United States: When It Comes To Analyzing Utility Tokens, The SEC Staff's "Framework For ‘Investment Contract' Analysis Of Digital Assets" May Be The Emperor Without Clothes (Or, Sometimes An Orange Is Just An Orange) (Part IV)

This is the fourth in a series of posts critical of the SEC’s approach to analyzing so-called “utility tokens” under the federal securities laws. The first, second and third posts can be found here, here, and here. This post, like the previous three, is not intended to be, nor should it be substituted for, legal advice, which turns on specific facts. Further, the legal treatment of utility tokens is uncertain and continues to develop, and there can be no assurance that any court or regulator would agree with any of the conclusions set forth below.

Part IV: The Investment/Consumption Duality
In my last post, I asserted that the central thrust of the case law surrounding the offer and sale of contracts, transactions or schemes that involve the sale of consumptive items is that the substance and economic reality of such contracts, transactions or schemes must be determined by the nature of the marketing efforts employed by the issuer. In this connection, perception is reality—not the subjective perception of the persons purchasing such items, but the objective perception that the issuer attempts to induce. If the issuer employs marketing methods that, analyzed objectively, would induce a person to view the purchase of the consumptive item as part of an investment package, then the substance and economic reality are that the issuer has engaged in the offer and sale of an “investment contract.” If, however, the issuer employs marketing methods that, analyzed objectively, would induce a person to view the purchase of the consumptive item as just that, then the substance and economic reality are that the issuer has engaged in the offer and sale of a consumptive item, not an “investment contract.”

As discussed below, at least one court has aptly referred to this duality as the investment/consumption duality. The courts have recognized this duality based on an understanding that, as broad as the remedial purposes of the federal securities laws may be, those laws cannot be read to support the assertion of liability against persons engaged in commercial, as opposed to investment, transactions – even if such transactions involve fraud.

In this post, I will explore how the courts have articulated the investment/consumption duality.

In my next post, I will explore how the courts have applied the investment/consumption duality to particular contracts, transactions or schemes involving the sale of consumptive items to determine whether such contracts, transactions or schemes constitute “investment contracts.” 

Howey Revisited
First, in under to have a sound understanding of the investment/consumption duality, it is important to revisit the definition of “investment contract” articulated by the Supreme Court in SEC v. W. J. Howey Co. (“Howey”).¹

In Howey, the Supreme Court held that:

“…an investment contract, for purposes of the Securities Act, means 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….”²

The Howey test typically is described as having three prongs or elements.³ Virtually all of the cases recite the first two prongs exactly as they are stated in Howey,⁴ but the cases express the third prong in different ways. Some cases recite the third prong exactly as it is stated in Howey.⁵ Other cases, for reasons unknown, reformulate the third prong of Howey in the following ways (among others):

• “the expectation of profits to be derived solely from the efforts of others;”^6vi
• “with an expectation of profits produced by the efforts of others;”⁷
• “with an expectation of profits solely from the efforts of others;⁸
• “with the expectation of profits to be derived from the efforts of a third party;”⁹
• “with profits to come solely from the efforts of others;”¹⁰
• “with the expectation of profits to come solely from the efforts of others;”¹¹ⁱ
• “a common venture premised on the reasonable expectation of profits to be derived from entrepreneurial or managerial efforts of others;”¹²
• “with the reasonable expectation of profits to be derived from the entrepreneurial or managerial [or ‘‘management”¹³] efforts of others;”¹⁴ and
• “with the expectation that profits will be derived solely from the efforts of individuals other than the investors.”^15v

Still other cases use different formulations or reformulations of the third prong in the course of the same opinion.¹⁶

Regardless of how the prongs of the Howey test are described, the cases generally address the following five factors (all of which are expressly included in Howey’s definition of “investment contract” set forth above) in determining whether a contract, transaction or scheme is an “investment contract:”

1. an investment of money;¹⁷
2. in a common enterprise;¹⁸
3. where the investor has been led to expect;
4. profits;^xix
5. solely from the efforts of the promoter or a third party.

Case law subsequent to Howey has tended to ignore the word “solely” in the fifth factor, with courts differing on the scope or degree to which investors must rely on the efforts of others in order for there to be a finding that a particular contract, transaction or scheme constitutes an “investment contract” and therefore a “security.” Current cases generally are of the view that “the word ‘solely’ should not be read as a strict or literal limitation on the definition of an investment contract, but rather must be construed realistically, so as to include within the definition those schemes which involve in substance, if not form, securities,” and that the true test is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”²⁰

While case law appears to read the word “solely” out of the Howey test, it has not abandoned the “common enterprise” test, even though the “ Framework for ‘Investment Contract’ Analysis of Digital Assets,” issued by the staff of the SEC’s Strategic Hub for Innovation and Financial Technology on April 3, 2019, gives the “common enterprise” test what can only charitably be characterized as perfunctory treatment.²¹

Interpreting the Term “Investment Contract” Broadly in Light of the Remedial Purposes of the Securities Acts
The courts have recognized that the term “investment contract” is to be given a broad definition in light of the remedial purposes of the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act” and, together with the Securities Act, the “Securities Acts”).  

For example, in SEC v. C.M Joiner Leasing Corp.,²² a case that preceded Howey and laid the basic foundations for the Howey test,²³ the Supreme Court stated that:

“the reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a security.’... In applying acts of this general purpose, the courts have not been guided by the nature of the assets back of a particular document or offering...The test, rather, is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect. In the enforcement of an act such as this it is not inappropriate that promoters’ offerings be judged as being what they were represented to be.’”²⁴

In Howey, the Supreme Court explained that:

“[t]he 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 [sic] other than themselves. [citations omitted]

“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 crystalized 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 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 [Joiner] and has been enunciated and applied many times by lower federal courts. [citations omitted] 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, 73rd 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.” 25

In Tcherepnin v. Knight,²⁶ the Supreme Court, in construing the term “security” as it is used in the Exchange Act,²⁷ stated that “we are guided by the familiar canon of statutory construction that remedial legislation should be construed broadly to effectuate its purposes. The [Exchange Act] quite clearly falls into the category of remedial legislation. [citations omitted] One of its central purposes is to protect investors through the requirement of full disclosure by issuers of securities, and the definition of security in §3(a)(10) necessarily determines the classes of investments and investors which will receive the Act’s protections. Finally, we are reminded that, in 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.”²⁸ 

In United Housing Foundation, Inc. v. Forman,²⁹ the Supreme Court stated that Congress broadly defined the term “security” “so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.”³⁰

In Reves v. Ernst & Young,³¹ the Supreme Court stated that:

“The fundamental purpose undergirding the Securities Acts is ‘to eliminate serious abuses in a largely unregulated securities market.’ United Housing Foundation, Inc. v. Forman,  421 U. S. 837,  421 U. S. 849 (1975). In defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits, SEC v. W.J. Howey Co.,  328 U. S. 293,  328 U. S. 299 (1946), and determined that the best way to achieve its goal of protecting investors was ‘to define the term “security” in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.’ … Congress therefore did not attempt precisely to cabin the scope of the Securities Acts…Rather, it enacted a definition of ‘security’ sufficiently broad to encompass virtually any instrument that might be sold as an investment.”³²

Notwithstanding the Broad Remedial Purposes of the Securities Act, Those Acts Cannot Be Invoked to Remedy Every Commercial Tort
While the courts have clearly concluded that the term “investment contract” must be construed broadly in order to effectuate the purposes of the Securities Acts, they have at the same time been wary of characterizing commercial arrangements involving the sale of goods and services as “investment contracts” for the sake of affording a remedy to persons who have entered into such arrangements and lost money.

Thus, in Reves, the Supreme Court – immediately after articulating the position (quoted above) that the Securities Acts must be construed broadly in light of their remedial purposes – concluded (quoting Marine Bank v. Weaver, 455 U.S. 551, 556 (1982)) that ‘‘Congress did not…intend to provide a broad federal remedy for all fraud.”

In Rodriguez v. Banco Cent. Corp., 990 F. 2d 7, 10 (1st Cir. 1993), the First Circuit stated that “…[Howey and Forman] mark out a concept, not a precise definition. The term ‘securities,’ we are told, must be flexibly applied to capture new arrangements comprising the essence of securities, however they may be named…But not all property is a security, and fuzzy edges do not mean that the concept is unbounded.”

Other cases make the same point. See, e.g., Long v. Shultz Cattle Co., Inc., 896 F. 2d 85, 88 (5th Cir. 1990) (en banc) (recognizing “the importance of a workable definition of the term ‘investment contract,’ one that fully implements the remedial purposes of the Securities Acts without unduly burdening commercial enterprises that Congress never intended to be covered under the federal securities laws.”); Garcia v. Santa Maria Resort, Inc., 528 F. Supp. 2d 1283, 1292 (S.D. Fla. 2007) (“Count I seeks relief under the federal securities laws; therefore, only if the transactions before the Court fall within the ambit of those laws could Plaintiffs have a federal securities claim. These laws are not a panacea for every alleged transactional wrong, however, because ‘federal securities laws were not intended to provide a federal remedy for all fraud or misconduct arising out of a commercial transaction.’”) [quotations omitted]; Haddad v. Rav Bahamas, Ltd., 431 F. Supp. 2d 1278, 1284 (S.D. Fla. 2006) (the definition of “investment contract” requires courts “to examine the economic substance of the transaction and is broadly applied to ‘encompass virtually any instrument that might be sold as an investment.’  Mutual Benefits Corp., 408 F.3d at 742 (citations omitted). Nevertheless, courts recognize that the federal securities laws were not intended to provide a federal remedy for all fraud or misconduct arising out of a commercial transaction.  Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982). Thus, ‘[e]ach transaction must be analyzed and evaluated on the basis of the content of the instruments in question, the purposes intended to be served, and the factual setting as a whole.’ Id. at 561 n. 11, 102 S. Ct. 1220.”).

The Investment/Commercial Dichotomy
Timmreck v. Munn³³ neatly summarizes the competing considerations discussed above:

As I will discuss in my next post, other courts have adopted the same analysis regarding the difference between “investment contracts” involving consumptive items, on the one hand, and commercial arrangements involving such items, on the other. While the cases have often struggled to draw the line clearly based on the particular facts and circumstances before them,³⁵ the basic principles that have guided them in this context are these:

• Application of the Howey test to a contract, transaction or scheme involving the offer and sale of a consumptive item involves an “objective” inquiry into whether the issuer/promoter has led potential purchasers to expect profits resulting from the managerial or entrepreneurial efforts of others. Put somewhat differently, the test is what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect. The test is an objective, rather than a subjective test. The fact that a person believes he or she is making an “investment” is not sufficient to prove the existence of an “investment contract.” What matters is whether the efforts utilized by the promoter would lead a reasonable person to believe he or she is making an investment.
• Central to this test is the “promotional emphasis” of the seller of the product. 
• Characterization of the inducement cannot be accomplished without a thorough examination of the representations made by the seller as the basis of the sale.
• Promotional materials, merchandising approaches, oral assurances and contractual agreements must be considered in applying the test.
• If, from an objective standpoint, the promoter does not offer and sell the item primarily as an investment, the offer and sale of the item will not constitute an “investment contract.”
• Without a promoter’s actual promise or agreement to take actions expressly designed to add value to an otherwise consumptive item, the contracts, transactions or schemes pursuant to which such items are offered and sold will not be considered “investment contracts,” even though the promoter takes actions that in fact increase the use and enjoyment, and thus the potential value, of the item. 

I will discuss many of these cases, and their implications for the offer and sale of utility tokens, in my next post.

Footnote

1 328 U.S. 293 (1946).

2 328 U.S. at 298-299. Later in its opinion, the Supreme Court restates this test as follows: “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.” 328 U.S. at 301. This second formulation of the test omits the “is led to expect” profits language contained in the Court’s initial formulation. As we shall see, however, the courts – by focusing on an “objective” analysis of the types of inducements offered by promoters – have either explicitly or implicitly found the “is led to expect” language to be a core component of the Howey test.

3 See, e.g., AFFCO Invs. 2001, L.L.C. v. Proskauer Rose, L.L.P., 625 F. 3d 185, 190 (5th Cir. 2010); Cameron v. Outdoor Resorts of Am., Inc., 608 F. 2d 187, 192 (5th Cir. 1979); Hodges v. Harrison, 372 F. Supp. 3d 1342, 1348 (S.D. Fla. 2019); Rocky Aspen Mgmt. 204 LLC v. Hanford Holdings LLC, 230 F. Supp. 3d 159, 164-65 (S.D.N.Y 2017); SEC v. Cooper, 142 F. Supp. 3d 302, 314 (D. N.J. 2015); Rossi v. Quarmley, 7 F. Supp. 3d 502, 507-8 (E.D. Pa. 2014); In Re Gables Mgmt., LLC, 473 B.R. 352, 360 (Bkrtcy. D. Idaho 2012); SEC v. Infinity Group Co., 993 F. Supp. 321, 322-4 (E.D. Pa. 1998); Copeland v. Hill, 680 F. Supp. 466, 467 (D. Mass. 1988); Seale v. Miller, 698 F. Supp. 883, 891 (N.D. Ga. 1988); Waterman v. Alta Verde Indus., Inc., 643 F. Supp. 797, 802-3 (E.D.N.C. 1986), aff’d, 883 F. 2d 1006 (4th Cir. 1987).    

Sometimes, the Howey test is described as having four prongs. See, e.g., Great Rivers Co-Op of S.E. Iowa v. Farmland Indus., Inc., 198 F. 3d 685, 700 (8th Cir. 1999); Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F. 2d 230, 239 (2nd Cir. 1985); Costa v. Carambola Partners, LLC, 590 F. Supp. 2d 1141, 1150 (D. Minn. 2008).

In Marini v. Adamo, 812 F. Supp. 2d 243, 255 (E.D.N.Y. 2011), the court described the Howey test as having four prongs, but noted that “the Supreme Court also added a fifth requirement in Marine Bank v. Weaver, 455 U.S. 551, 102 S. Ct. 1220, 71 L.Ed.2d 409 (1982), namely, that ‘for an instrument to be a security the investor must risk loss.’ Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230, 239 (2d Cir. 1985).”

At least one laconic court has reduced the Howey test to two prongs: “The test for whether an agreement constitutes an ‘investment contract’ for purposes of federal securities laws involves two inquiries: (i) whether the investor is investing in a common enterprise and (ii) whether the investor is led to expect profits solely from the efforts of the promoter or a third party.” quotations omitted Garcia v. Santa Maria Resort, Inc., 528 F. Supp. 2d 1283, 1292 (S.D. Fla. 2007).

4 But see, AFFCO Invs. 2001, L.L.C. v. Proskauer Rose, L.L.P., 625 F. 3d 185, 190 (5th Cir. 2010) (“The Howey test thus contains three elements: (1) an investment of money; (2) in a scheme functioning as a common enterprise; (3) with the expectation that profits will be derived solely from the efforts of individuals other than the investors.”); Copeland v. Hill, 680 F. Supp. 466, 467 (D. Mass. 1988) (“In Howey, the Supreme Court defined an investment contract as (1) an investment (2) in a common venture premised on the reasonable expectation of profits (3) to be derived from the entrepreneurial or managerial efforts of others.”) 

5 See, e.g., Bailey v. J.W.K Props., Inc., 904 F. 2d 918, 920 (4th Cir. 1990); SEC v. The Infinity Group Co., 993 F. Supp. 321, 322 (E.D. Pa. 1998); Baroi v. Platinum Condominium Dev., LLC, 914 F. Supp. 2d 1179, 1192 (D. Nev. 2012); Glazer v. Abercrombie & Kent, Inc., No. 07 C 2284, 2009 WL 3060269 at 6 (N.D. Ill. Sept. 22, 2009); SEC v. Kirkland, 521 F. Supp. 2d 1281, 1289-90 (M.D. Fla. 2007); Garcia v. Santa Maria Resort, Inc., 528 F. Supp. 2d 1283, 1292 (S.D. Fla. 2007).

6 See, e.g., SEC v. Kirkland, 521 F. Supp. 2d 1281, 1290 (M.D. Fla. 2007).

7 See, e.g., Salameh v. Tarsadia Hotels, 726 F. 3d 1124, 1130 (9th Cir. 2013), cert. denied, 751 U.S. 1201 (2014).

8 See, e.g., De Luz Ranchos Inv., Ltd. V. Coldwell Banker & Co., 608 F. 2d 1297, 1300 (9th Cir. 1979); Rocky Aspen Mgmt. 204 LLC v. Hanford Holdings LLC, 230 F. Supp. 3d 159, 164-65 (S.D.N.Y 2017); Seale v. Miller, 698 F. Supp. 883, 891 (N.D. Ga. 1988); Waterman v. Alta Verde Indus., Inc., 643 F. Supp. 797, 802-3 (E.D.N.C. 1986), aff’d, 883 F. 2d 1006 (4th Cir. 1987).

9 See, e.g., Rocky Aspen Mgmt. 204 LLC v. Hanford Holdings LLC, 230 F. Supp. 3d 159, 163 (S.D.N.Y 2017).

10 See, e.g., Smith v. Gross, 604 F. 2d 639, 642 (9th Cir. 1979); Rossi v. Quarmley, 7 F. Supp. 3d 502, 507-8 (E.D. Pa. 2014); Glazer v. Abercrombie & Kent, Inc., No. 07 C 2284, 2009 WL 3060269 at 6 (N.D. Ill. Sept. 22, 2009).

11 See, e.g., Hodges v. Harrison, 372 F. Supp. 3rd 1342, 1348 (S.D. Fla. 2019).

12 See, e.g., Copeland v. Hill, 680 F. Supp. 466, 467 (D. Mass. 1988).

13 See. e.g., In Re Gables Mgmt., LLC, add “LLC” to link473 B.R. 352, 360 (Bkrtcy. D. Idaho 2012).

14 See, e.g., Great Rivers Co-Op of S.E. Iowa v. Farmland Indus., Inc., 198 F. 3d 685, 700 (8th Cir. 1999); Costa v. Carambola Partners, LLC, 590 F. Supp. 2d 1141, 1150 (D. Minn. 2008).

15 AFFCO Invs. 2001, L.L.C. v. Proskauer Rose, L.L.P., 625 F. 3d 185, 190 (5th Cir. 2010).

16 See, e.g., Rocky Aspen Mgmt. 204 LLC v. Hanford Holdings LLC, 230 F. Supp. 3d 159, 163, 164-65 (S.D.N.Y 2017); Rossi v. Quarmley, 7 F. Supp. 3d 502, 507-8 (E.D. Pa. 2014); Salameh v. Tarsadia Hotels, No. 09CV2739 DMS CAB, 2010 WL 3339439 at 2 (S.D. Cal. Aug. 24, 2010); SEC v. Kirkland, 521 F. Supp. 2d 1281, 1289, 1290 (M.D. Fla. 2007).  

17 Case law has established that, for purposes of the “investment of money” prong of the Howey test, the term “investment of money” is to be broadly construed. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“In spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract. Instead, the ‘investment’ may take the form of ‘goods and services,’ …or some other ‘exchange of value.’”). See also, SEC v. Shavers, No. 4:13-CV-416, 2014 WL 12622292, at *5 (E.D. Tex. August 26, 2014) (holding that an investment of Bitcoin, a virtual currency, meets the first prong of Howey); AFFCO Invs. 2001, L.L.C v. Proskauer Rose, L.L.P., 625 F. 3d 185, 190 n.4 (5th Cir. 2010) (tax benefits may constitute an expectation of “profits” under the Howey test); Long v. Shultz Cattle Co., 881 F. 2d 129, 133 n.2 (5th Cir. 1989) (same), petition for rehearing den’d, 896 F. 2d 85 (5th Cir. 1980).

18 The term “common enterprise” has been the subject to a great deal of litigation. The courts require that in order to demonstrate the existence of a “common enterprise,” there must be a showing of “horizontal commonality” or “vertical commonality.” “Vertical commonality” has been subdivided into “broad vertical commonality” and “strict vertical commonality.” Different circuits adhere to different commonality standards. See, e.g., Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (2d Cir. 1994) (“A common enterprise within the meaning of Howey can be established by a showing of ‘horizontal commonality’: the tying of each individual investor's fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits. See  Hart v. Pulte Homes of Michigan Corp., 735 F.2d 1001, 1004 (6th Cir. 1984); Salcer v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 682 F.2d 459, 460 (3d Cir. 1982) (investment must be ‘part of a pooled group of funds’); Milnarik v. M-S Commodities, Inc., 457 F.2d 274, 276 (7th Cir.) (success or failure of other contracts must have a ‘direct impact on the profitability of plaintiffs' contract’), cert. denied, 409 U.S. 887, 93 S. Ct. 113, 34 L. Ed. 2d 144 (1972). In a common enterprise marked by horizontal commonality, the fortunes of each investor depend upon the profitability of the enterprise as a whole: ‘Horizontal commonality ties the fortunes of each investor in a pool of investors to the success of the overall venture. In fact, a finding of horizontal commonality requires a sharing or pooling of funds.’ Hart, 735 F.2d at 1004 (citations omitted). Some circuits hold that a common enterprise can also exist by virtue of ‘vertical commonality’, which focuses on the relationship between the promoter and the body of investors. See  SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 479 (5th Cir. 1974) (‘requisite commonality is evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy’ of the promoter); SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 n. 7 (9th Cir.), cert. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. 2d 53 (1973); Villeneuve v. Advanced Bus. Concepts Corp., 698 F.2d 1121, 1124 (11th Cir.1983), aff’d en banc, 730 F.2d 1403 (1984). In an enterprise marked by vertical commonality, the investors' fortunes need not rise and fall together; a pro-rata sharing of profits and losses is not required. Two distinct kinds of vertical commonality have been identified: ‘broad vertical commonality’ and ‘strict vertical commonality’. To establish ‘broad vertical commonality’, the fortunes of the investors need be linked only to the efforts of the promoter. See  Long v. Shultz Cattle Co., Inc., 881 F.2d 129, 140-41 (5th Cir. 1989). ‘Strict vertical commonality’ requires that the fortunes of investors be tied to the fortunes of the promoter. See  Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir. 1978).”

See also, Marini v. Adamo, 812 F. Supp. 2d 243, 255-7 (E.D.N.Y. 2011); Copeland v. Hill, 680 F. Supp. 466, 467-69 (D. Mass. 1988).

19Case law has established that, for purposes of the “profits” prong of the Howey test, “profits” includes capital appreciation. See, e.g., United Housing Foundation, Inc. v. Forman,  421 U.S. 837, 852 (1975) (“By profits, the Court has meant either capital appreciation resulting from the development of the initial investment...or a participation in earnings resulting from the use of the investors’ funds…”) See also, Aldrich v. McCulloch Props., Inc., 627 F. 2d 1036, 1039 (10th Cir. 1980); Cameron v. Outdoor Resorts of Am., Inc., 608 F. 2d 187, 193 (5th Cir. 1979); Timmreck v. Munn, 433 F. Supp. 396, 402 n.3 (N.D. Ill. 1977).

20SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482-3 (9th Cir. 1973), cert. den’d, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. 2d 53 (1973) (“Turner”). See also, AFFCO Invs. 2001, L.L.C v. Proskauer Rose, L.L.P., 625 F. 3d 185, 190-1 (5th Cir. 2010); Bailey v. J.W.K Props., Inc., 904 F. 2d 918, 920 n.3 (4th Cir. 1990); Aldrich v. McCulloch Props., Inc., 627 F. 2d 1036, 1040 n.3 (10th Cir. 1980); Smith v. Gross, 604 F. 2d 639, 642 (9th Cir. 1979); De Luz Ranchos Inv. v. Coldwell Banker & Co., 608 F. 2d 1297, 1300 (9th Cir. 1979); Cameron v. Outdoor Resorts of Am., Inc., 608 F. 2d 187, 193 (5th Cir. 1979); Miller v. Cent. Chinchilla Group, Inc., 494 F. 2d 414, 416-7 (8th Cir. 1974); Hodges v. Harrison, 372 F. Supp. 3d 1342, 1349 (S.D. Fla. 2019); Baroi v. Platinum Condominium Dev., LLC, 914 F. Supp. 2d 1179, 1195-6 (D. Nev. 2012); SEC v. Schooler, 902 F. Supp. 2d 1341, 1346-7 (S.D. Cal. 2012); SEC v. Kirkland, 521 F. Supp. 2d 1281, 1295-96 (M.D. Fla. 2007); Seale v. Miller, 698 F. Supp. 883, 891-2 (N.D. Ga. 1988); Waterman v. Alta Verde Indus., Inc., 643 F. Supp. 797, 803 (E.D.N.C. 1986), aff’d, 883 F. 2d 1006 (4th Cir. 1987). 

In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 n. 16 (1975), however, the Supreme Court expressly declined to express an opinion on the Turner interpretation of the word “solely.”

21 The Framework devotes two sentences (and related footnotes) to an analysis of the “common enterprise” in the context of digital assets: “Courts generally have analyzed a ‘common enterprise’ as a distinct element of an investment contract...In evaluating digital assets, we have found that a ‘common enterprise’ typically exists....” 

The first sentence of the Framework’s observation about the “common enterprise” test is unassailable, and the Framework cites case law to support its statement. Specifically, footnote 10 of the Framework states that “in order to satisfy the ‘common enterprise’ aspect of the Howey  test, federal courts require that there be either ‘horizontal commonality’ or ‘vertical commonality’ …” Then, however, in the same footnote, the Framework concludes that the “SEC, on the other hand, does not…view a ‘common enterprise’ as a distinct element of the term ‘investment contract.’ In re Barkate, 57 S.E.C. 488, 496 n.13 (Apr. 8, 2004); see also the Commission's Supplemental Brief at 14 in SEC v. Edwards, 540 U.S. 389 (2004) (on remand to the 11th Circuit).” A non-litigated enforcement action brought by the SEC and a brief filed by the SEC are not likely to convince the courts that they are now free of any obligation to apply the “common enterprise” prong of the Howey test when they are asked to determine whether a particular instrument constitutes an “investment contract.”

In support of the second sentence, the Framework states, “based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter's efforts. See SEC v. Int'l Loan Network, Inc., 968 F.2d 1304, 1307  (D.C. Cir. 1992).”

I will not undertake an examination of the “common enterprise” test in this post. It is sufficient to say that an analysis of that test undertaken in a fashion more nuanced and attuned to case law than that undertaken by the Framework could potentially lead to the conclusion that, under certain facts and circumstances, utility tokens do not involve the sellers and purchasers of such tokens in a “common enterprise.”  

22 320 U.S. 344 (1943) (“Joiner”).

23 However, in Marini v. Adamo, 812 F. Supp. 2d 243, 259 n.12 (E.D.N.Y. 2011), the court, citing Gary Plastic Packaging Corp., 756 F.2d 230, 239 (2nd Cir. 1985), noted that, “in Howey, the Supreme Court ‘narrowed the Joiner ... test for determining the existence of an investment contract.” In Joiner, the Court stated that the test was “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”  320 U.S. at 352-53, 64 S. Ct. 120 (emphasis added). In Howey, however, the Court “narrowed the Joiner `character in commerce’ test,” and set forth the “specific requirements that continue to be the analytical foundation for determining what constitutes an investment contract.” Gary Plastic Packaging Corp., 756 F.2d at 239. Accordingly, the court concluded that “it is Howey, and not Joiner, that sets forth the relevant analysis for determining whether a particular investment constitutes an investment contract for purposes of the securities laws.”

24 320 U.S. at 351, 352-3.

25 328 U.S. at 298-9.

26 389 U.S. 332 (1967) (“Tcherepnin”).

27 Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange define the term “security” in slightly different terms, but the Supreme Court has concluded that they should be treated as “essentially identical in meaning.” See SEC v. Edwards, 540 U.S. 389, 393 (2004).

28 i389 U.S. at 336, citing Howey,  328 U. S. at 298. 

29 421 U.S. 837 (1975) (“Forman”).

30 421 U.S. at 847-8.

31 494 U.S. 56 (1990) (“Reves”).

32 494 U.S. at 60-61.

33 433 F. Supp. 396 (N.D. Illinois 1977) (“Timmreck”).

34 433 F. Supp. at 399-400, 402-3.

35 vAs the Ninth Circuit stated in Aldrich v. McCulloch Properties, Inc., 627 F. 2d 1036, 1039 (9th Cir. 1980), “a security is not always an easily recognized creature.”  

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