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On March 31, 2019, the Southern District of New York held that digital coins sold in an initial coin offering (“ICO”) to finance a new blockchain were “securities” pursuant to the test set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Balestra v. ATBCOIN, 2019 WL 1437160 (S.D.N.Y. 2019) (Broderick, J.). The court explained that “[u]nder Howey, an offering is an investment contract security where there is (i) an investment of money; (ii) in a common enterprise; (iii) with the expectation of profits to be derived solely from the efforts of others.” The court rejected defendants’ contention that the second and third prongs of the Howey test were not met. The court explained that “[i]n analyzing whether an investment satisfies the Howey test, form should be disregarded for substance,” and “the emphasis should be on the economic realities underlying a transaction.”

Howey’s “Common Enterprise” Prong Does Not Require Pro Rata Profit Sharing

The court noted that plaintiffs can satisfy the “common enterprise” requirement “by pleading the existence of horizontal commonality,” which exists when “the fortunes of each investor in a pool of investors are tied to one another and to the success of the overall venture.” The court recognized that “a finding of horizontal commonality requires a sharing or pooling of funds.” Here, the court found that the “common enterprise” requirement was met because plaintiffs alleged that “the funds raised through the ICO were pooled together to facilitate the launch of the [blockchain], the success of which, in turn, would increase the value of” the digital coins sold in the ICO.

Defendants argued that there was no horizontal commonality because the digital coins “did not entitle purchasers to a pro rata share of the profits derived from any [company]-managed transaction.” But the court found that “a formalized profit-sharing mechanism is not required for a finding of horizontal commonality.” The court noted that the SEC had recently concluded that digital assets offered in an ICO to fund an iPhone application constituted securities “even though the terms of the offer did not provide for a pro rata distribution of profits.” The SEC determined that “investors were led to believe that as more individuals began using [the iPhone application], the value of investors’ [digital assets] would increase.” The court found that the digital coins at issue in the case before it were also securities because the value of the digital coins “was dictated by the success of [the company’s] enterprise as a whole, thereby establishing horizontal commonality.”

Howey’s Third Prong Was Met Because Defendants Alone Controlled the Success of the Blockchain, Which in Turn Determined the Value of the Digital Coins

The court explained that “[t]he third prong of the Howey test is satisfied where investors have been led to expect profits solely from the efforts of the promoter.” The court noted that in U.S. v. Leonard, 529 F.3d 83 (2d Cir. 2008), the Second Circuit cautioned that “the word ‘solely’ should not be construed as a literal limitation.” The Second Circuit further instructed that courts must “consider whether under all the circumstances, the scheme was being promoted primarily as an investment.” Here, the court found that plaintiffs adequately alleged that purchasers of the digital coins “reasonably believed that those coins would increase in value based primarily on [d]efendants’ entrepreneurial and managerial efforts” with respect to the blockchain.