Another court applies the Howey investment contract analysis to crypto
The ruling on the motion to dismiss in the SEC v. NAC case indicates that the SEC still has crypto sales in its crosshairs in 2021.
On June 25, 2020, the United States Securities and Exchange Commission brought suit in the Northern District of California against NAC Foundation LLC, also known as the NationalAtenCoin Foundation, and Rowland Marcus Andrade, the company’s CEO, alleging that the company had violated the federal securities laws by selling an unregistered, pre-functional version of an “Anti-Money Laundering BitCoin” token, to be known as AML BitCoin.
Unlike some of the other recent high-profile decisions applying the Howey Test, such as SEC vs. Telegram and SEC vs. Kik, the NAC lawsuit involved detailed allegations of fraud in connection with the sale of pre-functional tokens. Andrade was also indicted by the Department of Justice on charges of fraud arising out of the offering, and Jack Abramoff, a federal lobbyist, pled guilty to participating in the fraud.
On Jan. 8, 2021, Judge Richard Seeborg of the Northern District of California rebuffed NAC and Andrade’s motion to dismiss, finding that the SEC’s complaint had sufficiently alleged that there had been an unregistered sale of securities under the Howey investment contract test. NAC filed its motion to dismiss back in October of 2020, alleging misconduct by the SEC as well as advancing the legal claim that AML BitCoin tokens were not securities under the Howey Test because, among other things, the purchasers had been repeatedly told that they could not expect a return on their investment. The SEC responded colorfully arguing:
“If it looks like a duck, quacks like a duck, and has the genetic makeup of a duck, it is, indeed, a duck. It matters not if the seller puts a sign on the bird exclaiming, ‘this is not a duck.’”
The crypto offering
While many of the facts about the NAC offering are in dispute, some things appear to be settled. In October of 2017, NAC posted a “White Paper of AML BitCoin (AMLBit) and its Business Model” on its website. In this white paper, NAC stated:
“AML BitCoin rests on a privately regulated public blockchain that facilitates… anti-money laundering ‘know your customer’ compliance and identifies criminals associated with illicit transactions, while maintaining and strengthening the privacy protections for legitimate users.”
The white paper also explained that the “privately regulated public blockchain” was yet to be fully developed and that the original purchasers would be issued “ABTC tokens,” which could be exchanged one-for-one with AML BitCoin when the blockchain was finished. The ABTC tokens were, in all other respects, pre- or non-functional.
The white paper proclaimed that both ABTC and the eventual AML BitCoin could be traded “on participating exchanges and trading websites” and conceded there was the possibility of appreciation through speculation. A substantial portion of the white paper explains why, in NAC’s opinion, the AML BitCoins should not be securities.
The actual initial coin offering took place from October 2017 to February 2018, with some sales occurring both before and after that time period. Although the white paper indicated a goal of distributing 76 million ABTC tokens to the public in order to raise $100 million, the actual amount raised was approximately $5.6 million, attributed primarily to 2,400 retail purchasers in the United States. The ABTC thereafter traded on a number of online platforms, but at no time did NAC attempt to register the tokens with the SEC.
Applying the Howey investment contract test
Adopted during the Great Depression, the Securities Act of 1933 obviously does not include crypto or digital assets in the laundry list of things that are to be regulated as “securities.” However, the Securities Act, which requires securities to be registered or exempt from registration in order to be legally offered or sold, does include “investment contracts” within the scope of the securities laws. Crypto assets are generally regulated as securities if they fit within the definition of an investment contract.
In the case of AML BitCoins and ABTC tokens, both the SEC and NAC seemed to agree that the appropriate test for whether NAC had sold an investment contract (and therefore a security) was the one set out by the U.S. Supreme Court in 1945 in SEC v. W.J. Howey Co. As described in more detail elsewhere, the application of the Howey Test turns on the following questions:
- Did the purchasers invest something of value?
- Was there a common enterprise?
- Was the reason for their investment an expectation of profits?
- Were the purchasers relying on the essential managerial or entrepreneurial efforts of others?
All of those elements must be present in order for there to be an investment contract, although the Ninth Circuit (in which California is located) has collapsed the last two elements into a single factor.
As is true for most crypto sales, the NAC sales met the first element of this test. Since purchasers of the ABTC had either used fiat currency or other convertible digital assets to pay for the pre-functional tokens, they had clearly invested property of value. Instead of arguing that element, the issues raised by NAC in its motion to dismiss focused on its contentions that there were no allegations of a common enterprise in the complaint and that the ABTC investors had not purchased with a reasonable expectation of profits.
Commonality is admittedly one of the most complicated and confusing aspects of the Howey Test, with courts disagreeing about what is required to prove this element. Some courts look to vertical commonality, where the fortunes of the investors are tied to those of the issuer, often through a profit-sharing arrangement. Obviously, crypto offerings generally do not involve profit-sharing per se because purchasers acquire no stake or interest in the issuer’s business or profits. On the other hand, this is not necessarily the only way in which vertical commonality can be proven. For example, where the fortunes of an issuer and investors are tied together by a joint interest in the success and profitability of an asset that is yet to be developed, some courts have found vertical commonality to be present.
In addition, other courts look to horizontal commonality, which occurs where the fortunes of investors are tied together, even if the issuer’s profits are determined on some other basis. Such horizontal commonality is often proven by showing that investments are placed in a common pool from which profits are distributed on a pro rata basis.
In this case, NAC argued that this element was missing because investors were required to acknowledge that there was no pooled interest in any business or other common enterprise. Again, however, not all cases agree that a pooling agreement is necessary. Some courts have found that there is horizontal commonality where proceeds from a sale have been combined in a common fund. In its brief supporting its Motion to Dismiss, NAC pointed to a Ninth Circuit opinion that the foundation suggested required that the promoters “knew” their funds would be pooled together.
With regard to the expectation of profits from the efforts of others, NAC argued that that there was only a single mention in its white paper of the possibility that “tokens could ‘appreciate in value through speculative trading…’” NAC contends that this comment occurred in the course of explaining why AML BitCoin would operate like Bitcoin (BTC) in that profitability would “rely entirely on the expertise of the AML BitCoin’s holder.” NAC also pointed to other documents, such as the terms and conditions, which required purchasers to acknowledge that purchasers “expect no return on investment.”
The court’s ruling
Before considering the text of the Jan. 8, 2020, ruling, it is worth emphasizing that the decision was not on the merits. Because the court was responding to a motion to dismiss, the judge was required to determine whether the SEC had sufficiently alleged facts that would support a verdict if those allegations are eventually determined to be true. In other words, in making this ruling, the court assumed that the facts as stated in the complaint accurately recite what happened. The court was allowed to draw reasonable inferences from those facts in determining whether the action should continue but was not allowed to consider NAC’s opposing views as to what had been said and what happened.
The court, therefore, focused on whether the SEC sufficiently alleged that NAC had sold securities under the Howey investment contract test. The court considered both of the two elements identified by NAC: whether there was a common enterprise and whether the purchasers were expecting profits as a result of their investment. The court very quickly dismissed the argument that there was no common enterprise here, finding that both investors and the issuer would benefit from the development of the AML BitCoin system and that they would share proportionately in any future increases in value since the foundation retained the rights to a sizeable number of AML BitCoins. In the words of the court:
“The ‘fortunes’ of ICO participants—as measured by either the trading value of their ABTC tokens or the future trading value of AML BitCoin—were ‘linked’ to the ‘fortunes’ of defendants—as measured by the trading value of their ABTC tokens, the future trading value of AML BitCoin, or the general success of their enterprise…”
In a footnote, Judge Seeborg specifically noted that this result was consistent with the recent opinion in SEC v. Telegram, where the court found commonality based on the fact that every participant’s anticipated profits depended on the issuer’s success in developing the underlying blockchain.
With regard to whether the investors “reasonably expected profits based on the efforts of others,” the court concluded that the SEC had alleged “ample facts” to suggest both that there would be profits and that those profits depended on the issuer’s efforts. The profit motive was, according to the court, apparent from the fact that there was no use for the ABTC or AML BitCoin other than to hope for appreciation. Given that the demand for these assets would “rely almost exclusively on market perception of defendants’ work product” the court had no difficulty in concluding that the SEC’s complaint adequately pled that the assets sold by NAC were securities.
The ruling on the motion to dismiss in SEC v. NAC is not groundbreaking. It does not make new law with regard to when crypto assets should be considered to be securities. It does not involve anything like the amount of money at issue in either SEC v. Telegram or SEC v. Kik. It does not even dictate the final outcome in the case itself.
It is, however, an early indication in 2021 that the SEC still has crypto sales in its crosshairs, and it is further confirmation that the Howey Test is likely to control when crypto is regulated as a security, absent intervention from Congress or potentially a change in perspective from the SEC itself.
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The opinions expressed are the author’s alone and do not necessarily reflect the views of the University or its affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.