1. Reminder of Howey Case
I would like to shortly introduce some background facts of the Supreme Court of the United States in 1946. In early 1940s, a Florida corporation called W. J. Howey Company ("Howey Company") owned large tracts of citrus in Lake County and planted about 500 acres annually. Howey-in-the-Hills Service, Inc. ("Howey Service"), which is under direct common control and management with Howey Company, is a service company engaged in cultivating and developing these groves.
Prospective customers were offered both a land sales contract and a service contract. The land sales contract with the Howey Company provided a uniform purchase price per acre. Purchases were usually made for narrow strips of land arranged so that an acre consisted of a row of 48 trees. These tracts were not separately fenced, making the sole indication of ownership of small markings on the land intelligible only with a plat book record.
The service contract gave Howey Service a leasehold interest and complete possession of the acreage. For a specified fee plus the cost of labor and materials, Howey Service was given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. Howey Service was accountable only for an allocation of the net profits. The two companies offered prospective purchasers an opportunity to contribute money and to share the profits of a large citrus grove with the purchasers' respective shares, evidenced by land sale contracts and warranty deeds.
The above is a short background of the famous Howey case. Based on the above background, the Supreme Court of the United States held that an investment contract for the purpose 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.1 The Supreme Court further held that all the elements of profit-seeking business ventures are present in this case. Thereafter it is called the Howey test, which requires "a contract, transaction or scheme" in which (i) a person invests money, (ii) in a common enterprise, and (iii) is led to expect profits (iv) solely from the efforts of the promoter or a third party.
2. Recent Guideline by Korean Authorities and Implications for Fractional Investment
Until recently, people using the Yeouido subway station could see a lot of advertisements for Music Cow, Co., Ltd. ("Music Cow") saying that they could jointly invest in copyright and get profits from the joint copyright investment. Music Cow has been operating a platform since 2018 that sells claims to investors that divide the right to receive a distribution of the generated profits of specific music copyright or neighboring right into shares, and allows them to be traded between investors. The number of members increased to 910,000 in 2021, and the number of participating investors was around 170,000.
More specifically, regarding the platform structure, Music Cow Asset Co., Ltd. ("Music Cow Asset") purchases the music copyrights from the creators and entrusts them to the Copyright Association, then acquires the right to receive royalties from that Association. Based on the right to beneficiary, Music Cow Asset issues a right to participate in copyright fees, which is a right to claim the payment of copyright fees received from the Copyright Association, and then grants it to Music Cow, the platform operator. Music Cow divides and sells the right to participate in copyright fees, to be paid from Music Cow Asset, to investors. Investors buy and sell claims within the Music Cow's platform, and are entitled to claims acquired in the issuance and exchange markets.
Contrary to the general perception of investing directly in copyright, although jointly, the right that investors acquire is only a claim to Music Cow. Therefore, it is difficult to fully guarantee the right to claim in case of Music Cow's bankruptcy. On April 20, 2022, the Financial Services Commission issued an announcement via a press release stating that the above claims meet the statutory requirements of investment contract under the Act on Capital Market and Financial Investment Services ("CMFIS"), and requested business restructuring that includes the provision of core investor protection measures to safely protect investor's property. If a fractional investment falls under the investment securities, the business entity shall issue and distribute the securities while complying with all the regulations of the current CMFIS.
As you may know, the CMFIS was enacted in 2009 to first introduce the definition of securities, including the concept of the investment contract recognized in the Howey case. It is surprising that no precedent case has been reported or handled in the Korean capital market before the Music Cow case since this Act for investment contracts was first adopted in 2009.
Recently, fractional investment, in which multiple investors invest in assets such as artwork, music copyright, real estate, etc., and share profits, is widely prevalent. In this kind of investment, the issuer of the relevant deed is equipped with a computerized trading platform, and the service users can make convenient investment decisions with a small amount of money. Similarly, fractional non-fungible tokens (NFT) may also be classified as an investment contract depending on the case.
The Financial Services Commission also opened a financial regulation sandbox for innovative financial service providers. That is, in cases where it is difficult to issue and distribute within the current legal system due to the characteristics of fractional investment, the financial regulation sandbox system under the Special Act on Financial Innovation Support can be used to temporarily issue and distribute those securities by designation as an innovative financial service. The financial regulatory sandbox system allows financial service providers to test new financial services on the market and financial authorities the opportunity to improve systems and regulations based on the operation result.
Since the above press release, Music Cow recently applied to be designated as an innovative financial service by the Financial Services Commission after taking measures such as requiring investors to deposit in other securities' investor accounts. Taking advantage of the recent stock trading boom, a new type of financial investment platform, such as a decimal unit trading platform for domestic or overseas stock, has been designated as an innovative financial service.
In relation to decimal unit trading for domestic stock, the securities company collects orders from investors to create perfect unit stock and submits quotations to the Korea Exchange in its own name. The Korea Securities Depository issues beneficiary certificates after receiving a perfect unit stock as a trust from a securities company, and investors acquire beneficiary certificates according to the order quantity.
"Kasa," the first real-estate trust beneficiary trading platform that allows investors to buy and sell buildings like stocks, is also gaining popularity in partnerships with banks. "Sotwo" is a blockchain-based joint purchase platform that allow investors to invest in expensive limited-edition sneakers, artworks, and art toys in units of KRW 1,000. Investors can invest in a variety of assets, ranging from expensive sneakers such as the Nike Air Force, which costs up to KRW 1 million per pair, to artworks by famous artists.
In a situation where various types of fractional investment platforms are emerging, it is difficult for business operators or investors to determine whether these transactions can be evaluated as investment contracts, and this trend is expected to continue in the future. I believe conducting a preliminary legal review is essential when designing the platform business structure of fractional investment.
1. SEC v. W. J. Howey Co., 328 U.S. 293 (1946).
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