Previous crypto securities cases have been misrepresented as evidence of the adoption of the “separation theory”, a concept highlighted by the Honorable Judge Amy B. Jackson (SEC v. Binance). In her ruling regarding Binance’s motion to dismiss, Judge Jackson said: “[the] Court finds it necessary to distinguish between the digital coins themselves and the offers to sell them,” adding that “[the] Court notes that several of the district courts presented with SEC enforcement actions involving crypto currencies have taken pains to differentiate the alleged investment contracts from the tokens themselves.”
Judge Jackson cites the as evidence. An examination of the court cases cited shows that only the Ripple Court “differentiate[d] the alleged investment contracts from the tokens themselves.” Thus, the inclusion of the other two cases as evidence relies on misinterpretation.
SEC v. Telegram
Telegram created distributed ledger software on which it issued the Gram crypto token, a fungible unit of account. The SEC sued Telegram, alleging Telegram’s sales of Gram, and the anticipated resales to the public, to be an unregistered securities offering. Judge Castel in SEC v. Telegram Inc. did not “[take] pains to differentiate the alleged investment contracts from the tokens themselves” or hold that the “subject of the investment contract (Gram token) was a standalone commodity” as Judge Torres of the Ripple Court reasoned.
Judges Jackson and Torres quote the Telegram Court: “While helpful as a shorthand reference, the security in this case is not simply the Gram, which is little more than alphanumeric cryptographic sequence . . . This case presents a “scheme” to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sales and distribution of the Gram.” (SEC v. Binance) Judge Castel does not exclude or separate the Gram itself from Telegram’s security as he states that the security is “not simply the Gram.” Judge Castel instead suggests that the Gram is not a stand-alone commodity, because it is paired to Telegram’s whole security scheme. Telegram tried to argue that “delivery of the newly created Grams to the Initial Purchasers”’, and their resale, are not subject to securities laws because, “… Grams would have “functional consumptive uses [and] would be a commodity…”
Telegram wanted Judge Castel to separate the tokens themselves from the securities “scheme” they were issued under, viewing tokens as stand-alone commodities. Judge Castel declined, writing “[this] Court finds as a fact that the economic reality is that the Gram Purchase Agreements and the anticipated distribution of Grams by the Initial Purchasers to the public via the TON Blockchain are part of a single scheme.” Notice, even resales of the Gram itself are explicitly part of the “scheme”. The explicit design of Telegram’s scheme entails that the only way to receive the “promised” profit, is to rely on Telegram’s efforts to increase the value of the Gram in the secondary markets and to resell tokens to the public.
Judge Castel made numerous other statements interpreting Grams themselves to be securities writing that “[the] Second Circuit has held that securities do not come to rest with investors who intend a further distribution . . . The Grams would not and were not intended to come to rest with the Initial Purchasers but instead were intended to move from the Initial Purchasers to the general public. Therefore, this two-step process represents a public distribution [of securities] . . .” (SEC v. Telegram)
Judge Castel added that the public, “needs the protection of the [Securities] Act.” This is because the Grams themselves are not simply commodities or stand-alone tokens, but are securities, the means of participating in Telegram’s scheme. Additionally, Judge Castel described “[the initial purchaser’s] ability to sell their Grams, and thereby exit the common enterprise, does not mean that the Initial Purchasers are not part of a common enterprise while they continued to possess Grams.” The Gram itself is the means of entering and exiting the common, profit-seeking, enterprise with Telegram.
Moreover, the fact that Grams would be resold into the secondary market, where purchasers are unaware of whom they are purchasing from, was immaterial as the public would receive a security when receiving a Gram. This view is similar to that offered by Judge Rakoff in the SEC v Terraform ruling on Terra’s motion to dismiss “[that] a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.”
SEC v. Terraform
SEC v. Terraform brings forward the next citation offered by Judge Jackson as evidence of the adoption of “separation theory.” Judge Jackson quotes Judge Rakoff’s statement from his denial of Terra’s motion to dismiss: “the court need not restrict its Howey analysis to whether the tokens themselves –apart from any of the related various investment protocols– constitute investment contracts.” Judge Rakoff wrote that “the Court declines to erect an artificial barrier between the tokens and the investment protocols with which they are closely related for the purposes of its analysis” signifying that there is no barrier between the tokens themselves and the issuer’s promise of profits.
Judge Rakoff reasoned that because Terra’s “various investment protocols” were paired to the tokens themselves, the tokens at issue were not standalone tokens. He explains that “. . . the term ‘security’ cannot be used to describe any crypto-assets that were not somehow intermingled with one of the investments ‘protocols’, did not confer a ‘right to purchase’ another security, or were otherwise not tied to the growth of the Terraform blockchain ecosystem… But this conclusion is only marginally of interest, because, to begin with the coins were never, according to the amended complaint, standalone tokens.” Judge Rakoff held that when a token issuer, by means of a token, offers a “promise of profits” consisting of an “investment protocol” or “[ties the token] to the growth of the . . . ecosystem”, that token itself is NOT a standalone commodity, it is a security.
Even as Judge Rakoff wrote in the denial, “[it] does not, in other words, preclude the SEC from asserting, as it has here, that a token constitutes an investment contract when it is joined with a promise of future profits or the like to be generated by the offerors.” Judge Rakoff ultimately held that, “There is no genuine dispute that UST, LUNA, wLUNA, and MIR are securities because they are investment contracts.” This is the exact opposite of the “separation theory”.
The Proof Exists Outside of the Instrument
The assertion that Judges Castel and Rakoff took “pains to differentiate the alleged investment contracts from the tokens themselves” is simply wrong. Rather, their pains in looking “outside the [token] itself”, proved “that [the tokens] being sold were securities under the [Securities] Act”. (SEC v. Joiner)
This is entirely consistent with caselaw. In every securities case the court looked outside of the instrument itself to determine whether the instrument serves as means of participation to a securities “scheme”. The proof that any instrument is a security, extends outside of the instrument itself. In the Joiner case, the facts and circumstances that proved that the land interests at issue were securities existed outside of the interests themselves. The same applies in the SEC v. Howey case.
Even the “proof” that a stock like AAPL is a security extends outside of the stock token itself. Though the AAPL token itself is literally “simply code”, it was designed and offered as the means to invest in and profit by the efforts of the Apple company, a “scheme” detailed in the registration documents that exist outside of the token itself. In the United Housing Foundation, Inc. v. Forman case, the Supreme Court looked outside of the instrument itself, to the whole “scheme” to determine whether or not the “stock” at issue was a security.
Therefore, when courts look at the “whole scheme” a crypto token was issued under, the inquiry proves whether the token at issue is a security or not, it does NOT separate the token from the security. A particular crypto token designed and offered as the means to invest in and profit by the efforts of its issuer, is a security.
Joe Sho is an independent researcher focused on the intersection of public policy and the crypto asset market.
At first, even silver, gold, and fiat money were not completely safe, and I think over time, crypto assets will also find their own balance of security.