Six top law school professors attack the U.S. SEC: Is cryptocurrency really a security?

Written by: jk

A few days ago, law professors from Yale University, the University of Chicago, the University of California, Los Angeles, Fordham University, Boston University, and Widener University submitted an amicus brief that traced the historical meanings of the term "investment contract" before, during, and after the passage of the Securities Act of 1933, thoroughly refuting the SEC's "investment contract" theory.

Here are the scholars' conclusions:

• "By 1933, state courts had reached a consensus on how to interpret the term 'investment contract,' viewing it as a contractual arrangement that grants investors the right to share in the seller's subsequent income, profits, or assets."
• "After the 1946 Howey decision, the common characteristic of '[investment contracts]' remained… that investors must be promised a continuing contractual interest in the enterprise's income, profits, or assets due to their investment."
• "Every 'investment contract' identified by the Supreme Court involves a contractual commitment to provide a continuing interest in the enterprise."

@MetaLawMan on Twitter stated: In my view, this amicus brief delivers a fatal blow to the SEC's argument that cryptocurrencies traded on the secondary market are investment contracts.

Background: "Blue-Sky Laws"

When Congress included the term "investment contract" in its definition of "securities," the term already had a clear meaning in blue-sky laws, requiring contractual promises of future value.

When Congress adopted the Securities Act and the Exchange Act, nearly every state had already enacted state laws regulating securities transactions. In defining a national standard and federal regulatory scheme, Congress chose to create federal laws based on these so-called "blue-sky laws." Most relevantly, in defining the "securities" involved in the new national securities laws, Congress incorporated the term "investment contract" from these blue-sky laws as a whole.

With this background, we review the development of the concept of "investment contract" under blue-sky laws as cited in Howey, as a basis for the term's "uniform" definition.

In the early 20th century, some states in the U.S. began enacting the first blue-sky laws.

At the turn of the 19th century, as the U.S. economy prospered, the market for trading shares of American businesses also flourished. With the influx of middle-class and retail investors flocking to large exchanges in New York and San Francisco to purchase shares of business enterprises ranging from railroads to heavy industry, opportunities to invest in blue-chip stocks increased. However, at the same time, speculative or outright fraudulent investment opportunities from dubious sellers also proliferated, such as those involving "flash-in-the-pan companies, fanciful oil wells, distant gold mines, and other similar fraudulent schemes." Unlike their blue-chip counterparts, these investment opportunities were often sold through face-to-face interactions, newspapers, or even mass mailings. Unsurprisingly, the sale of these investment opportunities often came with clever "puffery" and fraud.

Starting in 1910, state legislatures began to respond to these developments by enacting the first state securities laws. These initial legislative efforts aimed to protect the public from the harm of "dishonest promoters selling shares under the blue sky."

The first blue-sky laws were relatively simple and did not explicitly define the instruments they covered. For example, Kansas's 1911 securities law is regarded as the first blue-sky law. It simply required that investment companies register before selling "any stock, bond, or any other kind or nature of security."

Other states attempted to provide some clarification on what was considered a "security." For instance, the initial regulations in California and Wisconsin explicitly defined "securities" to mean traditional instruments such as "stocks, stock certificates, bonds, and other evidence of debt."

Legislators quickly recognized the need to enact a second generation of securities laws. In fact, the bad, speculative, or fraudulent investment transactions or schemes that prompted the enactment of the first blue-sky laws were technically not stocks or bonds. These transactions, disguised as traditional stocks, proposed to give investors a contractual right to receive future value from the enterprise in exchange for an initial amount of money, similar to stocks or bonds. Moreover, given that these laws focused on genuine stocks and bonds, these fake stocks and bonds were clearly not governed by the first generation of blue-sky laws.

Subsequently, these states expanded their blue-sky laws to include "investment contracts," thereby encompassing the new forms of stocks and bonds.

To explicitly adjust these new instruments or proposals, which shared key economic and legal characteristics with stocks and bonds, state legislatures sought to clearly regulate them in the second generation of securities laws.

Minnesota included the term "investment contract" in its definition of "securities" in its 1919 blue-sky law. This new undefined term aimed to capture those investments that, while not formal stocks or bonds, depended on and granted a contractual right to future profits. Other states quickly followed suit, adding "investment contracts" to the list of instruments covered by their blue-sky laws.

Minnesota's Interpretation of "Investment Contract" in Gopher Tire Case

Although the term "investment contract" was not defined in the law itself, courts soon provided a definition based on the intent and context of the statutory term's adoption in blue-sky laws. In several early Minnesota cases, including the one cited by the Supreme Court in Howey, 328 U.S. 298 & n.4, the state supreme court examined the key characteristics that a set of instruments or rights must meet to be recognized as "investment contracts." These rulings are viewed as authoritative interpretations of the term's original meaning.

In the Gopher Tire case, a local tire dealer sold "certificates" of its business to investors. Gopher Tire, 177 N.W. 937-38. Under the agreement, investors would pay $50 and agree to promote the dealer's products to others. In exchange, investors received a "certificate" that granted them a contractual "right" to a certain percentage of the dealer's profits. After analyzing the definition of "securities" under blue-sky laws, the court ruled that these certificates were not technically or formally "stocks." Nevertheless, the Minnesota Supreme Court still ruled that these certificates "could properly be viewed as investment contracts." In making this ruling, the court reasoned and emphasized that these certificates shared the same key characteristics as stocks, namely that the investors provided "funds" to the dealer in exchange for a "right" to "share in the profits of the company."

Other early Minnesota cases followed this early judicial test to define the statutory term. In Bushard, the Minnesota Supreme Court faced another dispute regarding whether a profit-sharing arrangement constituted an investment contract. Here, a bus driver paid the bus company $1,000 and, in return, received a "contract" promising the driver a certain salary plus a share of the bus company's profits (in addition to "eventually returning" his $1,000 "investment"). Based on the Gopher Tire ruling, the court determined that this arrangement was an "investment contract," based on two key factors: the driver (i) "invested with the purpose of making a profit," and (ii) in exchange, received a "contract" ("operator agreement") that ensured an interest in the future profits of the enterprise.

In summary, early Minnesota cases primarily revolved around two statutory terms: "contract" and "investment." If an arrangement meets the following conditions, it is considered an investment contract: (i) the investor receives a contractual promise in another's business enterprise, and (ii) in exchange for the "investment," the investor is promised rights to share in the enterprise's future income, profits, or assets.

By the time the Securities Act and the Exchange Act were adopted, the term "investment contract" had a clear meaning.

By 1933, when the Securities Act was enacted, 47 of the 48 states had already passed their own blue-sky laws, many of which involved "investment contracts" (following Minnesota's lead). Moreover, in the decades leading up to 1933, as state courts applied the term "investment contract" to various arrangements, they reached a consensus on a unified meaning. As Howey explained, this is the meaning adopted by Congress.

In short, by 1933, state courts had reached a consensus on how to interpret the term investment contract, viewing it as a contractual arrangement that grants investors the right to share in the seller's subsequent income, profits, or assets. In fact, to our knowledge, it seems that no state court ruling has found an investment contract without these key characteristics. In some rulings, such as Heath, the court openly suggested that an "investment contract" requires an actual contract. In other rulings, the court emphasized the seller's obligation to pay (and the holder's right to receive) a portion of its future value in exchange for the initial capital expenditure. Courts typically rely on this requirement to distinguish genuine investment contracts from basic asset sales.

"Investment Contracts" Since the Howey Decision

For over 75 years since the Howey decision, courts have applied the Supreme Court's seemingly simple test to all novel and complex business contexts, resulting in a complex web of case law. The common thread remains—just as state courts interpret state blue-sky laws and as required by Howey—investors must be promised a continuing contractual interest in the enterprise's income, profits, or assets due to their investment. In this section, we will discuss some of these cases.

A. The Howey Test Requires Consideration of Whether a Proposal Resembles the Common Concept of Securities.

The Supreme Court has repeatedly interpreted the term "investment contract," including in Howey itself. Each time, when applying the Howey test, the court considered whether the transaction reflected the fundamental attributes typically associated with securities.

Additionally, the court compared the arrangement to other instruments previously deemed "securities." For example, in Forman, the court noted that there was no distinction between "investment contracts" and "instruments commonly referred to as securities," which is another enumerated term in the statutory definition of "securities." Applying Howey, the court concluded that shares in a nonprofit housing cooperative were not "investment contracts" because the investors' motivation was "merely to obtain a place to live, rather than to receive financial returns on their investment."

Marine Bank provided another example. There, a couple guaranteed a loan for a meat company and exchanged a certificate of deposit for a share of the company's profits and the right to use its facilities. The court ruled that the certificate of deposit and the couple's subsequent agreement with the company were not "securities."

Here, case law from the states—both from before 1933, as referenced in Section I above, and from federal courts after 1933—has emphasized that for there to be an "investment contract," the investor must obtain some contractual interest in the enterprise through which they may profit.

B. Every "Investment Contract" Identified by the Supreme Court Involves a Contractual Commitment to Grant a Continuing Interest in the Enterprise.

Echoing the rulings of state courts prior to the 1933 blue-sky laws, the Supreme Court's rulings after Howey recognized that holders of "investment contracts" must be promised the right to participate continuously in the enterprise's income, profits, or assets.

In International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979), the court particularly emphasized this theme. There, the court observed that "in every decision in which this court has found the existence of 'securities,' the individuals considered to be investors have chosen to forego specific consideration in exchange for separable financial interests characteristic of securities." The court found that there were, in fact, no "separable financial interests characteristic of securities" before it. Specifically, it concluded that a non-contributory, mandatory pension plan was not a "security" because the pension benefits claimed to be securities were merely a small part of the overall, non-security compensation that individuals received due to their employment.

To date, every arrangement that the Supreme Court has deemed an "investment contract" has promised investors some form of continuing, contractual interest in the enterprise's future efforts. S.E.C. v. C. M. Joiner Leasing Corp. was a case from three years before Howey, involving the offering of land lease rights near planned oil well test sites in exchange for investors to "share in the discovery value of the ongoing 'exploratory enterprise.'"

Howey itself involved providing parcels of land in an orange grove and entering into contracts with promoters to harvest, market, and sell the oranges in exchange for a "net profit distribution" made at the time of picking based on inspections.

C. Other Relevant Rulings

First, two "investment contract" rulings after Howey—S.E.C. v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65 (1959) and S.E.C. v. United Benefit Life Insurance Company, 387 U.S. 202 (1967)—involved annuity plans under which investors paid premiums to investment funds managed by life insurance companies and were entitled to corresponding shares of the profits.

The Tcherepnin case involved a proposal for "withdrawable capital shares" offered by a savings and loan association in Illinois, where investors purchasing these shares had the right to become members of the association, vote their shares, and "receive dividends declared by the association's board based on the association's profits."

Finally, the Edwards case involved a sale-leaseback plan in which a promoter provided public telephones along with a site lease, leaseback, and management agreement, and investors were entitled to a fixed 14% annual return from the daily operations of the public telephones, which were leased back and managed by the promoter.

In addition, the professors found that every "investment contract" identified by the Second Circuit involved a contractual commitment to grant a continuing interest in the enterprise, citing dozens of examples to support this.

Why This Is Considered a Complete Refutation of the SEC's Argument?

Based on the above, Minnesota's definition of "investment contract" primarily focuses on the two core concepts of "contract" and "investment." Its definition emphasizes the investor's receipt of some form of contractual promise in a business enterprise and the right to share in the enterprise's future income, profits, or assets due to their investment. This definitional approach is grounded in the traditional notions of capital investment and profit sharing.

However, existing cryptocurrencies differ from this definition. First, purchasing cryptocurrencies does not imply that investors will receive any form of contractual promise or a clear right to profit sharing in a specific business enterprise. The value of cryptocurrencies is typically based on market demand and supply, technological advancements, or other external factors, rather than on profit sharing with a specific company or enterprise.

Second, holders of cryptocurrencies generally do not expect or rely on a specific enterprise or individual for returns or profits. Their returns usually stem from the appreciation of the currency, which is determined by market forces rather than driven by a specific business activity or profit.

Overall, while cryptocurrencies do involve "investment" to some extent, their nature, return mechanisms, and relationship with traditional notions of "contracts" and "investment contracts" make them difficult to fit into the investment contract definition from early Minnesota cases.

Similarly, based on the relevant definitions argued in this article, cryptocurrencies differ from traditional securities or investment contracts in that their core value primarily depends on their characteristics as "commodities." First, cryptocurrencies, like Bitcoin, were initially designed as digital currencies intended to provide a decentralized payment method free from the constraints of traditional banking systems, which has been demonstrated as a means of paying gas fees across major public blockchains. This means that, in essence, it serves as a medium of exchange, possessing commodity value similar to gold or other items.

Furthermore, the value of cryptocurrencies largely depends on their scarcity, authenticity, and non-falsifiability. For instance, the total supply of Bitcoin is limited, akin to gold, which also has a fixed supply. This scarcity endows it with commodity value. Additionally, blockchain technology ensures the authenticity and uniqueness of each unit of cryptocurrency, making it difficult to forge or replicate.

These attributes make cryptocurrencies more akin to gold, crude oil, or any other form of physical commodity, rather than traditional securities or investment contracts. Although people do purchase cryptocurrencies as investments, hoping for their value to increase, this is no different from buying gold or art with the expectation of appreciation. Therefore, from this perspective, cryptocurrencies should be viewed more as assets with commodity value rather than traditional securities or investment contracts.