Rep. Torres Pressed On The Phrase “Investment Contract,” But He Was Not Satisfied With the Answers He Received
Rep. Torres Pressed On The Phrase “Investment Contract,” But He Was Not Satisfied With the Answers He Received
We have the answers
While we haven’t posted in a while, rest assured that we have been thinking and processing quite a bit of information on our favorite subject, the definition of investing, and its legal implications. Against this backdrop came the Congressional Hearing, Oversight of the Securities and Exchange Commission. The full hearing can be found here.
One exchange in particular caught our attention, one that is extremely relevant for the investing public as well as the crypto industry. It was between Congressman Ritchie Torres (it is an interesting coincidence that he shares the same last name with Judge Torres who rendered the Ripple decision back in July. As far as we are aware, they don’t appear to be related) and the SEC Chair Gary Gensler. The exchange is approximately five minutes long and must-watch TV. Why? Because it really goes through the core issues that remain unresolved, from both a finance and legal perspective. It’s a trillion-dollar problem, and we strongly believe we have the unique insights that are sorely needed.
Here is that exchange:
Rep. Torres asked many great questions, but it doesn’t sound like he was satisfied with the answers he received. This is what he posted on X (f/k/a Twitter):
I cross-examined @SECGov Chair Gary Gensler about the term 'investment contract', which is key to determining his authority over crypto. Gensler struggled to answer basic questions like whether an investment contract requires a contract. His evasions are deafening and damning.
We have been asking similar questions for a while now, and we believe we have the answers. Agree or disagree, we hope these insights can be the starting point toward developing a policy that works for all Americans.
Let us give you the executive summary first, regarding where we stand with respect to Rep. Torres’s questions:
Does an investment contract require an actual contract?
No. An investment contract can be any transaction or scheme where the investor needs protection in some form. It requires neither true investing (contrary to what Rep. Torres assumes), nor a contract. It does not necessarily require investing because speculators who think they are investing still need protection; they need the disclosure that they are engaging in a speculative activity. Further, because they are trading assets that do not generate cash flows, there doesn’t necessarily need to be a contract.
Did the Supreme Court find an investment contract without an actual contract?
No, but that’s a red herring. The fact that investors needed a certain type of protection in the past doesn’t mean they won’t need a different type of protection now. One should also ask: How many “investment contract” cases have ever reached the Supreme Court where non-cash-flow-generating assets were involved? Absence of evidence is not evidence of absence.
Does the purchase of a tokenized Pokémon card (as distinct from a physical Pokémon card) constitute a security transaction?
It may, but it has nothing to do with technology. There truly is no yes-or-no answer here because it will be based on facts and circumstances. If consumptive intent dominates for one channel (physical or digital) and not the other, the Howey test could produce different results.
Now we are ready to dive deeper. In what follows, we reproduce the majority of the exchange between Rep. Torres and Chair Gensler, elaborate on our answers and offer additional color commentary. Here is the rush transcript in full.
REP. TORRES: So, I want to take a few minutes to explore the concept of investment contracts in greater depth. And I want to start with an obvious definitional question. We know that an investment contract requires any investment. Does an investment contract require a contract?
This is a great question, but it actually presumes, in our view, an incorrect starting point that is absolutely central to the issues at hand. Here is where we stand on this: An investment contract does NOT require an investment, the way we define the term.
Why? Remember the simple definition of investing: Investing is like buying cheap apple trees. The threshold question needs to be whether or not the asset generates cash flows. Without cash flows, there is no investing. This was a fairly well-understood principle at the turn of the 20th century, and somehow we lost sight of that crucial tenet of finance.
Had Rep. Torres said, “We know that an investment contract requires any investment motive,” that would have been a better choice of language in our view. The word “motive” would have expanded the universe to all trades, and would have included the following groups of transactions:
Transaction Group 1 - Trades where people are truly investing.
Transaction Group 2 - Trades where people think they are investing but are actually speculating. (they are buying at too high of a price relative to value)
Transaction Group 3 - Trades where people think they are investing but are actually speculating. (they are buying an asset that does not generate any cash flows and therefore the intrinsic value is zero)
You might wonder: Why are we categorizing by transaction and not by people? “People'' doesn’t work because we all wear multiple hats, differing on what we trade and at which price. Consider this subtle fact that the industry has mostly overlooked: Investing vs. speculation is not a label that attaches to people; it attaches to transactions. One person can be an investor in some stocks, a speculator in other stocks, and also a speculator (but not an investor) in crypto and NFTs.
For the most part, the industry incorrectly bundles all of these transactions into the “investment” category. That is precisely the problem. If all trades are investing, then all traders must be investors. But, investor protection and the proper disclosures are fully dependent on which transaction types “investors” are engaging in. Before we can start developing a sensible policy, we must address this common-sense question first:
Can investors truly be protected when we don’t even agree on what investing means?
We don’t believe that they can.
In the early 20th century, there were many Group 1 transactions. Then, despite Ben Graham’s warnings to the contrary, Group 2 transactions expanded. Still, though, almost everybody was dealing with assets that generate cash flows (stocks, bonds, etc.). It is not a coincidence that all enumerated terms in the legal definition of security (we count 17 of them) involved assets that generate cash flows, directly or indirectly. Congress enumerated what it could, based on what was being transacted in the market at the time.
Congress did realize, however, that no such list can ever be complete because times are ever-changing. As such, Congress added the catch-all term “investment contract” to the statute. Does it require a contract? Chair Gensler refused to provide a clear answer to that question, which didn’t seem satisfactory to Rep. Torres:
REP. TORRES: Again, I do not go to MIT, but in the Bronx, if I ask whether any investment contract includes a contract, the answer is typically yes or no.
We certainly can’t fault Rep. Torres for demanding a yes-or-no answer here. At the same time, we can see why Chair Gensler doesn’t feel comfortable answering the question. He probably believes if he says “yes,” then he effectively concedes on the issue of secondary crypto transactions being a security. If he says “no,” then he has to reconcile that with the judicial history, a history that Rep. Torres and/or others continue to bring up.
Chair Gensler may not have been comfortable with a yes-or-no answer, but we are. The answer is no. An investment contract does not require a contract.
What about that judicial history, though?
REP. TORRES: In August, there were six law professors from law schools as preeminent as Yale, who came to the following conclusion – “No decision of the Supreme Court has ever found that a scheme that does not involve a contract could qualify as an investment contract.” And so, do you disagree with that statement? And if so, could you please cite the decision of the Supreme Court that has found an investment contract in the absence of an actual contract?
This is the amicus brief (PDF) Rep. Torres cites, the case is SEC v. Coinbase. On June 6, 2023, the SEC charged Coinbase for operating as an unregistered securities exchange, broker, and clearing agency. Coinbase moved to dismiss, here is Coinbase’s opening brief. The SEC is scheduled to file its opposition brief by October 3, 2023 (unclear to us how a potential government shutdown might affect this deadline).
What should we make of the assertion that “no decision of the Supreme Court has ever found that a scheme that does not involve a contract could qualify as an investment contract?” The authors of the amicus brief actually say more: “No Supreme Court or Second Circuit Decision Has Found That A ‘Scheme’ Without Accompanying Contractual Undertakings Qualifies As An ‘Investment Contract.’” In fact, it could go even further - we are wondering whether any appellate court has ever found an investment contract without a contract. We are looking into this as we speak. The question is: Does it matter?
If we create a universe in which all the parents have a toddler, we would likely find no parent that has ever talked to their toddlers about drugs or safe sex. On the other hand, we would likely find many parents who are telling their toddlers that the stove is hot. The drug/safe sex conversation must wait because the child is not in a position to understand those concepts just yet, and it certainly can wait because the child is not in imminent danger from either risk factor. The stove, on the other hand, is a risk that must be dealt with now. Safety and protection of our children is the overarching priority, no doubt, regardless of whether they are toddlers or teens. What is different is how we protect them and from what. Protection obviously looks very different depending on the age of the child.
This has been a subtle, but very critical point we have been trying to drive home:
21st-century finance is very different from 20th-century finance. As a result, investor protection looks very different, too.
20th-century finance primarily dealt with transaction groups #1 and #2. Participants could decide which risks to take, the bargain was full and fair disclosure. As Stephen Bainbridge, William D. Warren Distinguished Professor of Law at UCLA School of Law and one of the co-authors of the amicus brief colorfully pointed out:
As a result, the New Deal Congress explicitly rejected the blue sky regulatory model in favor of a disclosure-based system. The SEC thus has no authority to pass on the merits of an offering of securities.
The system that resulted fairly has been called a rotten egg statute. You could sell all the rotten eggs you wanted as long as you fully told people just how rotten they were.
All of that was fine, for cash-flow-generating assets. Congress required companies to be truthful with their disclosures, and tasked the SEC with executing on that mission; both branches moved to the sidelines, allowing participants (we are not going to call them investors) to decide whether they wanted to become investors, speculators, or both. Absent fraud, they had all the information they needed to make informed decisions.
Times have changed as we now have an entire group of people engaging in a third group of transactions, which is something that effectively amounts to Greater Fool Theory on steroids. To see how deep the rabbit hole goes, one can simply look at the June archives over at our sister blog F27. Unless there is cash flow generation, crypto purchases do not constitute investing, period. That said, the purchasers do not have that information, so they are not necessarily making informed decisions.
Are we opposed to speculation in crypto? No, at least as long as the net benefits to society are positive. Admittedly, it is a hard calculus at this stage in time, but in the interest of letting innovation run its natural course, we don’t believe it is unreasonable to give it the benefit of the doubt and let it run.
So, what are we opposed to? We have a very strong opposition to the monetization of ambiguous wording at the expense of the general public, namely selling speculation under the guise of investing. We are not necessarily saying all of that is intentional either. Certainly, many people seem to genuinely believe that one can invest in crypto. Why do we think that? Because some of the strongest crypto critics themselves call it that.
Intentional or not, many industry participants are happily selling speculation as investing, including Coinbase. Even worse, Coinbase wants to have its cake and eat it too. On one hand, they are positioning crypto as an investment vehicle. On the other hand, they took the position that secondary market crypto transactions are not investing. It has to be one or the other, but it can’t be both.
You may not find it ideal that your restaurant ran out of regular coffee after a nice meal, but you could settle for decaf. On the other hand, you would probably be upset if your waiter said that they do have regular coffee, but you were served decaf. Similarly, you may be perfectly fine buying inorganic food, but you would be aghast if inorganic food was sold to you under the organic label. In both cases, the principle is quite simple. People should have a choice, but only after they are fully informed. This is precisely why the Securities Act of 1933 and the Securities Exchange Act of 1934 were created.
One can say a disclosure regime still works. Sure, but 21st-century finance seems to revolve around assets that are not cash-flow-generating. The question then becomes: What is the most important disclosure? We believe the solution is simple: Tell people that they are speculating, not investing. The solution we are proposing is not dissimilar to the Surgeon General’s warning that was added to packs of cigarettes in 1970 (after Congress passed the Public Health Cigarette Smoking Act); in fact, a version of it was in place (albeit incorrectly) prior to the enactment of the securities laws. Contract or not, there is still a need for protection, and this solution is one way of accomplishing it.
Rep. Torres certainly seemed bothered by the fact that Chair Gensler could not name a court case that found an investment contract without a contract though:
REP. TORRES: What’s the name of the case Mr. Gensler? The Supreme Court case that has found an investment contract in the absence of an actual contract, you’ll need to cite a case…
MR. GENSLER: The SEC over the decades, whether it’s…
REP. TORRES: Can you cite a case?
MR. GENSLER: Whether it’s whiskey caskets, whether it’s crypto, if the public is investing based upon the efforts of others…
REP. TORRES: I find it telling that you cannot cite a single case.
MR. GENSLER: That’s a security.
REP. TORRES: How about a Second Circuit case? Can you cite a single Second Circuit case that found an investment contract in the absence of a contract?
MR. GENSLER: I understand where you’re trying to go. And I’m gonna leave that to the very fine attorneys at the SEC in front of the courts, but I’m saying the core principles that…
REP. TORRES: Mr. Gensler, let me finish. This is, this is a question to which you should know the answer because the definition of an investment contract is the central issue. That’s what determines the extent of your authority. That’s what determines the applicability of federal securities law to crypto transactions, and your inability to answer that question is baffling to me.
MR. GENSLER: I’m answering it consistent with what the Supreme Court has said which is the law of the land which is a four-part test.
REP. TORRES: And yet you cannot cite a single case that can support your argument.
MR. GENSLER: It’s called Howey, it’s called Reaves, it’s called many cases at the Supreme Courts are eight or nine times it’s been affirmed by the Supreme Court.
Rep. Torres is onto something here, but absence of evidence is NOT evidence of absence. Why should we expect to see court cases that found an investment contract without a contract? For the most part, the world of finance, and therefore, the corresponding litigation, dealt with cash-flow-generating assets. There must be a contract (or a set of contracts) when an asset generates cash flows, otherwise, how would the parties know what claims they have on the cash flows? The existence of a contract, then, was simply a result of the type of asset that was transacted in commerce. If there are no cash flows, then there is not necessarily a need to draft a contract that stipulates how and when the cash will move. That does not mean that the need for protection disappeared.
You might object, and say, “Wait a second, assets that do not generate cash flows are not exactly new. Gold has been around for a while. Collectibles have been around for a while. What about those? Rep. Torres realizes that too. Here is another great question he asked, and the subsequent exchange:
REP. TORRES: Suppose I would have purchased a Pokémon card. Would doing so constitute a security transaction?
MR. GENSLER: You could purchase a Pokémon card. I don’t know what the context is, but if you’re just purchasing a Pokémon card…
REP. TORRES: If I purchase a Pokémon card, is that a security transaction?
MR. GENSLER: That’s not as secure…
REP. TORRES: Okay, if I were to purchase a tokenized Pokémon card on a digital exchange via a blockchain? Is that a security transaction?
MR. GENSLER: I’d have to know more.
REP. TORRES: Okay, so for you the process of tokenization is what transforms a non-security transaction into a security transaction?
MR. GENSLER: If the investing public…
REP. TORRES: I thought you were technology-neutral.
MR. GENSLER: If the investing public is anticipating profits based upon the efforts of others and they’re exchanging fines. That’s the core of…
REP. TORRES: I see my time has expired.
This is a very clever line of questioning by Rep. Torres. First, he makes Chair Gensler take the position that purchases of physical Pokemon cards are not security transactions, and then he expects consistent application of the principles to tokenized versions of those cards (which would likely be NFTs). One difference between the two is technology, but should that matter? It’s the economic reality of the transaction, not the form of delivery. Rep. Torres also astutely references Chair Gensler’s earlier statements when he talked about being neutral to technology.
Again, we feel comfortable taking a position here. Rep. Torres is right, technology alone should not make a difference. There remains arguably, a crucial difference between physical Pokemon cards and their digital counterparts, though, and that is the intent of the buyer, i.e. whether or not there is consumptive use. The Howey test already has a prong on this called the “expectation of profits” prong.
Thus, there is a reasonable position that the purchase of digitized Pokemon cards may constitute security transactions, but the purchase of physical cards may not, not because of technology, but because the intent of the buyers is different on the consumption vs. profit-seeking spectrum. More specifically, if most people purchase physical Pokemon cards because they view them as collectibles and don’t really care about flipping them and achieving a profit, a Howey analysis would find that the purchases do not constitute security transactions. Along those lines, we don’t agree that the purchase of physical Pokemon cards can never constitute security transactions. They could, depending on the facts and circumstances and how the Howey test is applied.
You might ask: What evidence is out there, in either direction, regarding what the buyer’s intent is? Not a whole lot, and there are some real issues around understanding and measuring the buyer's intent. That doesn’t mean we shouldn’t try.
Let’s recap. Rep. Torres had three main issues:
These are all good questions. Reproducing our answers from above:
Does an investment contract require an actual contract?
No. An investment contract can be any transaction or scheme where the investor needs protection in some form. It requires neither true investing (contrary to what Rep. Torres assumes), nor a contract. It does not necessarily require investing because speculators who think they are investing still need protection; they need the disclosure that they are engaging in a speculative activity. Further, because they are trading assets that do not generate cash flows, there doesn’t necessarily need to be a contract.
Did the Supreme Court find an investment contract without an actual contract?
No, but that’s a red herring. The fact that investors needed a certain type of protection in the past doesn’t mean they won’t need a different type of protection now. One should also ask: How many “investment contract” cases have ever reached the Supreme Court where non-cash-flow-generating assets were involved? Absence of evidence is not evidence of absence.
Does the purchase of a tokenized Pokémon card (as distinct from a physical Pokémon card) constitute a security transaction?
It may, but it has nothing to do with technology. There truly is no yes-or-no answer here because it will be based on facts and circumstances. If consumptive intent dominates for one channel (physical or digital) and not the other, the Howey test could produce different results.
So, where does that leave us with respect to Chair Gensler’s positions? We agree with him on the most fundamental issue, i.e., whether or not the SEC has the power to regulate crypto. The SEC has all the authority it needs to regulate the crypto industry. No new legislation is needed. Congress’s goal was to protect investors, in whatever form.
Congress could not have anticipated a scenario where large swaths of speculators would fancy themselves as investors, based, in part, on representations made by the speculation ecosystem. This has created a false sense of security for those speculators. While Congress knows that it can't anticipate every possible scenario, it has ways of writing laws that would cover those scenarios. The phrase “investment contract” is the fruit of that anticipation.
The fact that the phrase “investment contract” is now needed as a legal basis to provide a disclosure to market participants who are neither investing nor entering into a contract is certainly ironic, but the alternative is much worse, which is effectively allowing the market participants to continue making decisions without being fully informed. After all, President Roosevelt’s message to Congress was:
Of course, the Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn profit.
There is, however, an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public. (emphasis added).
Bottom line: Is the fact that buyers are not investing when they think they are investing important? Yes, absolutely.
Is it being concealed from the public? Definitely.
Then, it needs to be disclosed if we truly care about Congress’ mandate of investor protection. That need is precisely what gives the SEC the authority to regulate crypto.
That said, we have our set of disagreements with Chair Gensler. We disagree with him on three points when he says:
Purchasing physical Pokemon cards does not constitute a security transaction.
They may not, but that conclusion is not automatic. To the extent the Pokemon cards continue to be predominantly a collector item, sure, they wouldn’t in that case. But if that ceases to be the case and the Howey test ever produces an affirmative result, such purchases could constitute a security transaction.
Bitcoin is not a security.
Why not? The standard (and widely popular) response here is that it is decentralized and the “efforts of others” prong of the Howey test is not satisfied. We have a counter to that. It’s a rather long and technical analysis, which we’ll address elsewhere, but here is a hint: It has something to do with the fact that a proper application of “the effort of others” prong is contingent on the cash flow generation potential of the asset.
Lastly, and most importantly:
One can invest in crypto.
One can speculate on, but not invest in crypto. Our sister blog, F27, has largely been dedicated to this matter.
It is unfortunate that this leaves the SEC in a difficult position. We believe the ideal scenario would be the SEC initiating a concept release or some other similar release followed by public comments. In one of our F27 posts, we have drafted a hypothetical investor alert along those lines.
While that would undoubtedly be a departure from the SEC’s earlier positions, it is a needed one, if we truly care about the American public. No fingers need to be pointed to the SEC or anybody else. It was a big collective mistake. Let’s get it right going forward.
Will the SEC depart from its earlier positions? They may not, but we feel that wouldn't be good for the SEC, or for the American public in general. That stance would likely continue to create unsatisfactory answers to many questions and potentially more court losses for them. In addition, it could lead to a crypto regulatory regime outside the SEC’s walls. Crypto is ultimately an investor protection matter with market participants continuing to pile into assets with zero intrinsic value, and we are concerned that an alternative regulatory regime would result in market participants gaining a false sense of comfort. In all likelihood, that alternative regime would fail to provide the most important disclosure of all: “This is a speculative security.”
