October 2022
Sean Yu-Shao Liu
In the middle of 2019, the Financial Supervisory Commission of Taiwan (hereinafter, the “FSC”) issued a significant directive (the Jin-Guan-Zheng-Fa-1080321165 Directive[1], hereinafter, the “FSC’s Directive”), laying out the standards to determine whether a cryptocurrency/token is a security under the Securities Exchange Act” (hereinafter, a “Security”). The FSC’s Directive borrows the concept of an investment contract under U.S. law and includes the following conditions: (1) there is an investment from the investor; (2) the investment is for a common enterprise or scheme; (3) the investor has an expectation of profits; and (4) the profits come primarily from the efforts of the issuer or a third party. Soon after its announcement, FSC’s Directive has drawn criticism because the FSC had not determined that an investment contract is a Security. Yet still, the FSC’s Directive jumped to the conclusion that a cryptocurrency/token satisfying the conditions above is a security according to the concept of the investment contract. Moreover, I believe the more serious problem of the FSC’s Directive is that the standard is not directed at an overall scheme committed by a legal entity, but a cryptocurrency/token itself. The misconception may contradict the concept of an investment contract and even inappropriately hamper the development of blockchain-related industries.[2]
Compared to the Howey case, in which the overall scheme committed by a legal entity was targeted to determine if it is an investment contract, the FSC’s Directive examines the cryptocurrency/token directly.
The FSC considered for reference SEC v. Howey Co. (328 U.S. 293 (1946),[3] a classic U.S. Supreme Court case interpreting the concept of investment contracts. The facts of the case indicated that Howey Co., the owner of the orchard, divided the orchard into many small parcels and attracted many investors who only pursued profits without paying intention to the planting and sales by predetermining the sale of small parcels of the orchard and related services (planting of fruit trees, sale of fruits, and payment of profits). The U.S. Securities Act of 1933 provides that an “investment contract” is a type of security under the act, but does not provide a definition. The U.S. Supreme Court in this case proposed a specific standard (the “Howey Test”) to conclude that the above “transaction scheme” constitutes a type of “investment contract”, thus a securtiy under the U.S. Securities Act of 1933.
When reading the Howey Test, one is prone to focus on its four determination criteria only, i.e., “investment of money” to a “common enterprise” with a “profit expectation” through the “efforts of others,” but there is one basic fact that should not be overlooked. The U.S. Supreme Court used the above criteria to examine whether the overall scheme committed and arranged by a legal entity, instead of a specific object in the scheme, is an investment contract. The overall scheme may be in the form of a contract, transaction, plan, etc. If it is regarded as an investment contract as objectively determined, then it is also considered an overall scheme committed by a legal entity, and it is not true that the specific object in the overall scheme constitutes an investment contract or a security. However, according to the FSC’s Directive, the FSC borrowed the criteria of the Howey case regarding an investment contract to determine whether a particular cryptocurrency/token, instead of a scheme committed by the issuer, constitutes a security. Therefore, compared to the Howey case, in which the overall scheme committed by a legal entity was targeted to determine if it was an investment contract, the FSC’s Directive examined the cryptocurrency/token as the target of examination. This seems to me conceptually distorted.
Ignoring the overall scheme and going directly to the cryptocurrency/token may lead to overkill for not being able to exclude cryptocurrency/token with utility.
When a particular cryptocurrency/token is examined under the Howey Test, one must certainly consider the “efforts of the issuer or third party” and the “investor’s profit expectation,” and the results of the examination may be no different than if the overall scheme committed by the legal entity or the issuer is targeted for examination. It seems that the U.S. SEC’s investigation report[4] released after the DAO hacking incident also indiscriminately and directly examined if a cryptocurrency/token is an investment contract or a security. Thus, while some may believe that, in determining the target of examination, the conceptual distinction between a cryptocurrency/token per se or the overall scheme committed by the issuer brings no actual benefits, this is not the case if the actual legal analysis is conducted.
To be specific, universally there are two fundamental issues over whether a cryptocurrency/token is a security. Firstly, is a utility cryptocurrency/token not a security? Secondly, can a cryptocurrency/token that used to be a security[5] get rid of the tag? In my opinion, although it is possible to address the above two issues correctly without distinguishing the examination targets mentioned above, such an analysis would be an unnecessary detour or even a cul-de-sac. The way to get to the root of the problem and easily resolve the above-mentioned issues is to directly target the “overall scheme committed by the legal entity” in determining if it is an investment contract/security.[6]
Firstly, in the Howey case, the court held that the overall scheme provided by Howey Co. was an investment contract, taking into account the important fact that although the investors purchased the land of the orchard and retained services such as planting and sales in this overall scheme on the surface, not only the investors were not allowed to enter the orchard but also they had no right to obtain the harvested fruits. The only right that the investors had was to claim the ultimate profits. The court concluded that this overall scheme meets the “profit expectation” criterion based on this important consideration. From the above reasoning process of the Howey case, it is apparent that the overall scheme committed by the legal entity and the fruits to be produced were distinguished. As a result, it is easy to understand that the scheme committed by Howey Co. pertains to planting fruit trees, selling fruits, and paying profits, and the investors were only entitled to the profits, not the acquisition or disposal of specific fruits. Since both the subjective intent and the objective agreement between the parties to the investment contract did not include the delivery of specific fruits or other rights of use, but rather focused on the distribution of profits, the court concluded that the investors had a profit expectation and that the scheme constituted an investment contract.
Conversely, if it is the fruits instead of the overall scheme committed by Howey Co. had been examined, the court would not have drawn the same conclusion without any difficulties. If it is admittedly inappropriate to apply the Howey Test to the examination of the fruits, why is it appropriate to directly examine a cryptocurrency/token while skipping the overall scheme of the entity that issues them? More importantly, given the clear distinction between the concept of the overall scheme committed by the legal entity and the fruits, it is easy to see the ramifications of the Howey case: if the investors had the right to obtain, enjoy, give away to others, or otherwise dispose of the fruits so produced in the overall scheme, likely, the overall scheme would not constitute an investment contract. When the same logic is applied to the situation where a developer raises funds via a cryptocurrency/token, if the overall fundraising scheme of the developer is conceptually differentiated from the related cryptocurrency/token, it is easier to conclude that if the cryptocurrency/token has a practical value and will be delivered to the buyer that has provided the funding in advance to decide its use or disposal, as in the case of fruit, neither the overall fundraising scheme nor the cryptocurrency/token is a security.
Ignoring the overall scheme and going directly to the cryptocurrency/token may lead to overkill for not being able to exclude cryptocurrency/token that has been sufficiently decentralized.
Furthermore, to address the second important issue mentioned above, i.e., “whether a cryptocurrency/token that used to be a security can be transformed into non-security?”, conceptually differentiating the overall scheme committed by the issuer from the cryptocurrency/token should be helpful. In an earlier interview, SEC Chairman Gary Gensler said that the only cryptocurrency/token that he is willing to explicitly state is not a security is bitcoin.[7] In other words, all cryptocurrencies/tokens, including Ether, are at risk of violating security laws and regulations. But if ether, the native cryptocurrency of Ethereum that has been developed for years and considered by most people to be highly decentralized, still faces legal risks, wouldn’t other new cryptocurrency developers have to walk on thin ice and fear that they could be faulted at every turn?
Since an investment contract is by nature a contract, if the obligations under the contract have been fulfilled, or if the legal entity responsible for the contractual obligations has disappeared with no other legal entity to succeed to the obligations, the investment contract will be extinguished or terminated.[8] Since the concept of an investment contract is applied to determine the existence of a security, the above basic principles concerning an investment contract cannot be violated. In other words, if an investment contract involving the issuance of a cryptocurrency/token has been performed or the obligated legal entity no longer exists, it should be deemed that the investment contract involving the issuance of the cryptocurrency/token has no longer been a security. When the subject of the examination in the above legal analysis is defined as the overall scheme committed by a legal entity, it is easier to determine when the performance of the contract is completed and whether there is still a legal entity that should assume the obligations to further deduce whether the investment contract and the cryptocurrency/token issued in connection with the contract have been transformed into non-securities. On the contrary, if the cryptocurrency/token itself is the subject of the examination, it would require significant efforts or even fail to reach the same conclusion.
Blockchain technology is characterized by decentralization, and the key to determining decentralization is to confirm whether there is control by a specific person, which is obviously and incidentally similar to the existence of a legal entity. Take bitcoin for example. The development work is carried out through an open-source project and the software upgrade requires the consent of most miners. If the miners’ computing power is decentralized enough, then the public blockchain is decentralized. As for the myriads of application protocols on the public blockchain, initially, they must be controlled by a specific development team, but if the development work is transferred to an open-source project, the governance authority is subsequently given to a decentralized autonomous organization (DAO), and if the token holders controlling the DAO are sufficiently decentralized, the application protocols should be considered decentralized and not controlled by a specific person.
William Hinman, a former SEC official, once stated in a speech that bitcoin and ether are not securities because they have been “sufficiently decentralized.” Although the SEC has never stated that this is its official position, and it is likely that the question of whether a particular utility token is a security will ultimately be a question of legal policy to be answered by legislators after public debates, if the relevant discussions are based on the concept of an investment contract, and the overall scheme committed by a legal entity is the subject of examination as to whether it is an investment contract, it is theoretically feasible to determine if the related legal entity for the investment contract still exists through the degree of decentralization to further decide if a cryptocurrency/token, which is part of the investment contract, can be subsequently transformed into a non-security.
The well-known Chinese poet Tong-po Su remarked in his poem, “Why can’t I tell the true face of Mount Lu? Because I myself am in the mountain.” The U.S. SEC is still unable to clearly explain how the Howey Test can apply to a cryptocurrency/token many years after the release of the DAO report. And there have been no applicable cases since the release of the FSC’s Directive. Certainly many internal and external factors lead to the status quo. However, this can probably be attributed to the failure to maintain a distance in the application of the Howery Test to take a step back to target the overall scheme committed by the developer for the examination. Conversely, directly examining the cryptocurrency/token per se too closely has resulted in the ambiguity of relevant legal analyses. In my view, the competent authority should carefully consider amending the FSC’s Directive to clarify that the relevant determination criteria apply to the overall scheme committed by the developer, not a cryptocurrency/token per se.
(This article has been slightly revised after it was originally published in Apple Online, an Internet news forum.)
[1] https://www.sfb.gov.tw/ch/home.jsp?id=88&parentpath=0&mcustomize=lawnews_view.jsp&dataserno=201907030002
[2] The author is grateful to Ankwei Chen, a colleague of the author and an attorney licensed in the District of Columbia of the U.S., for providing very helpful suggestions on the draft of this article, including sharing an article with similar viewpoints (https://www.winston.com/en/crypto-law-corner/when-it-comes-to-analyzing-utility-tokens-the-sec-staffs-framework-for-investment-contract-analysis-of-digital-assets-may-be-the-emperor-without-clothes-or-sometimes-an-orange-is-just-an-orange.html). That said, the author is solely responsible for this article.
[3] https://supreme.justia.com/cases/federal/us/328/293/
[4] https://www.sec.gov/litigation/investreport/34-81207.pdf
[5] It should be more accurately characterized as “cryptocurrencies/tokens that used to be part of an investment contract.”
[6] The analysis in this article is focused on the concept of an investment contract. If an object under review should be treated as a security due to other factors (such as related equities equivalent to stocks or bonds), it is certainly not excluded as a security for not being an investment contract.
[7] https://www.cnbc.com/video/2022/06/27/sec-chair-gary-gensler-discusses-potential-crypto-regulation-and-stablecoins.html?&qsearchterm=gary%20gensler
[8] For example, the Taiwan High Court held in its 108-Shang-Yi-513 Civil Decision: “There are many causes for the extinguishment of a mandate relationship like the causes for the extinguishment of a contract such as the completion of the mandated matters or inability to perform.” The Taiwan High Court held in its 102-Shang-177 Civil Decision: “Since the Appellant has completed the handling of the matters mandated to him, the mandate relationship was extinguished since the handling of the mandated matters is completed.”
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