If you’ve been following cryptocurrency chatter on Twitter or Telegram for the last thirty days, you’ve probably seen something about security tokens.
You may have seen that Polymath is building a protocol coded to allow compliant trading of security tokens on the Ethereum blockchain. You may have also seen that AirSwap, a Brooklyn-based technology company, has successfully built a decentralized platform that will soon allow peer to peer trades of security tokens on the Ethereum blockchain. These projects will allow owners to fractionalize the ownership of any asset using blockchain tokens, after which they can trade seamlessly and legally between verified investors anywhere in the world.
What a freakin’ time to be alive.
Unlike security tokens, the concept of utility tokens are fairly well understood in the blockchain space today. Utility tokens represent access to a network, and your token purchase represents the ability to buy goods or services from that network — kind of like an arcade token. Remember those days? Every summer, purchasing arcade tokens meant you could play Space Invaders or Marvel vs. Capcom without owning the game. Utility tokens give you that same type of access.
On the other hand, security tokens represent complete or fractional ownership interests (like shares or stock) in things like startups, public companies, real estate, art investments, intellectual property, or even professional sports teams.
As with any disruptive technology, there’s been some confusion as to what security tokens are, who can trade them, the exchanges that can sell them, and what benefits they’ll actually bring to the financial world. Over the coming months, I plan to write a series of articles that will try to answer some of these tough questions. You can follow my security token journey @derekedws on Twitter.
Before we can get to “what is a security token?” we need to understand “what is a security?” In this first article, we’ll explore the origin of securities laws in the United States. And where better to start than with Black Tuesday.
The Roaring Twenties
On October 24, 1929, the most destructive stock market crash in the history of the United States wiped out billions of dollars overnight, leading to a decade of widespread economic depression around the world.
There were warning signs. Over the summer that same year, national spending slowed, the agricultural economy was starting to fail, and consumer debt rose.
But in the words of @APompliano, the virus had already spread.
In the years leading up to the great crash, America had been gripped by a new favorite pastime — playing the stock market. Through the 1920s, America soared during a rapid financial expansion that saw the nation’s total wealth more than double during a period we call The Roaring Twenties.
And stock prices? Stock prices were damn near going bananas.
During this epic nine-year financial run, the New York Stock Exchange on Wall Street became ground zero for amateurs and speculators alike. Paperboys shared investment tips on their routes. Janitors poured their life savings into the market. Even though the economy had started to cool off, the US stock market was heating up, fueled by jaw-dropping amounts of amateur speculation on future values.
Sadly, we know how the next part of this story played out.
Once the radically speculative stock market bubble popped in 1929, billions of dollars in equity value disappeared from the face of the earth. Industry collapsed under the pressure. Businesses failed. By 1933, 25% of Americans faced unemployment. Let that sink in for a minute: One in four Americans no longer had the means by which to earn a paycheck.
At the time of the crash, there were no federal securities laws in place protecting the general public. Congress realized that without regulatory reform around public consumption of financial instruments, the United States was bound to find itself in another speculation-fueled catastrophe in the future. It was time for the federal government to step in.
The Securities Act of 1933
During a massive cleanup of the financial mess left behind, Congress created the Securities Act of 1933. This brand new set of laws required companies who were looking to sell and market financial instruments to the public (like stocks on Wall Street) to disclose specific information about the stuff they were trying to sell.
The rationale by our lawmakers was simple: Speculative trading has gotten way out of hand, and we just want folks to have more information about the stuff they’re buying in the public markets.
So, Congress created a master list to help these companies understand exactly what a security is, and when securities laws would apply to the sales they made to the public. Here’s a sample of some of the financial instruments defined as securities in the Securities Act of 1933:
- Investment Contracts
- Security Futures
- Participation in Profit-Sharing Agreements
This master list included both the obvious (e.g. stocks, bonds), along with the not-so-obvious (e.g. investment contracts). These new rules meant that if someone was marketing and selling one of the financial instruments in the list above for the first time (the “initial offering”), then securities laws would kick in and apply. Unfortunately, this list didn’t solve everything.
The thing about people? There’s always someone out there trying to find a loophole.
The thing about lawmakers? There’s no way they can foresee every future scenario.
The thing about laws? Those are just words on a page, and words can be pretty open to interpretation.
Even though the US now had a list of financial instruments triggering securities laws, it was only a matter of time before people started to look for loopholes in those laws, and for judges and courts to get involved. In 1946, that’s exactly what happened when the US Supreme Court decided to throw down the gauntlet. Over a bunch of orange trees.
The Howey Test
Around this same time in Florida, a man by the name of William J. Howey had a brilliant idea. Howey owned a number of large orange orchards, so he decided to cut up the land and sell portions of these orchards as “real estate contracts” to buyers. In exchange for cash, each buyer would receive a different plot filled with orange trees on the orchard.
The buyers of these small orchard plots had an option: they could farm the new orange trees themselves, or they could lease the land back to Howey. Why lease to Howey? Because if they did, Howey’s company would tend and harvest the land each season, and sell the oranges in the open market for a profit.
The best part? Howey planned to give each buyer a percentage of the profits from the oranges he sold, as long as these buyers were buying his orange groves, and leasing the land back to him. These buyers, many of whom were out-of-towners staying in nearby hotels, didn’t have to do any work themselves. All they had to do was enter into a contract with Howey for the purchase and leaseback of these orange groves, and they could share in the profits together.
See where this is going?
By the time the newly formed SEC caught wind of what was happening, Howey and his buyers were making a killing together. The SEC sent a letter to Howey arguing that the buyers purchasing Howey’s land and leasing it back to him weren’t regular buyers at all. These were investors in Howey’s orange-selling business.
This crazy case ended up reaching the US Supreme Court, where the legal argument brought forth by the SEC was that these contracts that Howey sold were investment contracts under the Securities Act of 1933. If these contracts fell under the definition of investment contracts, then securities laws would apply.
In 1946, the US Supreme Court weighed in and created the famous Howey Test, the de facto standard for analyzing many securities issues today. Under the Howey Test, a financial instrument qualifies as an “investment contract” for the purposes of the Securities Act of 1933, if a buyer:
- Invests money;
- In a common enterprise;
- Expecting a profit;
- Predominantly from the effort of others.
In Howey’s contracts with investors, all four prongs of the test were satisfied. Here’s how it shook out in court:
- There was an investment of money (Howey’s investors purchased the land for the possibility of investment returns);
- The investment was in a common enterprise (Howey’s company pooled the investors’ funds together, used it to tend/harvest the orchard business, and paid each of them pro rata profits from the sale of the oranges each season);
- There was an expectation of profit by the buyer (Howey’s company told each investor that they would share in the pro rata profits from the sale of the oranges each season);
- The profit was generated predominantly from the effort of others (Howey’s company was the only party to the contract who tended/harvested the land. The investors did not expend any effort on the land).
As a result, the US Supreme Court held that Howey’s contracts were securities. This meant that Howey wasn’t following the disclosure laws required by the Securities Act of 1933 when he was originally splashing posters up around town and offering these contracts for sale to these out-of-town investors. The SEC’s legal injunction over Howey’s business model went into full effect, and today, his story serves as a cautionary tale to enterprising businesses looking to offer securities to investors in the United States.
If you’ve made it this far, you’re probably wondering what the heck The Roaring Twenties, Black Tuesday, and a guy named Howey have to do with security tokens on the blockchain.
The answer? Not that much… directly. But understanding the building blocks of securities law is fundamental to understanding the tremendous value security tokens will one day unlock.
In my next article, I’ll start exploring the crazy concept of tokenized securities on the blockchain, and why these things promise to be more disruptive than sliced bread.