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Imagine a hypothetical. A startup company that produces graham crackers devises a plan to market and sell its crackers to the public under a new brand. In order to fund this marketing effort, the startup offers pre-sale, discounted stocks of glossy, branded boxes of crackers to a select group of wholesalers, promising to use the proceeds to promote the brand and develop a new market for premium crackers at a premium price. All involved expect to profit from this plan through public sales to graham cracker consumers.

It may come as a surprise that lawyers can argue both sides of the question whether this is an example of a securities offering. Let’s put that to the side and assume that it is. But does that mean the graham crackers themselves are securities?

The answer to this question should be self-evident. Of course they are not. Graham crackers are food. But some — particularly those steeped in the unsettled application of securities laws to the blockchain space — might think that in this hypothetical the crackers are, or at least could be, securities. This misunderstands the very nature of a security, so let’s discuss it.

Lots of Investments Are Not Securities

Securities are not things you consume or use. They are investments. But not just any investment fits the bill. The securities laws enumerate specific kinds of investments that are deemed securities, like stocks and bonds, along with a more general category called “investment contracts.” 15 U.S.C. §§ 77b(a)(1), 78c(a)(10).

What is an investment contract? It must be something more than just any investment — otherwise, we wouldn’t need the word contract in the statutes. Our guiding light on this issue is the Supreme Court’s decision in SEC v. Howey, 328 U.S. 293 (1946).

The venerable “Howey test” defines an investment contract as a “contract, transaction or scheme whereby a person invests . . . money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party.” But what does this mean? Surely, it does not mean any profitable or speculative investment is a security. Were that the case, it follows that your house is a security. Art and gold are securities. Even George Washington’s copy of the Constitution, which was sold at auction for $9.8 million, is a security. Yet, we all know that none of these things are securities.

Finding the Line in Howey’s Facts

For guidance, we can look to the facts of Howey. W.J. Howey Company owned large tracts of citrus growing land in Florida. Its sister company, Howey-in-the-Hills Service, Inc., cultivated the groves, and harvested and marketed the crops. To fund further land development, Howey sold about half of its land to public investors along with 10-year service contracts provided by Howey-in-the Hills.

The service contracts gave Howey “full and complete” possession of the land under a leaseback arrangement that barred the purchasers from entering the land to market their own crops. After cultivating the land, pooling together the fruit and selling it under its own name, Howey would cut a check to the investors based on their pro rata share of the net profits of the citrus enterprise as a whole.

Howey marketed these investments to business and professional people vacationing at a nearby resort hotel that Howey owned. The marketing materials represented that investors could expect profits of more than 20% within the next year, and a 10% annual return over a ten-year period. If investors expressed interest, they were given a sales talk, and Howey closed the deal before they returned from vacation to their homes out of state.

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These facts are important, because they give meaning to the “Howey test.” People gave Howey their money as investments in a citrus growing enterprise, based on the expectation that Howey would cultivate the land, pluck the trees, market and sell the fruit, and split the profits pro rata among the investors. This is a quintessential security. The investment contract in Howey was the entire “contract, transaction or scheme” — the full bundle of rights and expectations — offered by Howey, and purchased by the investors. It was not the land or trees or fruit. This same analysis applies to a multitude of cases involving investment contracts that reference garden-variety products or commodities, from rare coins to casks of whiskey to beaver pelts.

Understanding the factual context of Howey helps with drawing the line in our graham cracker example. If there is any investment contract involved, it is the entire “contract, transaction or scheme” offered and sold by the company — the promise to use the proceeds of the pre-sale to market the brand and increase the profits for the enterprise as a whole — not the crackers themselves.

A Distinction with a Difference

This distinction has major implications for our hypothetical, because it means the graham crackers — like the oranges in Howey — may be freely sold at the grocery store, rather than through compliance with the myriad regulations governing market purchases and sales of securities. And this makes sense. The securities laws were designed to govern the offering and exchange of securities, not products or commodities, even if those products or commodities are referenced by or integrated with an offering or sale of an investment contract.

The distinction also has major implications for the blockchain space, and courts are only just beginning to grapple with it. The injunction proceedings in the Telegram case in the Southern District of New York was an excellent example. Telegram raised $1.7 billion from 175 accredited investors in a private placement for the development and launch of a new blockchain network. In exchange, Telegram promised to deliver 2.9 billion cryptocurrencies called Grams at the time of network launch. It was undisputed that the initial private placement was a securities offering.

In 2019, the SEC sought to enjoin delivery of the Grams to the initial purchasers, alleging that the 2018 private placement was part of an intended public distribution of securities, through which the initial investors were conduits to the public. SEC v. Telegram Group, Inc., et ano., No. 19-cv-9439 (PKC) (ECF No. 1) at ¶ 99. In its complaint, the SEC took pains to allege that the Grams themselves were the investment contracts, and thus the securities, at issue. Id. at ¶¶ 3, 51.

Telegram argued, by contrast, that its contract with the initial purchasers was an exempt securities offering, and the initial purchasers’ anticipated sales to the public were separate transactions that did not implicate the securities laws. Telegram also argued that because the Grams would have a functional use as a cryptocurrency at the time of delivery to the initial purchasers, the Grams themselves would be commodities, not securities. See SEC v. Telegram Group, Inc., No. 19-cv-9439 (PKC), 2020 WL 1430035, at *8, 18 (S.D.N.Y. Mar. 4, 2020).

The Southern District of New York granted the injunction, but explicitly declined to hold that the Grams themselves were the securities. The court instead concluded that the security was “the full set of contracts, expectations and understandings centered on the sales and distribution of the Gram[s]” at the time of the offering and sale to the initial purchasers. Id. at *18. In ruling on a subsequent motion, the Telegram court made clear that “one of the central points” of its injunction ruling was that “the ‘security’ was neither the Gram Purchase Agreement nor the Gram but the entire scheme that comprised the Gram Purchase Agreements and the accompanying understandings and undertakings made by Telegram….” SEC v. Telegram Group, Inc., et ano., No. 19-cv-9439 (PKC), 2020 WL 1547383, at *1 (S.D.N.Y. Apr. 1, 2020).

What About Graham Crackers?

Turning back to our hypothetical, both Howey and Telegram support the commonsense conclusion that graham crackers are food, not investment contracts. Like the land, trees and oranges in Howey — and the Gram tokens in Telegram — virtually any good, service, commodity, collectible, or blockchain token can be the subject of an investment contract. That does not mean any of these things themselves are securities. The securities are the investment contracts that reference them.

Time will tell whether courts clearly articulate, and properly address, this important distinction.