulting from the development of the initial investment, as in [SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 349, 64 S.Ct. 120, 122, 88 L.Ed. 88 (1943)] (sale of oil leases conditioned on promoters’ agreement to drill exploratory well), or a participation in earnings resulting from the use of investors’ funds, as in Tcherepnin v. Knight, [389 U.S. 332, 339, 88 S.Ct. 548, 554-55, 19 L.Ed.2d 564 (1967)] (dividends on the investment based on savings and loan association’s profits). In such cases the investor is “attracted solely by the prospects of a return” on his investment. Howey, supra, [328 U.S.] at 300 [66 S.Ct. at 1103-04]. By contrast, when a purchaser is motivated by a desire to use or consume the item purchased — “to occupy the land or to develop it themselves,” as the Howey Court put it, ibid. — the securities laws do not apply. 421 U.S. at 852-53, 95 S.Ct. at 2060-61. If the examples of Joiner and Tcherepnin were exhaustive, then the concept of profits would exclude, for example, the return on an investment in a residential mortgage or in any form of consumer loan — neither of which ordinarily involves capital appreciation or earnings resulting from the use of the investors’ funds. Both activities are undertaken in the expectation of profits, however, at least as that term is commonly understood.
The Court’s general principle we think, is only that the expected profits must, in conformity with ordinary usage, be in the form of a financial return on the investment, not in the form of consumption. This principle distinguishes between buying a note secured by a car and buying the car itself.
The asset acquired by an LPI investor is a claim on future death benefits. The buyer is obviously purchasing not for consumption— unmatured claims cannot be currently consumed — but rather for the prospect of a return on his investment. As we read the Forman gloss on Howey, that is enough to satisfy the requirement that the investment be made in the expectation of profits.
The second element of the Howey test for a security is that there be a “common enterprise.” So-called horizontal commonality — defined by the pooling of investment funds, shared profits, and shared losses — is ordinarily sufficient to satisfy the common enterprise requirement. See, e.g., Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir.1994). Here, LPI brings together multiple investors and aggregates their funds to purchase the death benefits of an insurance policy. If the insured dies in a relatively short time, then the investors realize profits; if the insured lives a relatively long time, then the investors may lose money or at best fail to realize the return they had envisioned; i.e., they experience a loss of the return they could otherwise have realized in some alternative investment of equivalent risk. Any profits or losses from an LPI contract accrue to all of the investors in that contract; i.e., it is not possible for one investor to realize a gain or loss without each other investor gaining or losing proportionately, based upon the amount that he invested. In that sense, the outcomes are shared among the investors; the sum that each receives is a predetermined portion of the aggregate death benefit.
LPI claims, however, that there is no pooling and therefore no shared profits or losses because each investor acquires his own interest in the policy. Moreover, there is no requirement that the entire policy be purchased. It seems to us that the pooling issue reduces to the question whether there is a threshold percentage of a policy that must be sold before an investor can be assured that his purchase of a smaller percentage interest will be consummated. If not, then each investor’s acquisition is independent of all the other investors’ acquisitions and LPI is correct in asserting that there is no pooling. On the other hand, if LPI must have investors ready to buy some minimum percentage of the policy before the transaction will occur, then the investment is contingent upon a pooling of capital.
When we raised this point at oral argument, the SEC contended that inter-dependency among investors was not necessary to a determination that their funds are pooled; the test, according to the Commission, is whether the funds are “commingled.” In this context, however, commingling in itself is but an administrative detail; it is the interdependency of the investors that transforms the transaction substantively into a pooled investment. (Indeed, if the investments are inter-dependent, it would not matter if LPI scrupulously avoided commingling the investors’ funds — for example, by passing their checks directly to the seller at the closing.) Meanwhile, counsel for LPI volunteered that the issue of selling some minimum acceptable percentage of a policy has never arisen because LPI has always attracted purchasers for the full interest being offered. He went on to acknowledge, however, that if the situation were to arise, LPI would allow the insured the option of withdrawing from the transaction. Such a practice would of course serve LPI’s interest as well as that of the policyholder. Many of the post-purchase administrative functions (e.g., monitoring the insured’s health, collecting the death benefit) involve costs that are seemingly invariant to the number of investors or the percentage of a policy that has been sold. Neither LPI nor the investors would be anxious to spread these costs over contracts representing much less than the full value of a policy.
Therefore, we think that pooling is in practice an essential ingredient of the LPI program; that is, any individual investor would find that the profitability if not the completion of his or her purchase depends upon the completion of the larger deal. Because LPI’s viatical settlements entail this implicit form of pooling, and because any profits or losses accrue to all investors (in proportion to the amount invested), we conclude that all three elements of horizontal commonality — pooling, profit sharing, and loss sharing — attend the purchase of a fractional interest through LPI. (We need not reach, therefore, the SEC’s alternate contention that the LPI program entails “strict vertical commonality” — another formulation of the common enterprise test recognized in some circuits. See, e.g., Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir.1978).)
Although horizontal commonality is ordinarily enough to make out the common enterprise required under the Howey test, in this instance LPI argues that commonality is not a sufficient condition because it is not obvious that there is an “enterprise” in the picture. For this LPI relies heavily upon Rodriguez v. Banco Central Corp., 990 F.2d 7, 10 (1993), in which the First Circuit held that “[e]ven if bought for investment, the land itself does not constitute a business enterprise.” In that case the investors purchased lots in Florida; the land had value in itself, and the seller had created no “enterprise” that would have an effect upon that value. LPI suggests that the investors in a viatical settlement likewise are buying only their fractional interest in the death benefit, not a share in a common business enterprise.
The SEC, for its part, would have us distinguish Rodriguez from the present case on the ground that here the promoter makes specific commitments effective after the investors purchase their interests. Indeed, the First Circuit did remark that “commitments and promises incident to a land transfer … can cross over the line and make the interest acquired one in an ongoing business enterprise.” Id. at 11. As the SEC’s response implies, however, LPI’s argument that there is no enterprise in the picture is more properly 545*545 addressed to the third part of the Howey test — whether profits are expected to arise from the efforts of others. We consider that question in the next section, where we take up the importance of the promoter’s post-purchase commitments.
The final requirement of the Howey test for an investment to be deemed a security is that the profits expected by the investor be derived from the efforts of others. In this connection, the SEC suggests that investors in LPI’s viatical settlements are essentially passive; their profits, the Commission argues, depend predominantly upon the efforts of LPI, which provides pre-purchase expertise in identifying existing policyholders and, together with Sterling, provides post-purchase management of the investment. Meanwhile, LPI argues that its pre-purchase functions are wholly irrelevant and that the post-purchase functions, by whomever performed, should not count because they are only ministerial. On this view, once the transaction closes, the investors do not look to the efforts of others for their profits because the only variable affecting profits is the timing of the insured’s death, which is outside of LPI’s and Sterling’s control.
By its terms Howey requires that profits be generated “solely” from the efforts of others. 328 U.S. at 298, 66 S.Ct. at 1102-03. Although the lower courts have given the Supreme Court’s definition of a security broader sweep by requiring that profits be generated only “predominantly” from the efforts of others, see, e.g., SEC v. International Loan Network, Inc., 968 F.2d 1304, 1308 (D.C.Cir.1992); Goodman v. Epstein, 582 F.2d 388, 408 n. 59 (7th Cir.1978), they have never suggested that purely ministerial or clerical functions are by themselves sufficient; indeed, quite the opposite is true. See, e.g., SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 (5th Cir.1974); SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir.1973) (efforts of others must be “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”). Because post-purchase entrepreneurial activities are the “efforts of others” most obviously relevant to the question whether a promoter is selling a “security,” we turn first to the distinction between those post-purchase functions that are entrepreneurial and those that are ministerial; thereafter, we consider the relevance of pre-purchase entrepreneurial services.
Ministerial versus entrepreneurial functions, post-purchase.
In Version I of its program, LPI and not the investor could appear as the owner of record of the insurance policy. LPI’s ownership gave it the ability, post-purchase, to change the party designated as the beneficiary of the policy, indeed to substitute itself as beneficiary. That ability tied the fortunes of the investors more closely to those of LPI in the sense that it made the investors dependent upon LPI’s continuing to deal honestly with them, at least to the extent of not wrongfully dropping them as beneficiaries.
This does not, however, establish an association between the profits of the investors and the “efforts” of LPI. Nothing that LPI could do by virtue of its record ownership had any effect whatsoever upon the near-exclusive determinant of the investors’ rate of return, namely how long the insured survives. Only if LPI misappropriated the investors’ funds, or failed to perform its post-purchase ministerial functions, would it affect the investors’ profits. Such a possibility provides no basis upon which to distinguish securities from non-securities. The promoter’s “efforts” not to engage in criminal or tortious behavior, or not to breach its contract are not the sort of entrepreneurial exertions that the Howey Court had in mind when it referred to profits arising from “the efforts of others.”
In Version II LPI no longer appeared as the record owner of a policy, but LPI and Sterling continued to offer the following post-purchase services: holding the policy, monitoring the insured’s health, paying premiums, converting a group policy into an individual policy where required, filing the death claim, collecting and distributing the death benefit (if requested), and assisting an investor who might wish to resell his interest. LPI characterizes these functions as clerical and routine in nature, not managerial or entrepreneurial, and therefore unimportant to the source of investor expectations; in sum, anyone including the investor himself could supply these services. The district court seemed to agree with LPI about the character if not the significance of most post-purchase services, for it described them as “often ministerial in nature.”
The Commission disputes the district court’s characterization of post-purchase services as ministerial, but attempts to portray only one service in particular as entrepreneurial: we refer to the secondary market that LPI purportedly makes. By establishing a resale market, according to the SEC, LPI links the profitability of the investments it sells to the success of its own efforts. We find this argument unconvincing for several reasons. First, there is no evidence in the record before us that investors actually seek to liquidate their investments prior to the receipt of death benefits. Second, there is no evidence that LPI’s potential assistance adds value to the investment contract; an investor could, for all that appears, get the same help with resale (if any is needed) through any one of the many firms that sell viatical settlements. Third, LPI is quite specific in warning its clients that viatical transactions are not liquid assets. There is no established market for the resale of such policies. They should be purchased only by persons who are willing and able to hold the policy until it matures…. Life Partners’ present practice is to assist in the resale of policies purchased by its clients [but] … [t]here is no guarantee that any policy can be resold, or that resale, if it occurs, will be at any given price. LPI’s promise of help in arranging for the resale of a policy is not an adequate basis upon which to conclude that the fortunes of the investors are tied to the efforts of the company, much less that their profits derive “predominantly” from those efforts.
In Version III LPI provides no post-purchase services. All such services are the sole responsibility of the investors, who may purchase them from Sterling or not, as they choose. The district court minimized the significance of this choice, stating that “it is neither realistic nor feasible for multiple investors, who are strangers to each other, to perform post-purchase tasks without relying on the knowledge and expertise of a third party [and] the third party in this case will almost certainly be Sterling.” Even if we accept this assessment, it does not alter our analysis. As we have seen, none of Sterling’s post-purchase services can meaningfully affect the profitability of the investment. It is therefore of no moment whether Sterling performs those services usually or always, or whether it does so as the agent of LPI or as the agent of the investor.
In sum, the SEC has not identified any significant non-ministerial service that LPI or Sterling performs for investors once they have purchased their fractional interests in a viatical settlement. Nor do we find that any of the ministerial functions have a material impact upon the profits of the investors. Therefore, we turn to the question whether LPI’s pre-purchase services count as “the efforts of others” under the Howey test.
Entrepreneurial functions, pre-purchase. LPI’s assertion that its pre-purchase efforts are irrelevant receives strong, albeit implicit, support from the Ninth Circuit decision in Noa v. Key Futures, Inc., 638 F.2d 77 (1980) (per curiam). In that case, which involved investments in silver bars, the court observed that the promoter made pre-purchase efforts to identify the investment and to locate prospective investors; offered to store the silver bars at no charge for a year after purchase and to repurchase them at the published spot price at any time without charging a brokerage fee. The court concluded, however, that these services were only minimally related to the profitability of the investment: “Once the purchase … was made, the profits to the investor depended upon the fluctuations of the silver market, not the managerial efforts of [the promoter].” Id. at 79-80.
The Tenth Circuit applied the same principle (to reach a different result) with respect to an investment in undeveloped land. McCown v. Heidler, 527 F.2d 204 (1975). In that case, the plaintiffs claimed that the parcels they had purchased were securities. In marketing the parcels to potential investors 547*547 the promoters had promised to make future improvements to the lots. “[W]ithout the substantial improvements pledged by [the promoters] the lots would not have a value consistent with the price which purchasers paid…. The utilization of purchase money accumulated from lot sales to build the promised improvements” could bring the scheme within the purview of the securities laws. Id. at 211.
In both Noa and McCown, the courts of appeals regarded the promoter’s pre-purchase efforts as insignificant to the question whether the investments — in silver bars and parcels of land, respectively — were securities. The different outcomes trace wholly to the promoters’ commitment to perform meaningful post-purchase functions in McCown but not in Noa.
In the present case, the district court distinguished Noa on the ground that, because silver is a fungible commodity, the promoter’s pre-purchase efforts were inconsequential; LPI, in contrast, performed highly specialized functions in identifying and evaluating individual policies suitable for purchase by investors. Still, the district court declared (in its January 1996 opinion) that “pre-purchase activities cannot alone support a finding that investors’ profits derive from the activities of LPI.” Instead, the court relied upon the “pre-closing activities in addition to the post-closing activities that LPI continues to perform.”
The Commission at oral argument tried to distance itself from Noa on roughly the same ground, arguing that an investor could, without great effort, independently evaluate the silver bars in that case, whereas an LPI investor would have considerably greater difficulty, especially in those instances where the terminally ill insured insists upon anonymity until the closing of the sale. LPI counters that its investors also play an active pre-purchase role in setting their own purchase criteria (such as the insured’s life expectancy and the minimum acceptable risk rating of the insurer) and reviewing the insured’s health profile and his insurance policy. Even if true, the district court appropriately characterized LPI’s pre-purchase efforts as “undeniably essential to the overall success of the investment.” The investors rely heavily, if not exclusively, upon LPI to locate insureds and to evaluate them and their policies, as well as to negotiate an attractive purchase price.
The SEC urges us to go even further than did the district court, however, in appraising the significance of LPI’s pre-purchase activities insofar as they count toward “the efforts of others.” The Commission reminds us that the Supreme Court did not draw a bright line distinction in Howey between pre- and post-purchase efforts, and notes that LPI may continue to perform some functions, such as preparing the preliminary agreement and evaluating the insured’s policy and medical file, right up to the closing of the transaction. Therefore it would be hypertechnical, according to the Commission, to discount the importance of LPI’s pre-purchase entrepreneurial functions simply because they occur before the moment of closing.
Absent compelling legal support for the Commission’s theory — and the Commission actually furnishes no support at all — we cannot agree that the time of sale is an artificial dividing line. It is a legal construct but a significant one. If the investor’s profits depend thereafter predominantly upon the promoter’s efforts, then the investor may benefit from the disclosure and other requirements of the federal securities laws. But if the value of the promoter’s efforts has already been impounded into the promoter’s fees or into the purchase price of the investment, and if neither the promoter nor anyone else is expected to make further efforts that will affect the outcome of the investment, then the need for federal securities regulation is greatly diminished. While, to be sure, coverage under the 1933 Act might increase the quantity (and perhaps the quality) of information available to the investor prior to the closing, “the securities laws [are not] a broad federal remedy for all fraud.” Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S.Ct. 1220, 1223, 71 L.Ed.2d 409 (1982). They are concerned only with securities fraud, and the question before us is the threshold question whether a fractional interest in a viatical settlement is a security. To answer that question we look for “an investment in a 548*548 common venture” with profits “derived from the entrepreneurial or managerial efforts of others.” Forman, 421 U.S. at 852, 95 S.Ct. at 2060.
We see here no “venture” associated with the ownership of an insurance contract from which one’s profit depends entirely upon the mortality of the insured — just as the First Circuit saw no “enterprise” associated with holding land for investment in Rodriguez, 990 F.2d at 10. Nor is the combination of LPI’s pre-purchase services as a finder-promoter and its largely ministerial post-purchase services enough to establish that the investors’ profits flow predominantly from the efforts of others.[*]
While we doubt that pre-purchase services should ever count for much, for present purposes we need only agree with the district court that pre-purchase services cannot by themselves suffice to make the profits of an investment arise predominantly from the efforts of others, and that ministerial functions should receive a good deal less weight than entrepreneurial activities. The SEC (like the district court) has identified no post-purchase service provided by LPI or Sterling that could fairly be characterized as entrepreneurial and combined with LPI’s pre-purchase services to affect the outcome of the Howey test. Nor has the Commission pointed to a single case in which an investment vehicle was deemed a security subject to the federal securities laws although the investor did not look to the promoter (or another party) to provide significant post-purchase efforts.
In this case it is the length of the insured’s life that is of overwhelming importance to the value of the viatical settlements marketed by LPI. As a result, the SEC is unable to show that the promoter’s efforts have a predominant influence upon investors’ profits; and because all three elements of the Howey test must be satisfied before an investment is characterized as a security, Revak, 18 F.3d at 87, we must conclude that the viatical settlements marketed by LPI are not securities.
C. The LPI Program for IRA Investments in Viatical Settlements Finally, we must resolve the question, which the district court did not reach, whether the notes issued under the company’s IRA program might be securities even though the underlying fractional interests in viatical settlements are not. In brief, the program is structured as follows: LPI establishes a separate trust for each investor’s IRA; the trust borrows money from the IRA and issues a non-recourse note in exchange. The trust uses the loan proceeds to invest in a viatical contract, the death benefits of which collateralize the note. When the death benefits are ultimately paid, the trust distributes them to the IRA in satisfaction of the note.
The SEC urges that we decide whether the notes are securities by application of the “family resemblance test” of Reves v. Ernst & Young, 494 U.S. 56, 65, 110 S.Ct. 945, 951, 108 L.Ed.2d 47 (1990), pursuant to which a note is deemed to be a security unless it resembles one of a list of instruments that are not securities. Because we have already determined, however, that the underlying viatical contracts are not securities, and because the essential characteristics of the investment are no different whether the purchaser is an IRA or an individual investor, the status of the notes under the 1933 Act does not require extended analysis.
The note is used in these transactions, as the SEC itself affirms in its brief, merely in order to navigate around certain restrictions 549*549 in the tax code that preclude IRAs from investing in life insurance contracts. If the individual who owns the IRA wants to invest the IRA’s capital in a viatical settlement, then the note is nothing more than a device by which to make that investment in a form that complies with the tax code; use of the note does not alter the substance of the transaction in any manner that would suggest a role for the securities laws that is not otherwise indicated by law. In this we follow directly the teaching of the Supreme Court: “[I]n 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.” Tcherepnin, 389 U.S. at 336, 88 S.Ct. at 553. Applying this precept, we hold that the notes — like the viatical contracts for which they stand — are not securities.
III. Summary and Conclusion […] LPI maintains that the fractional interests which it sells to investors are not securities within the meaning of the 1933 Act, as controlled by the Supreme Court’s decision in Howey. In Parts II.B(1) and II.B(2), respectively, we conclude that LPI’s contracts meet two parts of the Howey test: investors purchase the contracts with an expectation of profits; and they pool their funds, then share any profits or losses that arise. In Part II.B(3), however, we hold that fractional interests in viatical settlements, in any of the three versions marketed or proposed by LPI, are not securities. The combination of LPI’s pre-purchase services as a finder-promoter and its largely ministerial post-purchase services is not enough to satisfy the third requirement in Howey: the investors’ profits do not flow predominantly from the efforts of others.
Does an expectation of profits require the taking on of financial risk on the part of the purchaser?
“A desire to use or consume”. The D.C. Circuit said “When a purchaser is motivated by a desire to use or consume the item purchased — “to occupy the land or to develop it themselves,” as the Howey Court put it, ibid. — the securities laws do not apply. This principle distinguishes between buying a note secured by a car and buying the car itself.”
What about NFTs? Does the specific intent of each purchaser need to be examined to see if there is an expectation of profits, or should they be considered as a class? What if there is no difference between the note securing the car, and the car itself?
What exactly is horizontal commonality? Why is it sufficient to show a common enterprise? The D.C. Circuit is focused on LPI’s efforts to pool investment resources as showing a common enterprise. What if the investors were brought together by an algorithm? An algorithm coded by LPI? [TO DISCUSS FURTHER], “pooling, profit sharing, and loss sharing” and vertical commonality in Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir.1978).
What is the difference between ‘entrepreneurial’ and ‘ministerial’ efforts, and why should this be a possible distinction over which SEC jurisdiction hangs? [TO DISCUSS FURTHER, paragraph on Ethereum oracles like chain.link]. Are Ethereum oracles ministerial or entreprenuerial? How about exchanges which facilitate the buying and selling of very thinly-traded cryptocurrencies?
SEC v. Life Partners, Inc., 87 F.3d 536 (D.C.Cir.1996), _available at https://scholar.google.com/scholar_case?case=15747911945175094719 ↩
448 F.Supp.3d 352 (2020)1
CASTEL, United States District Judge.
The Securities and Exchange Commission (“SEC”) seeks to enjoin Telegram Group Inc. and TON Issuer Inc. (collectively “Telegram”) from engaging in a plan to distribute “Grams,” a new cryptocurrency, in what it considers to be an unregistered offering of securities. In early 2018, Telegram received $1.7 billion from 175 sophisticated entities and high net-worth individuals in exchange for a promise to deliver 2.9 billion Grams. Telegram contends that the agreements to sell the 2.9 billion Grams are lawful private placements of securities covered by an exemption from the registration requirement. In Telegram’s view, only the agreements with the individual purchasers are securities. Currently, the Grams will not be delivered to these purchasers until the launch of Telegram’s new blockchain, the Telegram Open Network (“TON”) Blockchain. Telegram views the anticipated resales of Grams by the 175 purchasers into a secondary public market via the TON Blockchain as wholly-unrelated transactions and argues they would not be the offering of securities.
The SEC sees things differently. The 175 initial purchasers are, in its view, “underwriters” who, unless Telegram is enjoined from providing them Grams, will soon engage in a distribution of Grams in the public market, whose participants would have been deprived of the information that a registration statement would reveal.
Cryptocurrencies (sometimes called tokens or digital assets) are a lawful means of storing or transferring value and may fluctuate in value as any commodity would. In the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community connected via blockchain technology, which itself is administered by this community of users rather than by a common enterprise, is not likely to be deemed a security under the familiar test laid out in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). The SEC, for example, does not contend that Bitcoins transferred on the Bitcoin blockchain are securities. The record developed on the motion for a preliminary injunction presents a very different picture.
The Court finds that the SEC has shown a substantial likelihood of success in proving that the contracts and understandings at issue, including the sale of 2.9 billion Grams to 175 purchasers in exchange for $1.7 billion, are part of a larger scheme to distribute those Grams into a secondary public market, which would be supported by Telegram’s ongoing efforts. Considering the economic realities under the Howey test, the Court finds that, in the context of that scheme, the resale of Grams into the secondary public market would be an integral part of the sale of securities without a required registration statement.
Telegram knew and understood that reasonable purchasers would not be willing to pay $1.7 billion to acquire Grams merely as a means of storing or transferring value. Instead, Telegram developed a scheme to maximize the amount initial purchasers would be willing to pay Telegram by creating a structure to allow these purchasers to maximize the value they receive upon resale in the public markets.
As part of its Howey analysis, the Court finds an implicit (though formally disclaimed) intention on the part of Telegram to remain committed to the success of the TON Blockchain post-launch. Indeed, Telegram, as a matter of fact rather than legal obligation, will be the guiding force behind the TON Blockchain for the immediate post-launch period while the 175 purchasers unload their Grams into the secondary market. As such, the initial 175 purchasers possess a reasonable expectation of profit based upon the efforts of Telegram because these purchasers expect to reap whopping gains from the resale of Grams in the immediate post-launch period. Under the Howey test, the series of contracts and understandings centered on Grams are a security within the meaning of the Securities Act of 1933 (the “Securities Act”).
[…]
FINDINGS OF FACT AND CONCLUSIONS OF LAW A. Telegram. In 2006, Pavel Durov founded VKontakte, a Russian version of Facebook. (Joint Stip. ¶ 9). With the help of Nikolai Durov, his brother and a skilled programmer, Pavel successfully built VKontakte into the largest Russian social media network. (Joint Stip. ¶¶ 11-13). Pavel accumulated a sizeable personal fortune before exiting VKontakte and leaving Russia over disputes with the Russian government. (Plaintiff’s Exhibit (“PX”) 18 at 2 (Doc. 122-18)); (Defs.’ Resp. to Pls.’ Counter-Statement at 51 (Doc. 120)).
In 2013, the Durov brothers founded Telegram and released Telegram Messenger, which remains Telegram’s signature product. (Joint Stip. ¶¶ 16, 23); (Defs.’ 56.1 Statement ¶¶ 42, 45 (Doc. 75)). Telegram is a private company, (Pl.’s 56.1 Statement ¶ 154 (Doc. 80)), and Pavel is its chief executive officer, (Joint Stip. ¶ 3). Messenger is a messaging app that offers end-to-end encryption and also contains a diverse ecosystem of groups, channels, and in-app commerce. (Joint Stip. ¶¶ 18-19, 22); (Doc. 80 at 1); (PX 18 at 7). Messenger is globally popular and currently has a monthly user base of approximately 300 million. (Doc. 75 ¶ 43). Messenger is also particularly popular among the cryptocurrency community and has been described as the “cryptocurrency world’s preferred messaging app.” (Joint Stip. ¶ 23); (Joint Exhibit (“JX”) 8 at 12 (Doc. 72-8)). Telegram was founded with non-profit goals, (JX 8 at 5), and states that Messenger will never charge user fees or introduce advertising on the app, (Joint Stip. ¶ 21). As such, Messenger has never produced any revenues, (PX 18 at 1, 5), and, excluding the present offering of Grams, the Durov brothers have never received any income from their wildly successful creation. (Joint Stip. ¶¶ 14-15).
[…]
B. The TON Blockchain and Grams.
In 2017, Telegram began development of a proprietary blockchain and digital asset.[2] (Doc. 75 ¶ 49). The Durov brothers believed that Telegram could learn from the mistakes of existing blockchains and, by correcting their flaws, enable Telegram’s new cryptocurrency to be the first to achieve truly widespread adoption. (Doc. 75 ¶¶ 46-48). Telegram’s proposed blockchain would be named the “Telegram Open Network” (“TON”) Blockchain and its native token would be called the “Gram.”[3] (Doc. 75 ¶¶ 49, 52).
As part of the offering materials distributed in connection with the 2018 Sales discussed below, Telegram released a White Paper, authored by Nikolai and dated January 18, 2018, that discussed the unique features of the proposed TON Blockchain. (Joint Stip. ¶ 90); (JX 13 (Doc. 72-13)). The TON Blockchain would operate as a “Proof of Stake” system, which would rely on validator nodes (computers running full versions of the TON Blockchain software) to authenticate new blocks and to vote on rule changes. (Joint Stip. ¶¶ 122-23, 125); (JX 13 at 10); (McKeon Report ¶ 86, 190 (Doc. 102-1)). Validators would earn Grams for their services and would be required to stake at least 100,000 Grams as collateral. (Joint Stip. ¶¶ 125, 127); (JX 13 at 44). Due to the capital and technical resources required, acting as a validator would be beyond the ability of the hypothetical mass market user of the TON Blockchain. (Herlihy Report ¶ 19); (JX 13 at 45 (“[O]ne definitely cannot mine new TON coins on a home computer, let alone a smartphone.”)).
According to the White Paper, at least initially, the supply of Grams would be limited to five billion, which would be held by Telegram. (Joint Stip. ¶ 138); (JX 13 at 129). Each Gram subsequently sold by Telegram would be priced according to a formula that was based on the number of publicly outstanding Grams and priced each Gram slightly higher than the last one sold. (Joint Stip. ¶¶ 144-46); (JX 13 at 129-31). The price produced by this formula is called the “Reference Price.” (Joint Stip. ¶ 144); (JX 13 at 129-30). If the market price of Grams fell below half of the Reference Price, Telegram (or the TON Foundation, discussed below), would have discretion to repurchase Grams and, by reducing the number of Grams in circulation, potentially prevent the market price from falling further. (Joint Stip. ¶ 122); (JX 13 at 131).
C. The 2018 Sales to Initial Purchasers.
In 2018, Telegram sold “interests in Grams” to 175 entities and high net worth individuals (the “Initial Purchasers”) in exchange for dollars or euros. (Joint Stip. ¶ 40); (Doc. 75 ¶ 100); (JX 11 § 2.3 (Doc. 72-11)). The agreements (the “Gram Purchase Agreements”) entitled the Initial Purchasers to receive an allotment of Grams upon the launch of the TON Blockchain. (Joint Stip. ¶ 140). Telegram sold to the Initial Purchasers in two rounds: the “Round One Sales” in January to February 2018 and the “Round Two Sales” in February to March 2018 (collectively, the “2018 Sales”). (Joint Stip. ¶¶ 41, 46, 54).
In the Round One Sales, Telegram sold approximately 2.25 billion Grams to 81 purchasers for $850 million, which included $385.5 million from 34 U.S. purchasers. (Joint Stip. ¶¶ 48-51); (JX 1 at 5 (Doc. 72-1)); (JX 9 at 17 (Doc. 72-9)). The Grams are to be delivered when, as, and if the TON Blockchain launches. The price per Gram was approximately $0.38. (Joint Stip. ¶ 87). The Gram Purchase Agreements for Round One Sales included a lockup provision, which bars resale of Grams after their delivery to the Initial Purchaser. (Joint Stip. ¶ 88). Three months after receiving the purchased and delivered Grams, the Round One Purchaser would be permitted to resell up to one quarter of its allotment of Grams. The remaining three quarters of the Grams would be free of restrictions in three equal tranches: 6, 12, and 18 months after the launch of the TON Blockchain. (Joint Stip. ¶ 88). By February 2, 2018, the SEC had contacted Telegram regarding the Round One Sales. (McGrath Decl., Ex. H (Doc. 83-8)); (McGrath Decl., Ex. K at 158:5-159:17 (Doc. 83-11)). On February 13, 2018, Telegram filed a Form D for the Round One Sales, claiming an exemption under Rule 506(c). (Joint Stip. ¶¶ 48, 52); (JX 1 at 6).
In the Round Two Sales, Telegram sold approximately 700 million Grams to 94 purchasers for $850 million, which included $39 million from five U.S. purchasers. (Joint Stip. ¶¶ 55-56); (JX 2 at 5 (Doc. 72-2)). The price per Gram was approximately $1.33. (Joint Stip. ¶ 94). Grams purchased in the Round Two Sales did not carry a lockup provision. (Joint Stip. ¶ 93). On March 29, 2018, Telegram filed a Form D for the Round Two Sales, claiming an exemption under Rule 506(c). (Joint Stip. ¶ 55); (JX 2 at 6). Because of the claimed exemptions, Telegram did not register or file a registration statement for the Round One Sales or the Round Two Sales. (Joint Stip. ¶¶ 58-59). In total, the 2018 Sales raised $1.7 billion in exchange for approximately 2.9 billion Grams, which equates to 58% of all Grams. (Joint Stip. ¶ 43); (Doc. 75 ¶¶ 102-03); (Doc. 80 ¶ 37).
In advance of the 2018 Sales, Telegram circulated to all Initial Purchasers as well as other prospective purchasers a set of promotional materials, which included, among other things, primers, the Gram Purchase Agreements, the January 18, 2018 White Paper, and an explanation of certain risk factors. (Joint Stip. ¶¶ 60-64). These materials detailed the technical specifications of the TON Blockchain and the Gram, the terms of the Gram Purchase Agreements, Telegram’s plans for distributing Grams and promoting Grams as a mass market cryptocurrency, as well as the financial opportunity presented by Grams. (Joint Stip. ¶¶ 60-104). In particular, the promotional materials specified that 4% of Grams would be reserved for the Telegram developers who were to build the TON Blockchain, including 1% for each Durov brother. (Joint Stip. ¶¶ 158-59); (JX 9 at 16). The developers’ Grams would be subject to a four-year lockup period post-launch. (Joint Stip. ¶ 160); (JX 9 at 18).
The 1% of Grams given to each Durov brother is not the full extent of their ability to profit from the 2018 Sales. Indeed, the offering materials specifically noted that Telegram retained full discretion to allocate the funds raised between the TON Blockchain, Messenger, and Telegram generally. (JX 15 at 7-8). While a portion of the $1.7 billion has been used to develop the TON Blockchain, counsel for Telegram made plain at oral argument that Telegram still reserves the right to dividend any unspent portion of the proceeds of the 2018 Sales to Telegram’s shareholders, i.e. the Durov brothers. As noted, Messenger charges no user fees and sells no advertising and, thus, the proceeds of the 2018 Sales stand to be a major source of the Durov brothers’ profit for their years-long development of Telegram and Messenger.
The offering materials further detailed plans to integrate the TON Blockchain with Messenger in order to “leverag[e] Telegram’s massive user base and developed ecosystem.” (JX 9 at 11). Specifically, Telegram stated that 10% of Grams would be reserved for use in post-launch incentive programs, which would encourage the widespread adoption of Grams. (Joint Stip. ¶ 163); (JX 9 at 16). Half of this pool, 5% of all Grams, will be “distributed on a first-come, first-served basis to users of Telegram Messenger” who request Grams via a process within Messenger. (Defs.’ Resp. Pl.’s 56.1 Statement ¶ 387 (Doc. 95)). Telegram also aimed to ensure that “[t]he Gram will serve as the principal currency for the in-app economy on [Messenger]” and that “Telegram’s existing ecosystem will offer simple ways of buying the TON coins (Grams) and a range of services to spend them on, driving demand for the cryptocurrency.” (JX 9 at 11, 13). The offering materials described Messenger-integrated applications to further mainstream adoption of the TON Blockchain. In particular, Telegram pitched that “[i]ntegrated into Telegram applications, the TON [W]allet is expected to become the world’s most adopted cryptocurrency wallet.”[4] (JX 9 at 11). Finally, the offering materials again emphasized that Telegram would use any proceeds raised to fund both the development of the TON Blockchain as well as the ongoing operations and expansion of Messenger. (JX 9 at 19).
Next, the promotional materials specified that Grams unallocated in the aforementioned plans and unsold in the 2018 Sales, an amount ultimately totaling 28% of Grams, would be allocated to a reserve pool, the TON Reserve. (Joint Stip. ¶ 162). Telegram stated its intention to create a non-profit foundation, the TON Foundation, to which it would transfer control of the TON Reserve as well as of governance functions for the TON Blockchain. (Joint Stip. ¶¶ 147, 151); (JX 15 at 8 (Doc. 72-15)); 363*363 (JX 9 at 20). However, Telegram noted that there was no timetable for creating the TON Foundation and stated that it might not be created at all. (Joint Stip. ¶ 148); (JX 15 at 8). If the TON Foundation is not formed, then the TON Reserve would purportedly be “locked for perpetuity.” (Doc. 75 ¶ 231).
[…]
D. Post-2018 Sales Actions.
Following receipt of funds from the 2018 Sales, Telegram began to develop the TON Blockchain and Grams. As discussed, Telegram also used funds from the 2018 Sales to maintain and expand Messenger. (Joint Stip. ¶¶ 144-45). In October 2019, Telegram was prepared to launch the TON Blockchain and distribute Grams to the Initial Purchasers by the end of the month. (Doc. 75 ¶ 219); (McGrath Decl., Ex. J (Doc. 83-10)). If Telegram did not deliver Grams to the Initial Purchasers by October 31, 2019, the Gram Purchase Agreements would have obligated Telegram to refund any remaining funds from the 2018 Sales. (Joint Stip. ¶ 116). After this litigation commenced, the deadline was extended to April 30, 2020. (Joint Stip. ¶ 117). Since then Telegram has also continued efforts to further develop the TON Blockchain. (Joint Stip. ¶ 210). On January 6, 2020, Telegram posted a public statement to its website regarding the TON Blockchain, which stated that “Telegram will have no control over TON” and that “Grams won’t help you get rich.” (Drylewski Decl., Ex. 3 at 1, 2 (Doc. 73-3)).
[…]
F. Section 5 Liability and the Howey Test.
Section 5 of the Securities Act prohibits the offer, sale, or delivery after sale of any security without an effective or filed registration statement. 15 U.S.C. § 77e(a), (c). As such, a prima facie case of a section 5 violation requires the SEC to show: (1) that no registration statement was in effect or filed; (2) defendant offered or sold a security; and (3) the offer or sale took place in interstate commerce. S.E.C. v. Cavanagh, 1 F. Supp. 2d 337, 361 (S.D.N.Y.), aff’d, 155 F.3d 129 (2d Cir. 1998). In this case, the foundational question is whether Telegram’s contract, transaction, or scheme amounts to an offer or sale of a security.
“Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.” S.E.C. v. Edwards, 540 U.S. 389, 393, 124 S.Ct. 892, 157 L.Ed.2d 813 (2004) (quoting Reves v. Ernst & Young, 494 U.S. 56, 61, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990)). As such, section 2(a)(1) of the Securities Act defines a “security” to include an “investment contract” as well as investment vehicles such as stocks and bonds.[6] 15 U.S.C. 77b(a)(1). Known as the Howey test, the Supreme Court defined an “investment contract” as “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.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946).
“The enterprise and the described materials, by the very nature of the operation of the securities laws, must be examined as of the time that the transaction took place, together with the knowledge and the objective intentions and expectations of the parties at that time.” S.E.C. v. Aqua-Sonic Prods. Corp., 524 F. Supp. 866, 876 (S.D.N.Y. 1981) (citing United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852-53, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975)), aff’d, 687 F.2d 577 (2d Cir. 1982); see also Finkel v. Stratton Corp., 962 F.2d 169, 173 (2d Cir. 1992) (“[A] a sale occurs for [Securities Act] purposes when the parties obligate[] themselves to perform what they had agreed to perform even if the formal performance of their agreement is to be after a lapse of time.'" (quoting Radiation Dynamics, Inc. v. Goldmuntz, 464 F.2d 876, 891 (2d Cir. 1972))).
This definition of 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.” Howey, 328 U.S. at 299, 66 S.Ct. 1100. In the analysis of purported investment contracts, “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, 19 L.Ed.2d 564 (1967); see also Forman, 421 U.S. at 849, 95 S.Ct. 2051 (stating that “Congress intended the application of [the securities laws] to turn on the economic realities underlying a transaction, and not on the name appended thereto”); Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027, 1034 (2d Cir. 1974) (asking “whether, in light of the economic reality and the totality of circumstances,” an instrument was an investment contract). Disclaimers, if contrary to the apparent economic reality of a transaction, may be considered by the Court but are not dispositive. S.E.C. v. SG Ltd., 265 F.3d 42, 54 (1st Cir. 2001).
The Howey test provides the mode of analysis for an unconventional scheme or contract alleged to fall within the securities laws. Howey itself determined that a “scheme” involving the sale of small tracts of land, evidenced by contracts of sale and warranty deeds, together with service contracts for the growing of oranges on the land amounted to an “investment contract” that was a “security.” Howey, 328 U.S. at 299-300, 66 S.Ct. 1100. Courts have found other schemes and contracts governing a range of intangible and tangible assets to be securities. Glen-Arden Commodities, 493 F.2d 1027 (whiskey casks); Miller v. Cent. Chinchilla Grp., Inc., 494 F.2d 414 (8th Cir. 1974) (chinchillas); Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019) (digital tokens).
[…]
H. The Gram Purchase Agreements and Associated Understandings and Undertakings, Including the Expected Resales into the Secondary Market, Are Viewed as One Scheme Under Howey.
Telegram argues that there are two distinct sets of transactions at issue in this case, one subject to the securities laws and one that is not. In Telegram’s view, the first set of transactions was the offers and sales of the “interests in Grams,” as embodied in the Gram Purchase Agreements, to the Initial Purchasers. While Telegram concedes that the Initial Purchasers’ “interest in a Grams” are a security, it claims an exemption from registration under Regulation D. Telegram argues that a second and distinct set of transactions will be the delivery of the newly created Grams to the Initial Purchasers upon the launch of the TON Blockchain. Telegram stresses that, because, upon launch, Grams would have “functional consumptive uses” (i.e. could be used to store or transfer value), Grams would be a commodity and, therefore, not subject to the securities laws. Specifically, Telegram notes that, upon receipt of their Grams, Round Two Purchasers, who are not subject to a contractual lockup period, would then be free to use Grams as a currency to purchase goods or services on the TON Blockchain or to stake their Grams to become validators.
The economic reality of Telegram’s course of conduct is straightforward and rather easily understood. Telegram entered into agreements and understandings with the Initial Purchasers who provided upfront capital in exchange for the future delivery of a discounted asset, Grams, which, upon receipt (and the expiration of the lockup periods for Round One Purchasers), would be resold in a public market with the expectation that the Initial Purchasers would earn a profit. A reasonable Initial Purchaser understands and expects that they will only profit if the reputation, skill, and involvement of Telegram and its founders remain behind the enterprise, including through the sale of Grams from the Initial Purchasers into the public market.
The Gram Purchase Agreements and the future delivery and resale of Grams are viewed in their totality for the purpose of the Howey analysis. In Howey, although the land purchase contracts and the service contracts were separate agreements that took effect at different points in time and a purchaser was not mandated to enter into both, the Court analyzed the entirety of the parties’ interaction, finding that the whole scheme comprised a single investment contract and, therefore, a security. Howey, 328 U.S. at 297-98, 66 S.Ct. 1100 (reversing the lower court’s decision to “treat[] the contracts and deeds as separate transactions”). This Court finds as a fact that the economic reality is that the Gram Purchase Agreements and the anticipated distribution of Grams by the Initial Purchasers to the public via the TON Blockchain are part of a single scheme.
I. The Series of Understandings, Transactions, and Undertakings Between Telegram and the Initial Purchasers Is a Security.
As discussed, “a contract, transaction or scheme” is deemed an investment contract if it satisfies the four prongs of the Howey test, namely (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) from the essential efforts of another. Howey, 328 U.S. at 298-99, 66 S.Ct. 1100. The Court finds that the SEC has shown a substantial likelihood of success in proving that, at the time of the offers and sales to the Initial Purchasers, a reasonable investor expected to profit from Telegram’s continued support for Grams and the underlying TON Blockchain through the distribution of Grams by the Initial Purchasers to the public. Therefore, the series of understandings, transactions, and undertakings between Telegram and the Initial Purchasers were investment contracts satisfying the Howey test and, therefore, are securities.
i. The Series of Understandings, Transactions, and Undertakings Should Be Evaluated as of the Time of the 2018 Sales.
Telegram argues that Grams should be evaluated under Howey at the time of their delivery to the Initial Purchasers, i.e. at the launch of the TON Blockchain. It asserts that it will not be part of a common enterprise and will not provide essential managerial efforts once the TON Blockchain is launched. The post-launch distribution of Grams by the Initial Purchasers, Telegram argues, is independent of any Telegram action. But Howey requires the Court to examine the series of understandings, transactions, and undertakings at the time they were made. The Court finds that the SEC has shown a substantial probability of success in proving that the series of understandings, transactions, and undertakings are investment contracts, and therefore are securities, under Howey.
Under the Securities Act, “[t]he term sale' or sell’ shall include every contract of sale or disposition of a security or interest in a security, for value.” 15 U.S.C. § 77b(a)(3). The Second Circuit has held that, for the purposes of the securities laws, a sale occurs when “the parties obligated themselves to perform what they had agreed to perform even if the formal performance of their agreement is to be after a lapse of time.” Radiation Dynamics, 464 F.2d at 891; see also Finkel, 962 F.2d at 173. “[A] contract for the issuance or transfer of a security may qualify as a sale under the securities laws even if the contract is never fully performed.” Yoder v. Orthomolecular Nutrition Inst., 751 F.2d 555, 559 (2d Cir. 1985); Vacold LLC v. Cerami, 545 F.3d 114, 122 (2d Cir. 2008) (stating that a sale occurs “even if the later exchange of money and securities is contingent upon the occurrence of future events, such as the satisfaction of a financing condition, at least when the contingency is not so unlikely that it renders the stock transaction extremely speculative” (citing Yoder, 751 F.2d at 559 & n.4)); Aqua-Sonic Prods. Corp., 524 F. Supp. at 876 (stating that a transaction “by the very nature of the operation of the securities laws, must be examined as of the time that the transaction took place” (citing Forman, 421 U.S. at 852-53, 95 S.Ct. 2051)), aff’d, 687 F.2d 577. Further, there can be little argument that an offer, as a unilateral act, occurs at the time it is made. 15 U.S.C. § 77b(a)(3) (“The term offer to sell', offer for sale’, or offer' shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.").
Based on its filed Forms D, Telegram offered and sold Grams to the Initial Purchasers in the Round One and Round Two Sales by, at latest, February 13, 2018 and March 29, 2018, respectively. (JX 1 at 6); (JX 2 at 6). Whether the scheme, viewed as a whole, amounts to a security will be evaluated at this point in time.
ii. Investment of Money.
The first prong of Howey examines whether an investment of money was part of the relevant transaction. In this case, the Initial Purchasers invested money by providing dollars or euros in exchange for the future delivery of Grams. (JX 11 § 2.3); (JX 12 § 2.3 (Doc. 72-12)). In total, the Initial Purchasers provided Telegram with approximately $1.7 billion in exchange for the promised delivery of 2.9 billion Grams upon the launch of the TON Blockchain. (Joint Stip. ¶¶ 43, 48, 55); (Doc. 75 ¶¶ 102-03). Telegram does not dispute that there was an investment of money by the Initial Purchasers and the Court finds that this element has been established.
iii. Common Enterprise.
The second prong of Howey, the existence of a common enterprise, may be demonstrated through either horizontal commonality or vertical commonality. Horizontal commonality is established when investors’ assets are pooled and the fortunes of each investor is tied to the fortunes of other investors as well as to the success of the overall enterprise. Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994); see also SG Ltd., 265 F.3d at 49 (describing “horizontal commonality” as “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”); ATBCOIN LLC, 380 F. Supp. 3d at 353. In contrast, strict vertical commonality “requires that the fortunes of investors be tied to the fortunes of the promoter.”[7] Revak, 18 F.3d at 88 (citing Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir. 1978)); see also In re J.P. Jeanneret Assocs., Inc., 769 F. Supp. 2d 340, 360 (S.D.N.Y. 2011) (stating “that strict vertical commonality (like horizontal commonality) is sufficient to establish a common enterprise under Howey”).
The SEC has shown horizontal commonality. After the 2018 Sales, Telegram pooled the money received from the Initial Purchasers and used it to develop the TON Blockchain as well as to maintain and expand Messenger. (Joint Stip. ¶¶ 44-45, 118). The ability of each Initial Purchaser to profit was entirely dependent on the successful launch of the TON Blockchain. If the TON Blockchain’s development failed prior to launch, all Initial Purchasers would be equally affected as all would lose their opportunity to profit,[8] thereby establishing horizontal commonality at the time of 2018 Sales.
Further, horizontal commonality exists after the launch of the TON Blockchain. The plain economic reality is that, post-launch, the Grams themselves continue to represent the Initial Purchasers’ pooled funds. ATBCOIN LLC, 380 F. Supp. 3d at 354 (finding a pooling of assets in a post-launch digital asset). Post-launch, the fortunes of the Initial Purchasers will also remain tied to each other’s fortunes as well as to the fortunes of the TON Blockchain. Upon delivery of the Grams, Round Two Purchasers will possess an identical instrument, the value of which is entirely dependent on the success or failure of the TON Blockchain as well as on Telegram’s enforcement of the lockup provisions on Round One Purchasers. All Initial Purchasers, Round One and Round Two, were 370*370 dependent upon the success of the TON Blockchain software and, if it failed, all Initial Purchasers would suffer a diminution in the value of their Grams. The investors’ fortunes are directly tied to the success of the TON Blockchain as a whole.[9] Id. (holding that “the value of [a post-launch digital asset] was dictated by the success of the [blockchain] enterprise as a whole, thereby establishing horizontal commonality”). The Court finds that the SEC has made the required showing of horizontal commonality because the record demonstrates that there was a pooling of assets and that the fortunes of investors were tied to the success of the enterprise as well as to the fortunes of other investors both before and after launch.
Alternatively, the SEC has made a substantial showing of strict vertical commonality. Each Initial Purchaser’s anticipated profits were directly dependent on Telegram’s success in developing and launching the TON Blockchain. Telegram’s own fortunes were similarly dependent on the successful launch of the TON Blockchain as Telegram would suffer financial and reputational harm if the TON Blockchain failed prior to launch. Telegram was reliant on funds from the 2018 Sales to meet Messenger’s $190 million and $220 million expenses for 2019 and 2020, respectively. (Doc. 80 ¶ 26); (PX 18 at 5, 8); (Joint Stip. ¶¶ 44-45). Failure to launch the TON Blockchain by the contractual deadline would require Telegram to return any unspent funds to the Initial Purchaser, depriving Telegram of its primary planned source of funding for Messenger’s growing expenses. This loss of funding could potentially harm Telegram’s ability to continue to expand or even maintain its signature product and, thereby, damage the fortunes of the company as a whole.
The offering materials accompanying the 2018 Sales further detail how Telegram’s financial fortunes would continue to be inextricably linked to the fortunes of the TON Blockchain and, therefore those of the Initial Purchasers, after launch. After launch, Telegram’s most valuable asset would be the TON Reserve, consisting of 28% of all Grams. Telegram states that the TON Reserve would either be transferred to the TON Foundation, (Joint Stip. ¶ 162), or “locked for perpetuity,” (Doc. 75 ¶ 231). However, Telegram is under no legal obligation to undertake either course of action and could instead choose to retain control over the TON Reserve.[10] In that case, the TON Reserve would be Telegram’s largest asset, thereby linking the company’s financial fortunes to the price of Grams and the success of the TON Blockchain.
Telegram would also suffer critical reputational damage if the TON Blockchain failed prior to or after launch. Telegram generated interest in Grams and the to-be-built TON Blockchain based on the reputation of Pavel and his team as the creators of Messenger, a fast growing and well-regarded app. See, e.g., (PX 3 ¶ 12 (“Telegram’s founders had already created and 371*371 launched a successful messenger application, which also gave us confidence that Telegram’s ICO would be successful, as compared to unknown teams with no experience bringing a product to market.”)). In raising $1.7 billion, Telegram emphasized its technical expertise, promoted its teams of “A-players,” (JX 4 at 4 (Doc. 72-4)); (JX 8 at 21-24), and directly affixed its good name to the TON Blockchain (the “Telegram Open Network” Blockchain) and the Gram (“Tele gram”). As such, the failure of Telegram’s new signature cryptocurrency project soon after launch would tarnish the reputations of Telegram and the Durovs. The impairment of its goodwill, especially in light of its inability to generate revenue from Messenger, would significantly damage Telegram’s ability to develop new products, attract needed technical talent, and potentially even to raise the capital needed to sustain Messenger. Conversely, the successful launch of the TON Blockchain would burnish Telegram’s reputation, opening new and potentially financially lucrative doors for its next product idea. Based on the record presented, Telegram’s fortunes are directly tied to the fortunes of the Initial Purchasers, which will rise and fall with the success or failure of the TON Blockchain. As such, the Court finds that the SEC has made a substantial showing of strict vertical commonality.
iv. Expectation of Profit.
Howey’s third prong examines whether the investor entered the relevant transaction with the expectation of profit. Telegram disputes that Grams were purchased with an expectation of profit, arguing instead that the Initial Purchasers bought Grams with the expectation to use them as currency. The Court finds that the SEC has shown a substantial likelihood of success in proving that the Initial Purchasers purchased Grams in the 2018 Sales with an expectation of profit in the resale of those Grams to the public via the TON Blockchain, which would be developed by Telegram and the success of which would be implicitly guaranteed post-launch by Telegram.
An investor possesses an expectation of profit when their motivation to partake in the relevant “contract, transaction or scheme” was “the prospects of a return on their investment.” Howey, 328 U.S. at 301, 66 S.Ct. 1100; see also S.E.C. v. Hui Feng, 935 F.3d 721, 730-31 (9th Cir. 2019) (finding the requisite expectation of profit even when this investment intent was secondary to a motive unrelated to profit). Profit means an “income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment.” Edwards, 540 U.S. at 394, 124 S.Ct. 892; see also Forman, 421 U.S. at 852, 95 S.Ct. 2051 (stating that “[b]y profits, the Court has meant either capital appreciation resulting from the development of the initial investment”).
In contrast to an investment intent, an individual may acquire an asset with “a desire to use or consume the item purchased.” Id. at 852-53, 95 S.Ct. 2051. A transaction does not fall within the scope of the securities laws when a reasonable purchaser is motivated to purchase by a consumptive intent. Id. The inquiry is an objective one focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant. Warfield v. Alaniz, 569 F.3d 1015, 1021 (9th Cir. 2009) (“Under Howey, courts conduct an objective inquiry into the character of the instrument or transaction offered based on what the purchasers were `led to expect.’”).
Based upon the totality of the evidence, the Court finds that, at the time of the 2018 Sales to the Initial Purchasers, a reasonable investor, situated in the position of the Initial Purchasers, would have 372*372 purchased Grams with investment intent. The Court also finds that, without the expected ability to resell Grams into the secondary market, the $1.7 billion paid to Telegram would not have been raised. Several aspects of the 2018 Sales demonstrate this reasonable expectation of profit.
The sale price of Grams during the Round One and Round Two Sales, approximately $0.38 and $1.33 respectively, (JX 11 at 8); (JX 12 at 2), was set at a significant discount to the expected Reference Price post-launch and the expected market price in a post-launch public market, (JX 13 at 129-31). Upon the launch of the TON Blockchain, the only Grams available for public purchase would either be newly-released Grams from the TON Reserve or Grams resold by Round Two Purchasers, whose Gram Purchase Agreements did not contain a lockup clause. Under Telegram’s pricing formula, the Reference Price of Grams held in the TON Reserve at launch would be approximately $3.62. (Joint Stip. ¶ 143). If the market price reached the Reference Price but no higher, it would offer Round One and Round Two Initial Purchasers an approximate 852% and 172% premium, respectively, over their cost of acquiring Grams. This would provide a substantial opportunity for the Initial Purchasers to profit on the resale of Grams, even if the market price of Grams fell below the Reference Price as the TON Reserve is not permitted to sell newly floated Grams for less than the Reference Price. (Joint Stip. ¶ 166); (JX 13 at 131); (Doody Report ¶ 38 (Doc. 122-10)).
Telegram also promoted the TON Foundation’s power to support the market price of Grams. Specifically, the TON Foundation was authorized to repurchase Grams on the open market if their market price fell to half (or less) of the Reference Price, which at launch would equate to approximately $1.81 per Gram. (Joint Stip. ¶ 167); (JX 13 at 131); (Doody Report ¶ 44). This provision created the reasonable expectation among Initial Purchasers that, even if the market price of Grams fell, the TON Foundation would support a market price that would enable the Initial Purchasers to sell their Grams at a considerable profit. (Doody Report ¶ 40). Further, this price floor mechanism was pitched as a means of arresting and reversing declines in Grams’ market price, and thereby protecting the ability of the Initial Purchasers to profit from Gram resales, by reducing the supply of available Grams and presumably increasing the price per Gram. (Joint Stip. ¶ 122); (JX 13 at 131).
The size and concentration of their Gram purchases indicates that the Initial Purchasers purchased with investment, not consumptive, intent. The amount of capital raised ($1.7 billion), the large percentage of the total supply of Grams (58%), and the limited number of Initial Purchasers (175) support the finding that the Initial Purchasers did not intend to use their allotments of Grams as a substitute currency to store and transfer value.
The terms of the Gram Purchase Agreements also point to an investment intent on the part of the Initial Purchasers. In Round One, Grams were sold at $0.38 per Gram but were subject to a lockup agreement that prevented the Round One Purchasers from reselling their Grams until three months after launch. (Joint Stip. ¶ 88); (JX 11 § 10.1). After 3 months, a Round One Purchaser was then permitted to sell up to 25% of its allotment of Grams, with additional tranches of Grams unlocking 6 months, 12 months, and 18 months after launch. (Joint Stip. ¶ 88); (JX 11 § 10.1). In contrast, the Grams purchased by the Round Two Purchasers were not subject to such a lockup agreement. (Joint Stip. ¶ 93). This differential lockup granted an exclusive window for the Round Two 373*373 Purchasers—who paid considerably more per Gram—to resell Grams and profit from their investment before Grams owned by Round One Purchasers could be sold into the market and thereby place downward pressure on the price of Grams. (PX 30 at 11 (Doc. 122-18)). This exclusive window creates a structural incentive for the Round Two Purchasers to resell their holdings of Grams quickly and indicates that the Round Two Purchasers bought Grams with an investment intent.
Further, the existence of the lockups tend to negate the likelihood that a reasonable Round One Purchaser purchased Grams for consumptive use. Simply put, a rational economic actor would not agree to freeze millions of dollars for up to 18 months (following a lengthy development period) if the purchaser’s intent was to obtain a substitute for fiat currency. (Doody Report ¶ 5). The economic reality is that these lockups were part of the bargained-for-exchange with Round One Purchasers, who obtained their Grams at a much lower price than the Round Two Purchasers but with the expectation of a larger profit after the lockup period expired. The lockups supported the economic justification for Round Two Purchasers to pay a higher price for Grams because the Round Two Purchasers would have an exclusive window to sell without competition from Round One Purchasers.
The economic realities of the promised integration of Grams and the TON Blockchain with Messenger also support a finding of a reasonable expectation on the part of the Initial Purchasers that Grams would increase in value and return a profit. (Joint Stip. ¶ 9 (“Telegram informed the [I]nitial [P]urchasers that it hoped to integrate the TON Wallet into Telegram Messenger in part to encourage a wide adoption of Grams after launch.”)); (JX 8 at 11-14 (primer section entitled “Telegram Messenger-TON Integration”)); (JX 13 at 124). Integration of a TON Wallet into Messenger would quickly introduce Grams to Messenger’s 300 million monthly user base. This anticipated integration fueled the Initial Purchasers’ expectations of a spike in Gram demand upon launch.[11]
Telegram’s offering materials targeted buyers who possessed investment intent. Promotional materials emphasizing opportunities for potential profit can demonstrate that purchasers possessed the required expectation of profits. See, e.g., Forman, 421 U.S. at 853-54, 95 S.Ct. 2051; Edwards, 540 U.S. at 392, 124 S.Ct. 892. While the offering materials covered some potential consumptive uses, (JX 8 at 14), they also highlighted the opportunity for profit by capital appreciation and resale based on the discounted purchase price.[12] (JX 3 at 2); (JX 8 at 17). Specifically, the promotional materials highlighted the large discount, compared to the Reference Price, (Joint Stip. ¶ 143), as well as to the anticipated market price, (JX 3 at 2), at which Initial Purchasers could obtain Grams. The materials also discussed the TON Foundation’s ability to provide a price floor for Grams in the case of market turmoil. (Joint Stip. ¶¶ 164-65); (JX 13 at 131). In toto, the offering materials fueled the expectation that, after launch, the Initial 374*374 Purchasers would be able to resell their allotment of Grams for a profit.
Consumptive uses for Grams were not features that could reasonably be expected to appeal to the Initial Purchasers targeted by Telegram. In seeking participants for the 2018 Sales, Telegram did not focus on cryptocurrency enthusiasts, specialty digital assets firms, or even mass market individuals who had a need for an alternative to fiat currency. (Doc. 80 ¶ 142); (Doc. 95 ¶ 142). Instead, Telegram selected sophisticated venture capital firms (and other similar entities) as well as high net worth individuals with an inherent preference (i.e. their business model) toward an investment intent rather than a consumptive use. (Doc. 80 ¶¶ 139-42); (Doc. 95 ¶¶ 139-42); (PX 18 at 6).
The Court’s finding that the Initial Purchasers had a reasonable expectation of profit is buttressed by Initial Purchasers’ subjective views, as captured in internal memoranda and emails. The subjective intent of the Initial Purchasers does not necessarily establish the objective intent of a reasonable purchaser. However, the stated intent of prospective and actual purchasers, though not considered for the truth of their content, may be properly considered in the Court’s evaluation of the motivations of the hypothetical reasonable purchaser. S.E.C. v. Texas Gulf Sulphur Co., 446 F.2d 1301, 1305 (2d Cir. 1971) (finding that the testimony of individual investors “was relevant to whether [a document] was misleading to the `reasonable investor’”); Slevin v. Pedersen Assocs., Inc., 540 F. Supp. 437, 441 (S.D.N.Y. 1982).
An actual Initial Purchaser declared that it “purchased Grams with the aim of making a profit when it ultimately sold the Grams” and “did not intend to use Grams for consumptive purposes.” (PX 5 ¶¶ 21-22 (Doc. 122-5)). Another Initial Purchaser stated that they “hoped for an increase in the value of Grams and an opportunity to eventually sell Grams if the value increased” and did “not believe that [the investor entity] intended to use Grams as currency or for consumptive purposes.” (PX 6 ¶ 6 (Doc. 122-6)). Other Initial Purchasers similarly viewed Grams as an investment, not a consumptive asset. (PX 1 ¶ 14 (Doc. 122-1)); (PX 2 ¶¶ 14, 18 (Doc. 122-2)); (PX 3 ¶¶ 7, 18, 20 (Doc. 122-3)); (PX 4 ¶¶ 6, 13 (Doc. 122-4)); (PX 7 ¶¶ 18, 19, 21); (PX 8 ¶ 11 (Doc. 122-11)); (PX 30 at 11); (PX 31 at 4 (Doc. 122-31)); see also (PX 1 ¶ 15 (stating that “[t]he pricing mechanism described by Telegram indicated that any future token offerings would sell Grams at a higher price”)); (PX 7 ¶ 7 (stating that an investor “became interested in investing in the Telegram ICO because [it] did not think it was possible to invest into Telegram, the company, directly”)). The subjective views of these Initial Purchasers, taken with the totality of the evidence, support the Court’s finding that the SEC has shown a substantial likelihood of success in proving that a reasonable purchaser in the 2018 Sales had an expectation of profit.
Telegram argues that there can be no expectation of profit in light of its disclaimers and public statements emphasizing the consumptive use of Grams and rejecting any expectation of profit. (Drylewski Decl., Ex. 3 at 2 (“Third, you should NOT expect any profits based on your purchase or holding of Grams, and Telegram makes no promises that you will make any profits. Grams are intended to act as a medium of exchange between users in the TON ecosystem. Grams are NOT investment products and there should be NO expectation of future profit or gain from the purchase, sale or holding of Grams.”)). However, such statements, including an internet post after the initiation of this action, are insufficient to negate the substantial evidence 375*375 that a reasonable purchaser expected to profit from Grams upon their launch.
v. Efforts of Another.
The final Howey prong considers whether the expectation of profit stems from the efforts of another. Though Howey states that the expectation of profits should stem “solely from the efforts of the promoter or a third party,” Howey, 328 U.S. at 299, 66 S.Ct. 1100, subsequent decisions have focused on whether the “reasonable expectation of profits [were] derived from the entrepreneurial or managerial efforts of others.” Forman, 421 U.S. at 852, 95 S.Ct. 2051; see also Leonard, 529 F.3d at 88 (“[W]e have held that the word solely' should not be construed as a literal limitation; rather, we consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.’” (quoting S.E.C. v. Aqua-Sonic Prods. Corp., 687 F.2d 577, 582 (2d Cir. 1982)). The efforts of promotors, undertaken either before or after gaining control over investor funds, are relevant considerations due to Howey’s focus on economic realities. S.E.C. v. Mut. Benefits Corp., 408 F.3d 737, 743-44 (11th Cir. 2005) (stating that “[n]either Howey [n]or Edwards require such a clean distinction between a promoter’s activities prior to his having use of an investor’s money and his activities thereafter” and that “investment schemes may often involve a combination of both pre- and post-purchase managerial activities, both of which should be taken into consideration in determining whether Howey’s test is satisfied” (first citing S.E.C. v. Eurobond Exch., Ltd., 13 F.3d 1334 (9th Cir. 1994); then citing Gary Plastic Packaging Corp., 756 F.2d 230; and then citing Glen-Arden Commodities, 493 F.2d 1027).
The Court finds that the SEC has shown a substantial likelihood of success in proving that, at the time of the 2018 Sales, a reasonable Initial Purchaser’s expectation of profits from their purchase of Grams was based upon the essential entrepreneurial and managerial efforts of Telegram. As Telegram has noted, Grams do not exist and did not exist at the time of the 2018 Sales. (Doc. 71 at 7, 39). But the Initial Purchasers provided capital to fund the TON Blockchain’s development in exchange for the future delivery of Grams, which they expect to resell for a profit. The offering materials recognize this economic reality and made Telegram’s commitment to develop this project explicit. (JX 8 at 19 (stating that Telegram “intend[s] to use the proceeds raised from the offering for the development of the TON Blockchain”)); see also (JX 11 at 7). Thus, to realize a return on their investment, the Initial Purchasers were entirely reliant on Telegram’s efforts to develop, launch, and provide ongoing support for the TON Blockchain and Grams. The Court finds that if, after immediately after launch, Telegram and its team decamped to the British Virgin Islands, where Telegram is incorporated, and ceased all further efforts to support the TON Blockchain, the TON Blockchain and Grams would exist in some form but would likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits. See M. Todd Henderson & Max Raskin, A Regulatory Classification of Digital Assets: Toward an Operational Howey Test for Cryptocurrencies, ICOs, and Other Digital Assets, 2 Colum. Bus. L. Rev. 443, 461 (2019) (proposing a “Bahamas Test”). Initial Purchasers’ dependence on Telegram to develop, launch, and support the TON Blockchain is sufficient to find that the Initial Purchasers’ expectation of profits was reliant on 376*376 the essential efforts of Telegram. See ATBCOIN LLC, 380 F. Supp. 3d at 357.
Telegram’s advertised promotion of the TON Blockchain and Grams though integration with Messenger created a reasonable expectation in the minds of the Initial Purchasers that their anticipated profits were dependent on Telegram’s essential post-launch efforts. Since announcing the TON Blockchain, Telegram’s core message has been that Gram would be the first digital asset capable of true mass market adoption. (JX 4 at 1). Telegram highlighted the value proposition of participating in the launch of the first mainstream cryptocurrency in its offering materials for the 2018 Sales, (JX 8 at 5 (stating that “Telegram is uniquely positioned to establish the mass-market cryptocurrency”)); see also (JX 9 at 5); (Joint Stip. ¶ 141), and has continue to emphasize the potential for Gram’s mainstream adoption in its more recent public statements, (Drylewski Decl., Ex. 3 at 1 (stating its intention that “Grams will become a true complement to traditional currencies”)). The Initial Purchasers recognized that an investment in Grams was a bet that Telegram could successfully encourage the mass adoption of Grams, thereby enabling a high potential return on the resales of Grams. See, e.g., (PX 7 at 8 (investment thesis stating that Grams “ha[ve] the potential to be the first truly mass market cryptocurrency”)); (PX 31 at 4, 5 (investment thesis highlighting the chance to “ability to participate in what could be a category defining investment” and “[o]pportunity to invest in a token that could prevail as the leading store of value and smart-contract platform”)).
At the time of the 2018 Sales, Telegram’s stated goal of developing Grams into the first mass market cryptocurrency was plausible, to Telegram, the Initial Purchasers, and the wider market, because of Messenger and its enormous user base. If the plans for a technically identical blockchain were floated, stripped of Telegram’s branding and support, it is unlikely that such an offering would have raised $1.7 billion in less than three months. Telegram’s offering achieved its success because of its stated intention to integrate the TON Blockchain with Messenger in order to encourage the widespread use of Grams. Telegram knew that Messenger was the critical element for the TON Blockchain to become something more than a new competitor to other cryptocurrencies, bluntly stating that “Telegram will serve as a launch pad for TON, ensuring its technological superiority and widespread adoption at launch.” (JX 9 at 20). A variety of planned integrations would introduce Grams to Messenger’s 300 million current monthly users as well as to all future Messenger users, a category which appears set to grow quickly. (PX 17 at 2 (Doc. 122-17) (Pavel writing that he “see[s] both TON and Telegram as integral parts of the success of the project as Telegram provides the necessary userbase and adoption to make the whole idea of mass market crypto-currency work”)).
Investors also knew that Messenger represented the key to Grams’ mass adoption and therefore expected Telegram to use Messenger to advance this goal. See, e.g., (PX 32 at 1 (“TON has an effective way to bootstrap the blockchain by leveraging Telegram’s 200M active users.”)); (PX 2 ¶ 14 (“Telegram already had a captive community of users, which made it less difficult to create a new network.”)); (PX 1 ¶ 11 (“I felt that the Telegram Messenger’s user base was a factor that was tied to how much demand there would be for Grams in the future.”)); (PX 4 ¶¶ 14-15 (investor stating that it “felt that Telegram’s Messenger application would continue to drive demand for Grams” and that “Grams would have a good synergy with Telegram’s Messenger application”)); 377*377 (PX 5 ¶ 13 (“I viewed the Messenger platform and the to-be-developed TON platform to be connected.”)); (PX 7 ¶ 19 (“Our belief was that with 180 million users, Telegram and its applications and uses would grow in popularity, and with increased use and demand the price of Grams would rise over time.”)); (PX 33 at 2 (“The Telegram Messenger ecosystem provides a significant go to market advantage for TON.”)); see also (PX 1 ¶¶ 11, 15); (PX 2 ¶ 7); (PX 5 ¶ 12); (PX 30 at 5); (PX 31 at 1). The Initial Purchasers reasonably expected that Telegram would continue to support the TON Blockchain in the post-launch period.
Telegram structured post-launch financial incentives to ensure that the link between Grams and Messenger was unmistakable to users. As part of its promotion of the 2018 Sales, Telegram stated it planned to reserve 10% of all Grams for post-launch incentive payments to encourage the growth of the TON ecosystem. (JX 8 at 18). Half of this pool, 5% of all Grams or nearly 250 million Grams, would be offered as incentives for Messenger users to try the TON Blockchain for the first time. (Drylewski Decl., Ex. 5 at 3-4 (Doc. 73-5)). Grams would be freely “distributed on a first-come, first-served basis to users of Telegram Messenger,” who request them via Messenger. (Doc. 95 ¶ 387); (Drylewski Decl., Ex. 5 at 3-4). These incentives, which Telegram still plans to employ, are intended to entice Messenger users to interact with the TON Blockchain for a monetary reward, in hopes of generating a host of first time blockchain users. (Joint Stip. ¶ 163); (Doc. 95 ¶ 387).
The Gram Purchase Agreements anticipate a critical role for Telegram in the post-launch TON Blockchain. Section 5.2 of both the Round One and Round Two Purchase Agreements oblige Telegram to “use its reasonable endeavours to facilitate the use of [Grams] as the principal currency used on Telegram Messenger by building TON Wallets into Telegram Messenger.” (JX 11 § 5.2); (JX 12 § 5.2). These still valid provisions created the reasonable expectation in the minds of the Initial Purchasers that, following launch, Telegram would integrate the TON Blockchain with Messenger and, thereby, continue to work to improve and advance the TON Blockchain. Further, the Gram Purchase Agreements’ “Risk Factors” described a pertinent potential risk to the 2018 Sales as the “[r]isks [a]ssociated [w]ith [i]ntegrating the TON Blockchain and Telegram Messenger.” (JX 14 at 5); see also (JX 15 at 5-6). It continued that “Telegram intends to integrate the TON Blockchain with Telegram Messenger as described in the `Telegram Messenger-TON Integration’ section of the Telegram [Round One] Primer,” before warning that, due to any issues with this integration, “adoption of Grams as a form of currency within Telegram Messenger’s existing ecosystem may be more limited than anticipated.” (JX 14 at 5); see also (JX 15 at 5-6). The Gram Purchase Agreements’ still enforceable terms set and continue to shape the Initial Purchasers’ expectations and would lead a reasonable purchaser to believe that Telegram would work to integrate Messenger and the TON Blockchain in a manner to advance the TON Blockchain’s success.
Indeed, as part of the 2018 Sales, Telegram explicitly promoted multiple ways in which the TON Blockchain and Grams would be directly integrated with Messenger. In the “Telegram Messenger-TON Integration” section of offering materials, Telegram stated that the official TON Wallet would be integrated into Messenger, thereby allowing Messenger users to control their Grams without leaving the app and permitting Grams to “serve as the principal currency for the in-app economy on Telegram.” (JX 8 at 11, 13 (“Integrated 378*378 into Telegram applications, the TON [W]allet is expected to become the world’s most adopted cryptocurrency wallet.”)); (JX 9 at 11); (Joint Stip. ¶ 140); see also (PX 31 at 2 (investor forecast that “[a]t launch, the Telegram TON [W]allet will become the world’s most adopted cryptocurrency wallet”). Since the institution of this action, Telegram has purported to abandon of its promise to integrate the TON Wallet into Messenger.) (Drylewski Decl., Ex. 3 at 2 (“At the time of the anticipated launch of the TON Blockchain, Telegram’s TON Wallet application is expected to be made available solely on a stand-alone basis and will not be integrated with the Telegram Messenger service.”)). However, such disclaimers are not dispositive and this disclaimer in particular is equivocal on its face. In the next breath, the disclaimer states that “Telegram may integrate the TON Wallet application with the Telegram Messenger service in the future.” (Id.).
Telegram pledged to give Grams to its development team and the lockup provision governing those Grams fed reasonable expectations that this development team would continue to play an important role in the growth of the TON Blockchain. Specifically, Telegram has reserved 4% of all Grams for the TON Blockchain development team, including 1% for each Durov brother, and has stated that these Grams would be distributed subject to a four-year lockup period. (Joint Stip. ¶¶ 158-60); (JX 9 at 16, 18). A lockup period imposed on critical employees aligns their interests with the success of Grams and the TON Blockchain during the lockup period. These lockups have their most plausible and logical economic justification if the employees subject to the lockup will play a critical role in the ongoing success of the entity. In fact, one investor specifically discussed the developer lockup period with Pavel and then told him that, in terms of Pavel’s own allocation of Grams, “more is better!” because it ensured that Pavel’s interests were “fundamental[ly] aligned with the success of TON.” (PX 25 at 2 (Doc. 122-25) (inquiring whether “the tokens issued to employees and developers pre launch being subject to the same lockup as the investors [as] [t]his is what typically happens for IPOs to ensure the people needed to deliver the core intellectual property have incentives to stay engaged through the lockup”)); (Doc. 80 ¶ 148).
The cumulative effective of the advertised integration of the TON Blockchain with Messenger and the lockups placed on the developer’s Grams created a reasonable expectation among the Initial Purchasers that Telegram would continue to provide essential support for the TON Blockchain after launch. See, e.g., (PX 2 ¶ 14 (“Based on Telegram’s offering materials, we also believed that the Telegram team would continue to support and grow the TON network after launch and make it more useful, and the value of Grams would continue to go up.”)); (PX 4 ¶ 14 (“Based on the due diligence I did, I expected Telegram to continue to work on the TON Blockchain platform it was building after launch, which would increase the value of Grams.”)); (PX 6 ¶ 3 (“[Initial Purchaser] anticipated that Telegram would remain involved in the development of the TON network after it was launched.”)). Based on the totality of the evidence, a reasonable Initial Purchaser would expect Telegram to continue to support and improve the TON Blockchain post-launch.`
The Court finds that the SEC has shown a substantial likelihood of success in proving that the Initial Purchasers’ investment was made with a reasonable expectation of Telegram’s essential entrepreneurial and managerial efforts to develop and support the TON Blockchain and Grams.
Examining the totality of the evidence and considering the economic realities, the Court finds that the SEC has shown a substantial likelihood of success in proving that the 2018 Sales were part of a larger scheme, manifested by Telegram’s actions, conduct, statements, and understandings, to offer Grams to the Initial Purchasers with the intent and purpose that these Grams be distributed in a secondary public market, which is the offering of securities under Howey.
J. Grams Are Not Evaluated Upon the Launch of the TON Blockchain.
Telegram argues that Grams, as distinct from the Gram Purchase Agreements, must be evaluated under Howey when the Grams come into existence with the launch of the TON Blockchain. Telegram then contends that, at launch, Grams would be commodities, not securities, because Grams would be used consumptively, would not be supported by Telegram’s essential efforts, and would lack the requisite common enterprise. Telegram emphasizes that, even if the Court found Grams to be securities at the time of the 2018 Sales, Grams were then covered by a valid Rule 506(c) exemption. This exemption would extend until the launch of the TON Blockchain, at which point Grams would be commodities not covered by the securities laws.
The Court rejects Telegram’s characterization of the purported security in this case. While helpful as a shorthand reference, the security in this case is not simply the Gram, which is little more than alphanumeric cryptographic sequence. Howey refers to an investment contract, i.e. a security, as “a contract, transaction or scheme,” using the term “scheme” in a descriptive, not pejorative, sense. This case presents a “scheme” to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sales and distribution of the Gram. Howey requires an examination of the entirety of the parties’ understandings and expectations. Howey, 328 U.S. at 297-98, 66 S.Ct. 1100 (declining to “treat[] the contracts and deeds as separate transactions”). Further, for the reasons discussed previously, the Court finds that the appropriate point at which to evaluate this scheme to sell and distribute Grams is at the point at which the scheme’s participants had a meeting of the minds, i.e. at the time of the 2018 Sales, rather than the date of delivery.[13]
K. The Grams Sales to the Initial Purchasers Do Not Fall Within an Exemption and so Constitute a Violation of the Securities Laws.
[…]
The Court finds that Telegram did not intend for the Grams to come to rest with the Initial Purchasers. Specifically, Telegram’s goal of establishing Grams as “the first mass market cryptocurrency” required that the 58% of all Grams sold in the 2018 Sales reach a much wider pool than the 175 Initial Purchasers. As discussed previously, Telegram built economic incentives into the 2018 Sales, including large discounts and differential lockups, to ensure that the Initial Purchasers resold Grams soon after launch. Further, Telegram sought out participants for the 2018 Sales, such as major venture capital firms, that would purchase with an investment intent and so would sell their allocation of Grams quickly to earn a profit.
The Second Circuit has held that securities do not come to rest with investors who intend a further distribution. Gilligan, Will & Co., 267 F.2d at 468 (stating that a security does not come to rest with an investor who purchased “speculatively” and with “a view to distribution”); see also Geiger v. S.E.C., 363 F.3d 481, 487-88 (D.C. Cir. 2004) (stating that one “did not have to be involved in the final step of [a] distribution to have participated in it” and that the purchase of shares at “a substantial discount” followed by their quick resale supported a finding that the shares were not at rest). The Court finds that Telegram intended that Grams be distributed to the public through the Initial Purchasers. The Court further finds that the public “need[s] the protection of the [Securities] Act.” Ralston Purina Co., 346 U.S. at 125, 73 S.Ct. 981. The Court concludes that Telegram’s offer and sale of Grams to the Initial Purchasers is a public offering 381*381 and ineligible for a section 4(a)(2) exemption to the registration requirement.
Rule 506(c) exempts transactions that meet its conditions from section 5’s registration requirement. 17 C.F.R. § 230.506(c). One requirement of Rule 506(c) exemption is that the issuer “exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(a)(11) of the [Securities] Act,” which in turns requires a “[r]easonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons.” Id. § 230.502(d). The Court finds that Telegram failed to use reasonable care to ensure that the Initial Purchasers were not underwriters, and therefore may not avail itself of a Rule 506(c) exemption.
Section 2(a)(11) defines an “underwriter” as “any person who has purchased from an issuer with a view to … the distribution of any security.” 15 U.S.C. § 77b(a)(11). And, again, a distribution includes “the entire process by which in the course of a public offering the block of securities is dispersed and ultimately comes to rest in the hands of the investing public.’” R. A. Holman & Co., 366 F.2d at 449. The Initial Purchasers bought Grams from Telegram, the issuer, with an intent to resell them for profit in the secondary market soon after launch of the TON Blockchain. The Grams would not and were not intended to come to rest with the Initial Purchasers but instead were intended to move from the Initial Purchasers to the general public. Therefore, this two-step process represents a public distribution and the Initial Purchasers, who acted as mere conduits to the general public, are underwriters.
Telegram argues that, even if Initial Purchasers are statutory underwriters, it complied with Rule 502(d) by taking reasonable care to ensure that the Initial Purchasers were purchasing for themselves and not to resell to their Grams to others. Specifically, Telegram points to a representation and warranty in each Gram Purchase Agreement that required the Initial Purchasers to warrant that they were “purchasing the Tokens for [their] own account and not with a view towards, or for resale in connection with, the sale or distribution.” (Doc. 75 ¶ 209); (JX 11 at 20). However, in evaluating economic reality of this scheme, legal disclaimers do not control. The representation and warranty that the Initial Purchasers purchased without a view towards resale rings hollow in the face of the economic realities of the 2018 Sales. From Telegram’s perspective, it was critical that the Initial Purchasers could flip their Grams in a post-launch secondary market because this feature would increase the amount of money it could raise. Based on these economic realities, Telegram’s contrary representations will not be accorded controlling weight. Telegram did not take reasonable care to ensure that statutory underwriters were not participants in the 2018 Sales. As the 2018 Sales to the Initial Purchasers were merely a step in a public distribution of Grams and Telegram was aware that Initial Purchasers were statutory underwriters, Telegram’s sales of Grams do not qualify for a Rule 506(c) exemption from the registration requirement.
The Court finds that the SEC has shown a substantial likelihood of success in proving that the Gram Purchase Agreements, Telegram’s implied undertakings, and its understandings with the Initial Purchasers, including the intended and expected resale of Grams into a public market, amount to the distribution of securities, thereby requiring compliance with section 5. Telegram has failed to establish an exemption to the registration requirement under either section 4(a)(2) or Rule 506(c). 382*382 Further, the Court concludes that the SEC has shown that the sale and imminent delivery of Grams represent a single ongoing violation of section 5. The Court also finds that the delivery of Grams to the Initial Purchasers, who would resell them into the public market, represents a near certain risk of a future harm, namely the completion of a public distribution of a security without a registration statement. An injunction, prohibiting the delivery of Grams to the Initial Purchasers and thereby preventing the culmination of this ongoing violation, is appropriate and will be granted.
Secondary public markets. Can intending to resell a cryptocurrency asset on a secondary market make something which is not a security, a security?
[TO DISCUSS] Circling back to the registration safe-harbor.
Whose Consumption? The District Court reasoned that the initial purchaers of the Grams did not intend to use them on the TON network, but rather intended to resell them for profit. “Consumptive uses for Grams were not features that could reasonably be expected to appeal to the Initial Purchasers targeted by Telegram. In seeking participants for the 2018 Sales, Telegram did not focus on cryptocurrency enthusiasts, specialty digital assets firms, or even mass market individuals who had a need for an alternative to fiat currency.” As crypto assets become more prevelant and well understood among the general public, does that change the consumption calculus?
‘Little more than alphanumeric cryptographic sequence’. The court repeatedly returns to analyzing the sequence of transactions and understandings between the party as the ‘security’ at issue, rather than the Grams alone.
‘The Court finds that if, after immediately after launch, Telegram and its team decamped to the British Virgin Islands, where Telegram is incorporated, and ceased all further efforts to support the TON Blockchain, the TON Blockchain and Grams would exist in some form but would likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits’.
If the TON blockchain survived without Telegram’s post-sale efforts, would Grams still be a security? How about partial efforts? What if they were the largest contributor to an otherwise open source project?
Securities and Exchange Commission v. Telegram Group Inc., 448 F.Supp.3d 352 (2020), _available at https://scholar.google.com/scholar_case?case=12155610832399912630 ↩
Digital Asset Transactions: When Howey Met Gary (Plastic) )1
This event provides a great opportunity to address a topic that is the subject of considerable debate in the press and in the crypto-community – whether a digital asset offered as a security can, over time, become something other than a security.[2]
To start, we should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold. To that end, a better line of inquiry is: “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.” In these cases, calling the transaction an initial coin offering, or “ICO,” or a sale of a “token,” will not take it out of the purview of the U.S. securities laws.
But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.” I would like to share my thinking with you today about the circumstances under which that could occur.
Before I turn to the securities law analysis, let me share what I believe may be most exciting about distributed ledger technology – that is, the potential to share information, transfer value, and record transactions in a decentralized digital environment. Potential applications include supply chain management, intellectual property rights licensing, stock ownership transfers and countless others. There is real value in creating applications that can be accessed and executed electronically with a public, immutable record and without the need for a trusted third party to verify transactions. Some people believe that this technology will transform e-commerce as we know it. There is excitement and a great deal of speculative interest around this new technology. Unfortunately, there also are cases of fraud. In many regards, it is still “early days.”
But I am not here to discuss the promise of technology – there are many in attendance and speaking here today that can do a much better job of that. I would like to focus on the application of the federal securities laws to digital asset transactions – that is how tokens and coins are being issued, distributed and sold. While perhaps a bit dryer than the promise of the blockchain, this topic is critical to the broader acceptance and use of these novel instruments.
I will begin by describing what I often see. Promoters,[3] in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.
When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey.[4] That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. And it is important to reflect on the facts of Howey. A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc. for a return. In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.”[5] So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.
Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.
In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.
As an aside, you might ask, given that these token sales often look like securities offerings, why are the promoters choosing to package the investment as a coin or token offering? This is an especially good question if the network on which the token or coin will function is not yet operational. I think there can be a number of reasons. For a while, some believed such labeling might, by itself, remove the transaction from the securities laws. I think people now realize labeling an investment opportunity as a coin or token does not achieve that result. Second, this labeling might have been used to bring some marketing “sizzle” to the enterprise. That might still work to some extent, but the track record of ICOs is still being sorted out and some of that sizzle may now be more of a potential warning flare for investors.
Some may be attracted to a blockchain-mediated crowdfunding process. Digital assets can represent an efficient way to reach a global audience where initial purchasers have a stake in the success of the network and become part of a network where their participation adds value beyond their investment contributions. The digital assets are then exchanged – for some, to help find the market price for the new application; for others, to speculate on the venture. As I will discuss, whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis.
I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way. In other words, conduct the initial funding through a registered or exempt equity or debt offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer. This allows the tokens or coins to be structured and offered in a way where it is evident that purchasers are not making an investment in the development of the enterprise.
Returning to the ICOs I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security.[6] But under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, if the housing unit is offered with a management contract or other services, it can be a security.[7] Similarly, when a CD, exempt from being treated as a security under Section 3 of the Securities Act, is sold as a part of a program organized by a broker who offers retail investors promises of liquidity and the potential to profit from changes in interest rates, the Gary Plastic case teaches us that the instrument can be part of an investment contract that is a security.[8]
The same reasoning applies to digital assets. The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract. And regulating these transactions as securities transactions makes sense. The impetus of the Securities Act is to remove the information asymmetry between promoters and investors. In a public distribution, the Securities Act prescribes the information investors need to make an informed investment decision, and the promoter is liable for material misstatements in the offering materials. These are important safeguards, and they are appropriate for most ICOs. The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise – and the ability to realize a profit on the investment – turns on the efforts of the third party. So learning material information about the third party – its background, financing, plans, financial stake and so forth – is a prerequisite to making an informed investment decision. Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk.
But this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
And so, when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.[9] And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.[10] Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security. If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.
Let me emphasize an earlier point: simply labeling a digital asset a “utility token” does not turn the asset into something that is not a security.[11] I recognize that the Supreme Court has acknowledged that if someone is purchasing an asset for consumption only, it is likely not a security.[12] But, the economic substance of the transaction always determines the legal analysis, not the labels.[13] The oranges in Howey had utility. Or in my favorite example, the Commission warned in the late 1960s about investment contracts sold in the form of whisky warehouse receipts.[14] Promoters sold the receipts to U.S. investors to finance the aging and blending processes of Scotch whisky. The whisky was real – and, for some, had exquisite utility. But Howey was not selling oranges and the warehouse receipts promoters were not selling whisky for consumption. They were selling investments, and the purchasers were expecting a return from the promoters’ efforts.
Promoters and other market participants need to understand whether transactions in a particular digital asset involve the sale of a security. We are happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.[15] In addition, we recognize that there are numerous implications under the federal securities laws of a particular asset being considered a security. For example, our Divisions of Trading and Markets and Investment Management are focused on such issues as broker-dealer, exchange and fund registration, as well as matters of market manipulation, custody and valuation. We understand that market participants are working to make their services compliant with the existing regulatory framework, and we are happy to continue our engagement in this process.
What are some of the factors to consider in assessing whether a digital asset is offered as an investment contract and is thus a security? Primarily, consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. That question will always depend on the particular facts and circumstances, and this list is illustrative, not exhaustive:
Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value? Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset? Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate? Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network? Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset? Do persons or entities other than the promoter exercise governance rights or meaningful influence? While these factors are important in analyzing the role of any third party, there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security. Again, we would look to the economic substance of the transaction, but promoters and their counsels should consider these, and other, possible features. This list is not intended to be exhaustive and by no means do I believe each and every one of these factors needs to be present to establish a case that a token is not being offered as a security. This list is meant to prompt thinking by promoters and their counsel, and start the dialogue with the staff – it is not meant to be a list of all necessary factors in a legal analysis.
Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation? Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading? Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent? Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment? Is the asset marketed and distributed to potential users or the general public? Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application? Is the application fully functioning or in early stages of development? These are exciting legal times and I am pleased to be part of a process that can help promoters of this new technology and their counsel navigate and comply with the federal securities laws.
“Digital Asset Transactions: When Howey Met Gary (Plastic)” (June 18), available at https://www.sec.gov/news/speech/speech-hinman-061418 ↩
Potential Proposed Securities Act Rule 195. Time-limited exemption for Tokens.1
This potential safe harbor is not a rule, regulation, or statement of the Securities and Exchange Commission. It cannot be relied on. It does not necessarily reflect the views of the Securities and Exchange Commission or my fellow Commissioners.
Proposed Securities Act Rule 195. Time-limited exemption for Tokens.
Preliminary Notes:
However, for a network to mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts, the Tokens must be distributed to and freely tradeable by potential users, programmers, and participants in the network. The application of the federal securities laws to the primary distribution of Tokens and secondary transactions frustrates the network’s ability to achieve maturity and prevents Tokens sold as a security from functioning as non-securities on the network.
Accordingly, this safe harbor is intended to provide Initial Development Teams with a three-year time period within which they can facilitate participation in, and the continued development of, a functional or decentralized network, exempt from the registration provisions of the federal securities laws so long as certain conditions are met. The safe harbor is designed to protect Token purchasers by requiring disclosures tailored to the needs of the purchasers and preserving the application of the anti-fraud provisions of the federal securities laws to Token distributions by an Initial Development Team relying on the safe harbor.
By the conclusion of the three-year period, the Initial Development Team must determine whether Token transactions involve the offer or sale of a security. Token transactions may not constitute securities transactions if the network has matured to a functioning or decentralized network. The definition of Network Maturity is intended to provide clarity as to when a Token transaction should no longer be considered a security transaction but the analysis with respect to any particular network will require an evaluation of the particular facts and circumstances.
(a) Exemption. Except as expressly provided in paragraph (d) of this section, the Securities Act of 1933 does not apply to any offer, sale, or transaction involving a Token if the following conditions are satisfied by the Initial Development Team, as defined herein.
(1) The Initial Development Team intends for the network on which the Token functions to reach Network Maturity within three years of the date of the first sale of Tokens;
(2) Disclosures required under paragraph (b) of this section must be made available on a freely accessible public website.
(3) The Token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
(4) The Initial Development Team files a notice of reliance in accordance with paragraph (c) of this section.
(5) An exit report is filed in accordance with paragraph (f) of this section.
(b) Disclosure. The Initial Development Team must provide the information described below on a freely accessible public website.
(1) Initial Disclosures. Prior to filing a notice of reliance on the safe harbor, provide the following information. Any material changes to the information required below must be provided on the same freely accessible public website as soon as practicable after the change.
(i) Source Code. A text listing of commands to be compiled or assembled into an executable computer program used by network participants to access the network, amend the code, and confirm transactions.
(ii) Transaction History. A narrative description of the steps necessary to independently access, search, and verify the transaction history of the network.
(iii) Token Economics. A narrative description of the purpose of the network, the protocol, and its operation. At a minimum, such disclosures must include the following:
(A) Information explaining the launch and supply process, including the number of Tokens to be issued in an initial allocation, the total number of Tokens to be created, the release schedule for the Tokens, and the total number of Tokens outstanding;
(B) Information detailing the method of generating or mining Tokens, the process for burning Tokens, the process for validating transactions, and the consensus mechanism;
(C) An explanation of governance mechanisms for implementing changes to the protocol; and
(D) Sufficient information for a third party to create a tool for verifying the transaction history of the Token (e.g., the blockchain or distributed ledger).
(E) A hyperlink to a block explorer.
(iv) Plan of Development. The current state and timeline for the development of the network to show how and when the Initial Development Team intends to achieve Network Maturity.
(v) Prior Token Sales. The date of sale, number of Tokens sold prior to filing a notice of reliance on the safe harbor, any limitations or restrictions on the transferability of Tokens sold, and the type and amount of consideration received.
(vi) Initial Development Team and Certain Token Holders. Furnish the following information.
(A) The names and relevant experience, qualifications, attributes, and skills of each person who is a member of the Initial Development Team;
(B) The number of Tokens or rights to Tokens owned by each member of the Initial Development Team and a description of any limitations or restrictions on the transferability of Tokens held by such persons; and
(C) If any member of the Initial Development Team or Related Person has a right to obtain Tokens in the future, in a manner that is distinct from how any third party could obtain Tokens, identify such person and describe how such Tokens may be obtained.
(vii) Trading Platforms. Identify secondary trading platforms on which the Token trades, to the extent known.
(viii) Sales of Tokens by Initial Development Team. Each time a member of the Initial Development Team sells five percent of his or her Tokens as disclosed pursuant to paragraph (b)(1)(vi)(B) of this section over any period of time, state the date(s) of the sale, the number of Tokens sold, and the identity of the seller.
(ix) Related Person Transactions. A description of any material transaction, or any proposed material transaction, in which the Initial Development Team is a participant and in which any Related Person had or will have a direct or indirect material interest. The description should identify the nature of the transaction, the Related Person, the basis on which the person is a Related Person, and the approximate value of the amount involved in the transaction.
(x) Warning to Token Purchasers. A statement that the purchase of Tokens involves a high degree of risk and the potential loss of money.
(2) Semiannual Disclosures. Every six months following the date of filing the notice of reliance, pursuant to paragraph (c) of this section, until the end of the three-year period or a determination that Network Maturity has been reached, whichever occurs first, provide updated information required by paragraph (b)(1)(iv) of this section as of the end of the six-month period. These updates must be made within 30 calendar days after the end of the semiannual period.
(c) Filing of Notice of Reliance. The Initial Development Team must file a notice of reliance on the safe harbor prior to the date of the first Token sold in reliance on the safe harbor.
(1) The notice of reliance must contain the following information:
(i) The name of each individual on the Initial Development Team;
(ii) Attestation by a person duly authorized by the Initial Development Team that the conditions of this section are satisfied; and
(iii) The website where disclosure required under paragraph (b) may be accessed.
(iv) An email address at which the Initial Development Team can be contacted.
(2) A notice of reliance must be filed with the Commission in electronic format through the Commission’s Electronic Data Gathering, Analysis, and Retrieval System (EDGAR) in accordance with EDGAR rules set forth in Regulation S-T.
(d) Limitation. The exemption provided in paragraph (a) of this section does not apply to the provisions of Section 12(a)(2) or Section 17 of the Securities Act of 1933.
(e) Duration of Exemption. The relief provided by this section will expire three years from the date the notice of reliance was filed.
(f) Exit Report. An exit report must be filed no later than the date of expiration as calculated in paragraph (e) of this section.
(1) The exit report must contain the following information:
(i) If Network Maturity has been reached for a decentralized network, an analysis by outside counsel must be provided. The analysis should include:
(A) A description of the extent to which decentralization has been reached across a number of dimensions, including voting power, development efforts, and network participation. If applicable, the description should include:
(1) Examples of material engagement on network development and governance matters by parties unaffiliated with the Initial Development Team.
(2) Explanations of quantitative measurements of decentralization.
(B) An explanation of how the Initial Development Team’s pre-Network Maturity activities are distinguishable from their ongoing involvement with the network. The explanation should:
(1) Discuss the extent to which the Initial Development Team’s continuing activities are more limited in nature and cannot reasonably be expected uniquely to drive an increase in the value of the Tokens;
(2) Confirm that the Initial Development Team has no material information about the network that is not publicly available; and
(3) Describe the steps taken to communicate to the network the nature and scope of the Initial Development Team’s continuing activities.
(ii) If Network Maturity has been reached for a functional network, an analysis by outside counsel must be provided. The analysis should:
(A) Describe the holders’ use of Tokens for the transmission and storage of value on the network, the participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.
(B) Detail how the Initial Development Team’s marketing efforts have been, and will be, focused on the Token’s consumptive use, and not on speculative activity.
(iii) If the Initial Development Team determines that Network Maturity has not been reached and no other party has filed an exit report, the following information must be provided:
(A) The status of the project and the next steps the Initial Development Team intends to take.
(B) Contact information for Token holders to communicate with the Initial Development Team.
(C) A statement acknowledging that the Initial Development team will file a Form 10 to register under Section 12(g) of the Securities Exchange Act of 1934 the Tokens as a class of securities within 120 days of the filing of the exit report.
(2) The exit report must be filed with the Commission in electronic format through EDGAR in accordance with EDGAR rules set forth in Regulation S-T.
(g) Transition Period for Trading Platforms. No trading platform shall be subject to the requirements of Section 6 of the Exchange Act due to activity related to the trading of Tokens subject to a determination pursuant to paragraph (f)(iii) of this section, provided that the trading platform prohibits such trading within six months of such determination.
(h) Tokens Previously Sold. An Initial Development Team that prior to the effective date of this rule sold Tokens pursuant to a valid exemption from registration or sold in violation of Section 5 of the Securities Act of 1933 as determined in a Commission order pursuant to Section 8A of the Securities Act of 1933 that does not identify any other violations of the federal securities laws may rely on this section if the conditions of paragraph (a) are satisfied. The notice of reliance required by paragraph (c) of this section must be filed as soon as practicable.
(i) Definition of Qualified Purchaser. For purposes of Section 18(b)(3) of the Securities Act of 1933, a “qualified purchaser” includes any person to whom Tokens are offered or sold in reliance on paragraph (a) of this section.
(j) Disqualifications. No exemption under this section is available for the Tokens of any Initial Development Team if it or its individual members would be subject to disqualification under Rule 506(d).
(k) Definitions.
(1) Initial Development Team. Any person, group of persons, or entity that provides the essential managerial efforts for the development of the network prior to reaching Network Maturity and makes the initial filing of a notice of reliance on this safe harbor.
(2) Network Maturity. Network Maturity is the status of a decentralized or functional network that is achieved when the network is either:
(i) Not economically or operationally controlled and is not reasonably likely to be economically or operationally controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control, except that networks for which the Initial Development Team owns more than 20% of Tokens or owns more than 20% of the means of determining network consensus cannot satisfy this condition; or
(ii) Functional, as demonstrated by the holders’ use of Tokens for the transmission and storage of value on the network, the participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.
The definition is not meant to preclude network alterations achieved through a predetermined procedure in the source code that uses a consensus mechanism and approval of network participants.
(3) Related Person. Related person means the Initial Development Team, directors or advisors to the Initial Development Team, and any immediately family member of such persons.
(4) Token. A Token is a digital representation of value or rights
(i) that has a transaction history that:
(A) is recorded on a distributed ledger, blockchain, or other digital data structure;
(B) has transactions confirmed through an independently verifiable process; and
(C) cannot be modified;
(ii) that is capable of being transferred between persons without an intermediary party; and
(iii) that does not represent a financial interest in a company, partnership, or fund, including an ownership or debt interest, revenue share, entitlement to any interest or dividend payment.
Proposed Exchange Act Rule 3a1-2. Exemption from the definition of “exchange” under Section 3(a)(1) of the Act.
An organization, association, or group of persons shall be exempt from the definition of the term “exchange” to the extent such organization, association, or group of persons constitutes, maintains, or provides a marketplace or facilitates bringing together purchasers and sellers of Tokens satisfying the conditions of Rule 195 of the Securities Act, or otherwise performs with respect to such Tokens the functions commonly performed by a stock exchange as that term is generally understood.
Proposed Exchange Act Rule 3a4-2. Exemption from the definition of “broker” for a person engaged in a Token transaction.
A person is exempt from the definition of the term “broker” to the extent it engages in the business of effecting transactions in Tokens satisfying the conditions of Rule 195 of the Securities Act of 1933 for the account of others.
Proposed Exchange Act Rule 3a5-4. Exemption from the definition of “dealer” for a person engaged in a Token transaction.
A person is exempt from the definition of the term “dealer” to the extent it engages in the business of buying and selling Tokens satisfying the conditions of Rule 195 of the Securities Act of 1933 for such person’s own account through a broker or otherwise.
Proposed Exchange Act Rule 12h-1(j). Exemptions from registration under Section 12(g) of the Act.
Issuers shall be exempt from the provisions of section 12(g) of the Act with respect to the following securities:
New paragraph (j):
(j) Any Token offered and sold in reliance on Rule 195 of the Securities Act of 1933.
“Proposed Safe Harbor – Time-limited Exemption for Tokens.” (April 11, 2021), available at (https://github.com/CommissionerPeirce/SafeHarbor2.0/blob/main/README.md) ↩