WHY YFI ARE NOT INVESTMENT CONTRACTS
A Recreational Legal Memo
This ‘recreational legal memo ‘sets forth an analysis of whether YFI tokens (the governance tokens of the yearn.finance ecosystem) are, or represent, investment contract securities under U.S. federal securities laws. Certain defined terms are set forth on Exhibit A.
EXTREMELY IMPORTANT DISCLAIMERS, PLEASE READ:
This memo was prepared pursuant to the principles of autonomous lawyering. Thus, I wrote this memo for myself in the context of being an incentive-aligned participant in the yearn.finance community—i.e., a user of the Yearn Technologies, a holder of some YFI and an occasional gadfly in various yearn.finance-related messaging groups. There is no attorney-client relationship associated with this memo, it was not issued by a law firm (especially not my law firm), it is not backed by malpractice insurance, and it is not intended to provide legal advice or other benefits to any person. Please review my Autonomous Law Disclosure, which contains some additional specifics.
My motivations for writing this memo are essentially selfish and are roughly as follows:
publishing a memo arguing that YFI should not be considered a security could make YFI (including my YFI) more valuable by giving other people a ‘head-start’ in conducting their own research and analysis into the same issue, and I believe that if others conduct their own research, they will reach a similar conclusion;
if YFI community members like the memo, then it is possible they could tip me retrospectively or, in the future, hire me for some other task prospectively;
writing the memo required me to do in-depth research into Yearn Technologies, which I wanted to do anyway;
the memo provides an example of autonomous lawyering, and therefore may lead to additional opportunities for myself and others to do further autonomous lawyering, which could be edifying, lucrative or both;
the memo is being published for my substack subscribers, who pay a modest fee, which is a source of revenue;
the memo showcases my expertise and could lead people to engage me to write legal memos for them on a compensated, attorney-client basis rather than an autonomous lawyering basis;
many people involved in cryptocurrencies have never seen a securities law memo analyzing whether a token is a security because lawyers typically write them for clients and keep them secret—by publishing one, I can educate people, which might increase everyone’s understanding of the issues and help create better solutions;
I have previously said I think many tokens are likely to be securities, and thus wanted to provide an example of one that I think is not a security, which may provide other developers an additional incentive to decentralize their project aggressively rather than following the currently favored “progressive decentralization” approach; and
the memo provides an opportunity for me to apply the “sufficient decentralization” tests I have previously articulated in articles, and thus to further spread my memes and viewpoints about this aspect of cryptolaw.
This memorandum does not present an exhaustive list or analysis of all securities law issues or other regulatory considerations regarding YFI or the Yearn Technologies. Among other legal issues that one might raise in connection with Yearn or YFI, this memorandum does not analyze and offers no view on:
whether depositing funds in the Yearn Technologies with the hope of realizing “yields”—e.g., through yVaults and their Strategies—constitutes a securities transaction;
whether Yearn Contributors or any other relevant person may be acting as unregistered investment advisors, broker-dealers or other regulated securities professionals in connection with the Yearn Technologies ;
any commodities law issues relating to the Yearn Technologies, including whether the Yearn Technologies facilitate or involve commodities trading by retail investors on a margined, financed or leveraged basis or involve swaps or other types of commodities required to be traded on a CFTC-regulated market; or
whether the Yearn Technologies involve a “money services business” or are subject to KYC/AML or suspicious activity reporting requirements.
This memorandum might not reflect all relevant facts and circumstances. The primary source of information for our analysis is public information available on the internet regarding the Yearn Technologies and YFI. In addition, I had limited discussions with a pseudonymous Multisig Holder and several pseudonymous Yearn Contributors through a messaging application. A subset of these persons also reviewed and provided factual feedback on rough drafts of this memorandum. I assume the accuracy and completeness of all public information and all information I obtained from the aforementioned Yearn community participants and have made no effort to independently investigate, confirm or test the veracity or completeness thereof.
This memorandum is intended to speak as to facts and circumstances solely as of the date hereof (October 18, 2020), and I do not assume any obligation or undertaking to keep it up to date or to disclose to readers any material changes in circumstances occurring after the date hereof.
This memorandum is not intended as legal advice or a legal opinion letter, but, rather, is being provided solely for entertainment purposes or to help organize the independent research efforts of other persons on the topics discussed. By reading on, you covenant and agree not to rely on or hold me responsible for this memorandum or any information or conclusions herein, but solely to use it for entertainment, as an inspiration for your own research or as an aid to discussions with your own legal counsel. I am not your lawyer.
COPYRIGHT AND LICENSING
I hold the copyright to this memorandum and all rights are reserved. If, despite the foregoing, you end up using this memorandum (or a derivative thereof) as a starting point or inspiration for your own work, please consider sending me a tip reflective of my value contribution at lex-node.eth. I am a strong advocate for lawyer openness and produce a lot of free or low-priced content; if others are monetizing it, they should give me a reasonable cut and a virtuous cycle can be fostered in which more lawyers are encouraged to follow a similar path. If you wish to fork this memo to publicly analyze YFI tokens on a similar basis (on an autonomous lawyering basis) or suggest improvements to it for public consumption, please reach out to discuss and I will likely grant a free license or add the edits myself and credit you (and possibly compensate you in some way, if the suggestion is valuable).
A. Executive Summary
I analyze whether YFI tokens or transactions therein are, or represent, investment contract securities under U.S. federal securities laws. I conclude, subject to the facts, assumptions, qualifications and limitations described in this memorandum, that YFI and ordinary transactions therein should not currently be deemed to be or represent investment contract securities under U.S. federal securities law. I also note some sensitivities in the analysis & how future developments could affect the conclusion or require a fresh analysis.
B. Factual Background
Yearn Finance is a suite of decentralized finance (DeFi) products (the “Yearn Technologies”) aiming to provide returns on digital asset deposits via third-party asset-borrowing applications, liquidity pools and community-made yield farming strategies on Ethereum. A diagram depicting the Yearn Technologies can be found below:
YFI is intended to function as the “governance token” for Yearn Finance and the associated marketing, research and development efforts. The exact social and legal significance of YFI is under-specified in certain regards, but I can describe certain practices and expectations that have been established regarding YFI and then discuss the implications of such practices and expectations.
1. YFI - Technology Layer. On the technological level:
YFI can be staked/deposited into the Governance Contract to receive the benefit of a pro rata portion of net Surplus System Fees or can be deposited into a yVault to leverage YFI Strategies; and
YFI can be used to vote on governance proposals through the Governance Contract (if staked in the Governance Contract) or snapshot (if not staked in Governance Contract but otherwise eligible to vote (i.e., not held on a centralized exchange or other blacklisted venue)).
It is currently anticipated that the so-called “on-chain governance” functions of YFI will be increased through deployment of additional smart contracts enabling votes of YFI holders to be more directly given effect on an automated and trust-reduced basis. Meanwhile, there is significant reliance by YFI holders on the ministerial efforts of the “multisig council” (described below) to implement the results of YFI governance votes.
2. YFI - Social Layer. On the socio-cultural level, the persons who have historically been most active in marketing, researching, developing, testing and deploying the Yearn Technologies (“Yearn Contributors”) voluntarily adhere to a set of practices whereby substantially all proposed material decisions relating to the Yearn Technologies (or proposals to delegate authority to make or implement such decisions) are submitted to be approved or denied by vote of the YFI holders.
3. YFI - Legal Layer. On the legal level, the nature and implications of the aforementioned technological features and social practices related to YFI are unclear and remain open to interpretation:
a. One interpretation could be that, through such features and practices, YFI holders have actually become vested in certain legally enforceable rights and obligations. One way such legal rights and obligations could arise would be through the existence of a “contract-implied-by-law” arising from YFI holders’ reliance on the past effects of these functions and practices, along with past statements by Yearn Contributors about how YFI should work. If this legalistic interpretation is correct, then, for example, if the Yearn Contributors forked (i.e., deployed a copy or derivative of) the Yearn Technologies in an adversely competitive manner without an approving vote of the YFI holders, YFI holders might have a claim against them for breach of contract, breach of fiduciary duty, misrepresentation or misappropriation of assets.
b. On the other hand, considering the absence of express written legal agreements determining the rights and obligations of YFI holders, Yearn Contributors and other community members, along with the free open source software model used for the Yearn Technologies, it is equally possible that for legal purposes the current status quo of the Yearn community is a kind of alegal epiphenomenon or temporary non-binding social consensus, an emergent social effect of the voluntary peer-to-peer interactions of participants. This type of status quo is sometimes (mis-)described as a “social contract.” On this theory, the yearn community is held together (and, by implication, the value of YFI depends on) a tenuous détente arising from the forces of moral suasion and a coincidence-by-design of aligned incentives. This would imply that the technological functions and social practices currently associated with YFI could change without violating any law or contract or giving rise to any legal cause of action.
U.S. securities laws elevate substance over form and do not require tokens to confer legal rights in order for such tokens (or transactions in such tokens) to be or represent investment contract securities. Thus, for purposes of this memo, beyond noting the relevant ambiguities, I do not view it as important to determine whether “a” or “b” is a better interpretation of YFI’s legal significance.
The history of Yearn Contributors, Yearn Technologies and YFI is unusual compared to that of many other Ethereum-based projects and tokens and is highly relevant to a securities law analysis of YFI.
Development of Yearn Technologies
The initial Yearn Technologies (also known as “v1”) were first deployed to Ethereum under the project name “iearn.finance” in January 2020 by a smart contract developer named Andre Cronje. There was no business model associated with v1, and there was no actual or planned governance token such as YFI. V1 provided a simple, but effective, automated on-chain software-as-a-service for rotating Ethereum-based stablecoins into and out of other, third-party-operated, Ethereum-based smart contract systems that pay a “yield” (i.e., a reward for deposits, similar in effect but not underlying mechanisms to the interest paid by a bank to depositors). The reward rates offered by these third-party smart contract systems (“Yield Systems”) vary depending on market conditions. The innovation and principal feature of v1 was to automatically compare each relevant Yield System’s current yield to the others using on-chain data and rotate the deposited stablecoins to whichever Yield System offered the highest yield. This component of the Yearn Technologies is now known as “Earn” and accommodates lending of DAI, USDC, USDT, TUSD, sUSD and wBTC.
In the ensuing months, Mr. Cronje made various improvements to v1 and changed the name of the project to “yearn.finance”. On July 24, Mr. Cronje announced “yearn.finance v2”, which introduced the yVault system consisting of three main components:
yVaults, which hold deposited tokens and provide the depositors, in effect, with liquid tokenized certificates of deposit corresponding to the deposited assets on a 1:1 basis (‘yTokens’);
Strategies, which are smart contracts defining yield-generating methods utilizing other Yield Systems; and
the Controller, a smart contract which configures the Strategies for yVaults based on the votes of YFI holders (currently implemented manually by the Multisig Holders).
There may be one or more Strategies applicable to a particular yVault/asset. YFI holders control the use of the Strategies in the sense that they determine the % of the yVault to be devoted to each Strategy and the risk/reward parameters to be applied to each Strategy .
The profits (loosely speaking) generated by the application of a Strategy to a yVault are available to the yVault depositors (pro rata in accordance with their deposited amounts). These profits are net of certain potential fees and costs which get allocated, roughly speaking, ‘the vault system’. These fees and costs are as follows:
a 0.5% fee (the “Excess Withdrawal Fee”) charged on withdrawals from a yVault that require removing tokens that are being actively utilized by a Strategy at the time of withdrawal—the Excess Withdrawal fee is allocated to the Executive Treasury (to the extent that the Executive Treasury holds less than the Treasury Reserve Target) or the Governance Contract (to the extent not needed for Executive Treasury because the Treasury Reserve Target has already been met);
a 5% fee on ‘additional yield’ (the “Harvesting Fee”)—which is yield arising at the phase of a Strategy when the Strategy ‘harvests’ (i.e., withdraws and market-sells) a liquidity-incentive token that the Strategy ‘farmed’ from a Yield System—the Harvesting Fee is allocated as follows:
10% of the Harvesting Fee goes to the Strategy creator (who theoretically could be any person, but was Mr. Cronje for the initial set of Strategies); and
90% of the Harvesting Fee is treated the same as Excess Withdrawal Fees—i.e., 90% of the Harvesting Fee is allocated to the Executive Treasury (to the extent that the Executive Treasury holds less than the Treasury Reserve Target) or the Governance Contract (to the extent not needed for the Executive Treasury because the Treasury Reserve Target has already been met).
We refer to the Excess Withdrawal Fees and Harvesting Fees as “Surplus System Fees”.
Launch and Distribution of YFI
On July 17th, Mr. Cronje announced the creation & distribution of YFI, explaining it as follows:
[The Yearn Technologies] have control mechanisms, configurable fees, maintenance controls, and rules that can be modified. Thus far, these have been managed by us. In further efforts to give up this control (mostly because we are lazy and don’t want to do it), we have released YFI, a completely valueless 0 supply token. We reiterate, it has 0 financial value. There is no pre-mine, there is no sale, no you cannot buy it, no, it won’t be on uniswap, no, there won’t be an auction. We don’t have any of it…[S]tandard voting rules apply, minimum quorum required (>33%) to propose a change, usual veto rights (>25%), and usual agreement thresholds (>50%) required to pass a vote and update a change…We don’t have any of it…And just because we feel we didn’t stress it enough, 0 value. Don’t buy it. Earn it.”
The only method of obtaining YFI was to: (1) stake tokens in a supported Yield System (such as curve.fi) and (2) stake the ‘output tokens’ obtained in step “(1)” into a Yearn Technologies smart contract. YFI would then be distributed on a pro rata basis to the stakers at rates determined by the smart contract’s parameters. In interviews, Mr. Cronje has explained this distribution method as being designed to put governance of the Yearn Technologies into the hands of sophisticated Ethereum DeFi users who understand the Yearn Technologies and other Yield Systems.
The entire supply of 30,000 YFI was distributed in this fashion over an approximately week-long period. Due to public interest, YFI began trading on secondary markets such as Uniswap, and eventually was listed on “centralized” exchanges such as Binance and Coinbase Pro. YFI’s secondary market price skyrocketed, rising from $34.53 (its price when first tracked by coingecko.com) on July 18, 2020 to an all-time high of $43,678 on September 12, 2020.
Governance – YFI and the Multisig
Governance of the Yearn Technologies primarily involves two groups: (1) YFI holders in their capacities as such and (2) the nine holders of the nine private keys (the “Multisig Holders”) controlling a 6-of-9 Gnosis Safe multisignature smart contract (the “Multisig”).
Governance of the Yearn Technologies by YFI holders commenced the day after YFI was first announced and distributed. The primary governance mechanism is submitting Yearn Improvement Proposals (YIPs) to be voted upon by YFI holders. YIPs are discussed and refined in a dedicated forum (https://gov.yearn.finance) and then submitted for a formal vote of YFI holders to be held through the Governance Contract. Certain governance proposals are not “YIPs” because they are not defined as formally. .
The Multisig’s initial purpose was to provide a secure way of governing the smart contract responsible for minting and tracking balances of YFI. As such, the Multisig Holders (through their power over the Multisig) hold the theoretical power to mint more YFI beyond the existing 30,000 supply. The approval and implementation of YIP 36 established the Treasury Reserve and gave the Multisig Holders the power (through the Multisig) to give effect to YFI votes relating to the spending of funds from the Treasury Reserve. Beginning with the approval and implementation of YIP 41, the powers and responsibilities of the Multisig Holders expanded (on a temporary, modifiable and revocable basis) “to make basic, limited operational decisions including budgetary expenditures, protocol grants, and hiring for six months, as we prepare a more robust governance architecture…for no more than six month. During this six-month term, the Multisig will be responsible for facilitating the creation and transition to a multi-DAO structure.”
A purportedly complete list of YIPs which have made it to the on-chain voting stage is available at https://yips.yearn.finance/all-yip. Non-YIP proposals are currently listed at https://snapshot.page/#/yearn. Some of the most important proposals implemented to date have been:
YIP 0, establishing YIP Purposes and Guidelines;
YIP 12: Reducing the quorum for accepting proposal (reduced YFI voting quorum from 33% of YFI to 20% of YFI);
YIP 32: Remove YFI burning (eliminated “burning” of YFI as a method of obtaining fees from the Governance Contract, leaving “staking” of YFI in the Governance Contract as the sole method of collecting fees from the Governance Contract);
YIP 36: System rewards as operational capital (established the various treasuries in order to fund operational expenses out of Surplus System Fees); and
YIP 41: temporarily empower multisig (establishing the expanded Multisig powers summarized above).
An important pending proposal which has not yet been formalized as a YIP but has received soft social support on the governance forum is Mr. Cronje’s proposal to destroy the ability of the Multisig to mint additional YFI—if approved and implemented as a YIP, then no more YFI could ever be legitimately minted and the current 30,000 YFI supply would be a permanent cap.
Other Yearn Technologies
Other Yearn Technologies deployed to date include Zap and yCover (fka as yInsure). Zap enables “swap[ing] various assets bi-directionally into pooled interest-bearing tokens….to facilitate more seamless and frictionless swaps between various coins.” yCover provides pooled “coverage” for smart contract security issues through Nexus Mutual; the persons who deposit into yCover are collectively in the position of the coverage providers and receive fees for committing the coverage capital.
D. Overview of U.S. Securities Laws
Offers and sales of securities are regulated in the United States under both U.S. federal law (e.g., the Securities Act of 1933 (“’33 Act”), the Securities Exchange Act of 1934 (“’34 Act”) and the regulations of the Securities Exchange Commission (“SEC”) thereunder) and the securities laws of each State (“blue sky laws”). This memorandum focuses on the U.S. federal securities laws.
The core principle of the federal securities laws is that all offers and sales of securities must be either registered with the SEC or exempt from registration requirements. Registration occurs by the filing of extensive public reports with the SEC and typically entails that the issuer also file additional reports periodically. Extensive accounting, governance and other regulations also apply to such reporting companies.
Due to the legal and accounting costs associated with this complex reporting regime, typically only mature companies with robust valuations “go public” and become reporting companies with freely trading securities. The vast majority of businesses remain “private”, do not file public reports with the SEC and rely on “private placement” exemptions for the issuance and trading of their securities.
However, complying with such exemptions carries burdens of its own—for example, issuers must typically either avoid publicly offering their securities or only sell their securities to “accredited investors.” Even if the exemptions have been complied with, the resulting securities are “restricted” and either may not trade or may only trade in private, relatively illiquid markets. To the extent such securities eventually become tradeable, the issuer must be conservative due to secondary market regulations—for example, if an issuer’s equity securities become held of record by more than 499 non-accredited investors or more than 1,999 investors of any kind, and the issuer has more than $10 million in assets, the issuer will be deemed to have the same reporting obligations as a “public company” whose stock trades on a national securities exchange such as NYSE or NASDAQ.
E. What is a “Security”?
Securities are defined slightly differently under the different federal laws. The primary definition of “security” is set forth in Section 2(a)(1) of the ‘33 Act, which provides:
The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
While seemingly straightforward, this definition has been extensively enlarged upon, analyzed and interpreted by judges, regulators and academics over nearly 90 years, forming a formidable corpus of nuanced securities laws that varies based on the type of security at issue and the specific context in which it is offered or sold.
It is important to highlight the “flavor” of securities law jurisprudence, both because it can be counterintuitive to non-lawyers and because it differs significantly from how courts treat other types of laws that are construed more narrowly. The securities laws are considered “remedial legislation” and thus may be interpreted broadly with the aim of applying them in situations where their purposes, such as investor protection, would be served. Therefore, U.S. federal courts tend to adopt the principle that the label given to a contract, scheme or transactions does not determine whether it is a security. Instead, courts will assess all relevant circumstances “in terms of their substance (the economic realities of the transaction), rather than their form” and assess whether the policy concerns of the securities laws are implicated. This makes the legal analysis complex, policy-driven, potentially uncertain and, in many cases, a matter of professional judgment on which well-informed and reasonable attorneys could reach different conclusions.
F. Analyzing Tokens as Representing Investment Contracts
Different tests apply to different types of securities. For example, there are different tests to determine whether an investment is a “note,” “stock” or “investment contract.”
In the context of blockchain tokens, the theory most commonly asserted by the SEC and other litigants is that such tokens (or the transactions in which they are offered and sold) constitute “investment contracts.” Potential investment contracts are assessed under the test articulated in the case of Securities and Exchange Commission v. W. J. Howey Co., as modified by subsequent case law (the “Howey test”). Under the Howey test, an investment contract will be found to exist when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others.
The interpretation of the Howey test has evolved over time, mostly in the direction of expanding the test to “encompass virtually any instrument that might be sold as an investment.” For example, the Howey opinion itself originally required that the relied-upon efforts be “solely” from the efforts of others, but subsequent case law has broadened the test to encompass “essential managerial or entrepreneurial efforts” that might not be the “sole” efforts. While most cases contemplated that the “efforts of others” must be expected to be ongoing after the investor’s investment of money, later cases have allowed that pre-investment entrepreneurial efforts can count. The case law also provides for certain exceptions where the Howey test might nominally be met but an investment contract will not be found to exist—e.g., where the transaction primarily has a consumer purpose rather than an investment purpose.
Howey and related judicial opinions deal with facts that can be analogized to token issuances but also differ from them in many ways. Many of the most famous Howey test cases deal with investment schemes involving tangible assets like orange groves, portfolios of rare collectible coins, whiskey, condominiums, gas leases and pay telephones, though some deal with more obvious financial instruments like certificates of deposit. In one recent case, SEC vs. Telegram Group, Judge Castel of the U.S. Federal District Court for the Southern District of New York enjoined Telegram’s issuance of a native blockchain token based on a finding that the SEC had shown a likelihood of probable success on its claim that the overall scheme among Telegram and its SAFT investors violated the securities laws; however, the court pointedly refrained from determining whether the tokens themselves should be considered securities.
Because directly relevant case law is limited, the most helpful authority remains the SEC’s Framework for “Investment Contract” Analysis of Digital Assets. The SEC’s Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO is another useful touchstone, especially in the context of DAOs or other systems involving governance tokens. The SEC has also issued two no-action letters regarding tokens, though the fact-patterns are so conservative that they are of little use in evaluating fact patterns that are even somewhat ‘close to the line.’ Finally, although featuring more cursory reasoning, the reasoning set forth in the SEC’s settlements with certain token issuers can be informative.
The SEC is not a court of law or legislature, and thus details of the SEC guidance could be wrong as a matter of law and are not binding precedent. Nevertheless, I view the SEC guidance as being generally consistent with the Howey test. The SEC is also currently the most likely source of legal actions regarding tokens; thus, insight into how the SEC views the law is useful regardless of potential debates as to the soundness of such views. Accordingly, this Memorandum generally refers to SEC guidance as if it were on par with case law, notwithstanding that that only the case law is legally binding.
In addition to case law and SEC guidance, a third reference point is commentary by practicing lawyers, law professors, and SEC officials speaking in their personal capacities. Such sources are the least likely to determine the outcome of whether a token represents an investment contract, but can provide insight into theoretically sound policy viewpoints. Credible theories concerning when a blockchain network is “sufficiently decentralized” or has reached “network maturity” can be especially helpful.
G. Debunking Common Securities Law Myths About Tokens
I believe the blockchain community has given prominence to many rumors and misconceptions regarding the securities laws and how they apply to tokens. Since the early days of “ICOs”, lawyers and venture capital investors have been eager to launch new supposedly ‘SEC-approved’ or ‘compliant’ methods for distributing tokens in manner unburdened from the securities laws—“utility tokens”, “consumptive tokens”, “SAFTs” and so on, and each has proven to be largely out-of-sync with the views of both securities regulators and mainstream securities law attorneys. Readers of this memorandum should read the author’s article “Debunking Securities Law Myths About Tokens” to understand why most popular theories regarding the non-securities status of tokens are overstated or incorrect.
H. SEC v. Telegram
SEC v. Telegram Grp., 2020 WL 1430035 (S.D.N.Y. March 24, 2020) was the first major substantive opinion by a U.S. federal court analyzing a token under the Howey test and is worth reviewing for potential insights.
First, though, it is important to note some limitations of this opinion: This case was settled after the court held against Telegram on the SEC’s motion for a preliminary injunction; the opinion explains the court’s reasoning for granting the injunction and thus prohibiting the distribution of GRAMs. Accordingly, there was never a trial of the case and the merits of the case were never finally determined after a full presentation of facts by both sides. Furthermore, the court never addressed the question of whether GRAMs themselves should be considered securities.
Instead, the court held that Telegram’s sale of SAFTs or similar instruments convertible into GRAMs to venture capital investors was a securities law transaction that lacked a valid private placement exemption (even though all such investors were “accredited”) because the investors’ intended resale of GRAMs after network launch “were part of a larger scheme, manifested by Telegram’s actions, conduct, statements, and understandings, to offer Grams to the Initial Purchasers with the intent and purpose that these Grams be distributed in a secondary public market, which is the offering of securities under Howey.”
The court also averred that “Grams…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” and that this “represents a public distribution and the Initial Purchasers, who acted as mere conduits to the general public, are underwriters.” The SAFT purchasers, of course, were not registered securities underwriters and, even if they were, Telegram had relied on an exemption that does not cover sales of securities to underwriters. Thus, the court enjoined the distribution of GRAMs.
Although the court sidestepped the deeper question of whether GRAMs themselves were securities, instead relying on the extremely obvious finding that the SAFTs sold prior to network launch were securities, the court’s reasoning is nevertheless instructive and may shed some light on token-related securities issues more broadly. The court’s opinion is especially relevant when development of the system by the creator/promoter has been funded by selling token instruments to venture capital investors prior to the network launch.
The result in Telegram is, at first glance, surprising, because Telegram had a strong argument that the sale of SAFTs (and even the distribution of GRAMs) was compliant. To establish that the sale of SAFTs was an exempt securities law transaction, Telegram relied on long-established standard practices for undertaking private placements of securities: Telegram sold SAFTs only to “accredited investors” in apparent compliance with Rule 506(c) of Regulation D. In the sale, Telegram obtained standard representations and warranties from the SAFT purchasers, including that they were “purchasing the Tokens for [their] own account and not with a view towards, or for resale in connection with, the sale or distribution” Furthermore, the proposed distribution of GRAMs was more than 12 months after the SAFTs were sold; accordingly, via Rule 144 and its “tacking rules,” even if the GRAMs themselves were still securities at launch, the holding period for non-affiliates of Telegram should have been deemed to have elapsed and transfers of GRAMs by SAFT holders should not have been considered underwriting activity.
Why did the court not accept this conventional reasoning? Conceptually, the answer is as follows: Regulation D requires that an issuer “exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(a)(11) of the [Securities] Act.” Merely obtaining representations from purchasers that they are not underwriters is insufficient to establish this “reasonable care.” On the facts, Telegram should have been on notice—and in the court’s view was itself responsible for encouraging—that the SAFT investors “bought Grams from Telegram, the issuer, with an intent to resell them for profit in the secondary market soon after launch of the TON.”
What were those facts? First, under the hypothetical “Bahamas test,” the court found that GRAMs could not reasonably be expected to have value without Telegram’s continuing post-launch entrepreneurial ‘efforts. Secondly, the court found that Telegram had committed to a secondary market price structure that would guarantee SAFT purchasers’ profits based on the implied discount they received in the SAFT sales:
The sale price of Grams during the Round One and Round Two Sales, approximately $0.38 and $1.33 respectively, (JX 11 at 8); (JX 12 at 2), was set at a significant discount to the expected Reference Price post-launch and the expected market price in a postlaunch public market Upon the launch of the TON Blockchain, the only Grams available for public purchase would either be newly-released Grams from the TON Reserve or Grams resold by Round Two Purchasers, whose Gram Purchase Agreements did not contain a lockup clause. Under Telegram’s pricing formula, the Reference Price of Grams held in the TON Reserve at launch would be approximately $3.62. If the market price reached the Reference Price but no higher, it would offer Round One and Round Two Initial Purchasers an approximate 852% and 172% premium, respectively, over their cost of acquiring Grams. This would provide a substantial opportunity for the Initial Purchasers to profit on the resale of Grams, even if the market price of Grams fell below the Reference Price as the TON Reserve is not permitted to sell newly floated Grams for less than the Reference Price.
Based on the foregoing, Judge Castel’s opinion was that the prompt “dumping” of GRAMs on the public by the SAFT purchasers was an inherent part of the Telegram’s plan, and enjoined the distribution of GRAMs as constituting the final step in a scheme to evade the registration requirements of the ’33 Act.
Although the Telegram opinion is just the opinion of one federal district court on a motion for a preliminary injunction, it is likely to be influential on the SEC and on other judges and should be taken seriously. In general, I view the Telegram opinion as standing for the proposition that the issuer of a token-related security has heightened due diligence obligations to establish the lack of an underwriting intent on the part of pre-launch investors. Many tokens lack intrinsic long-term value and thus are intrinsically more apt to be rapidly “flipped” by venture investors in the secondary market. Whether this reasoning applies in a given case will be a facts-and-circumstances inquiry and reasonable legal minds may differ on their opinion of the outcome. I draw distinctions between the Telegram case and the circumstances being analyzed later in this memo.
I. SEC v. Kik
U.S. Securities and Exchange Commission v. Kik Interactive Inc., No. 1:2019cv05244 - Document 88 (S.D.N.Y. 2020) provides another recent U.S. federal court opinion relating to a token sale/distribution. Unlike the opinion in SEC v. Telegram, this one was decided on a motion for summary judgement, rather than a preliminary injunction. The court held that Kik’s sale of KIN violated securities laws as a matter of law and granted the SEC’s motion for summary judgment on the merits.
The Kik case is noteworthy as compared to the Telegram case because the Kik court focused mainly on the question of whether KIN represented investment contracts, whereas the Telegram court focused mainly on whether the distribution of GRAMs represented a part of a scheme to evade the securities laws. The Kik court held that KIN were investment contract securities, and that the security being purchased even by pre-sale purchasers who entered into SAFTs with Kik was really KIN itself.
Applying the Howey test, the court found that:
purchasers made an “investment of money” in KIN (this was undisputed)
there was a “common enterprise” relating to KIN because all KIN holders would benefit from increases in value of KIN arising from Kik’s pooling of the funds raised from the sale of KIN;
KIN purchasers had an expectation of profits based on the efforts of others, because:
Kik’s CEO extolled the Kin’s profit-making potential based on increasing demand for Kin;
growth in demand for Kin “would rely heavily on Kik’s entrepreneurial and managerial efforts” and “Kik promised to ‘provide startup resources, technology and a covenant to integrate with the Kin cryptocurrency and brand’”;
“Kik had a unique incentive to increase demand for Kin because it retained for itself 30% of the tokens created”; and
“these efforts by Kik were crucial because without the promised digital ecosystem, Kin would be worthless.”
Accordingly, the court concluded that KIN were investment contract securities and that the unregistered sale of KIN to the public violated Section 5 of the Securities Act of 1933. I draw distinctions between the Kik case and the circumstances being analyzed later in this memo.
J. SEC Guidance—A Closer Look
The SEC guidance does not provide clear, deterministic tests for whether a token is a security, but situates various fact patterns within a framework for applying the Howey test. Accordingly, I find it most useful to view the SEC guidance as inspiring a set of “red flags,” “green flags” and “yellow flags”. No “flag” by itself determines that a token either represents or does not represent an investment contract, but, all else being equal, the presence of many green flags within a fact pattern would tend to indicate that the token does not represent an investment contract, while the presence of many red and/or yellow flags would tend to indicate that the token does represent an investment contract. Of course, it is important to bear in mind that the Howey test is not a points system—accordingly, this is merely one lens through which to analyze the facts, and should not be relied upon to the exclusion of a more legalistic analysis. Moreover, the SEC does not itself “rank” the flags by severity as red or yellow—rather, I am layering this “flag” schema onto the SEC guidance based on my own legal judgment.
The SEC guidance also uses the concept of an “Active Participant”—defined as a “promoter, sponsor or other third party (or affiliated group of third parties)” who is undertaking activities that would tend to cause the token to increase in value. The presence of an Active Participant, in and of itself, does not entail that the token is a security—for example, there are many “Active Participants” promoting BTC and ETH without BTC and ETH being deemed securities. However, depending on the details of an Active Participant’s activities, the Active Participant’s position and role within the relevant token ecosystem and the effect that the Active Participant’s public presence has on the expectations of token investors, an Active Participant’s efforts could count toward a holding that certain tokens (or transactions or schemes involving certain tokens) are or represent investment contract securities. Nevertheless, the SEC’s notion that Active Participants who are unaffiliated with the token “issuer” can provide the “essential managerial or entrepreneurial efforts” under an investment contract for Howey purposes—along with the implication that a token can begin as not implicating the securities laws but later come to implicate the securities laws due to the activities of such an Active Participant— is speculative and without clear foundation in the applicable case law.
K. Other Guidance—A Closer Look
The SEC staff and others have informally adopted a doctrine that if a blockchain system is “sufficiently decentralized,” the token for that system may not be a security—or, having once been a security when the system was centralized, may cease to be a security upon the system becoming sufficiently decentralized. The SEC has not released any official guidance using the term “sufficient decentralization” and there is no legal test for determining when a system is “sufficiently decentralized,” but what we refer to as the “green flags” alluded to in William Hinman’s speech and the SEC’s Framework can serve as evidence that sufficient decentralization has been achieved:
Commissioner Pierce of the SEC has suggested an alternative test—the “network maturity” test, where “network maturity” is defined as follows:
Network Maturity is the status of a decentralized or functional network that is achieved when the network is either:
(i) Not controlled and is not reasonably likely to be controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control; or
(ii) Functional, as demonstrated by the ability of holders to use tokens for the transmission and storage of value, to prove control over the tokens, to participate in an application running on the network, or in a manner consistent with the utility of the network
In our view, only “(i)” has been embraced as a test by the SEC and has a foundation in securities laws, whereas “(ii)” may be true—the network may be functional—but the securities laws may nevertheless continue to apply if in fact many purchasers of the token do not have an objectively demonstrable consumptive intent. See “Debunking Common Securities Law Myths” by Gabriel Shapiro. Nevertheless, both prongs of the definition are potentially relevant and should be considered in evaluating a token.
Other commentators have also weighed in on the potential meanings of “sufficient decentralization,” including Gabriel Shapiro (the author of this memorandum), Balaji S. Srinivasan, Jake Brukhman and M. Todd Henderson & Max Raskin. These proposed tests and metrics are potentially insightful on policy grounds, but do not have the force of law and have not been endorsed by any SEC staff or commissioners.
The “Bahamas test” formulated by Henderson & Raskin is especially interesting because it was cited with implicit approbation by Judge Castel in SEC v. Telegram. The most intuitive version of the Bahamas test goes like this:
If the sellers fled to the Bahamas or ceased to show up to work--like Satoshi Nakamoto—would the project still be capable of existing? If the answer is “yes,” then the risk of fraud is sufficiently reduced such that the instrument is not a security.
In elaborating on the Bahamas test, Henderson and Raskin state that
One key factor in the above analysis is whether there are technical barriers to entry to participation in the project-network. The SEC weighed the existence of such barriers in the Munchee order above when they found it relevant that “no other person could make changes to the Munchee App [.]” If there are no technical barriers, however, and anyone can make changes to the project-application or network, then there is much less of a reason to think the instrument is centralized.
Thus, the Bahamas test is a gloss on the “efforts of others” prong of Howey. It is not a legal test, but it is an intuition pump that helps do a gut-check on the importance of the “efforts of others” to a given system.
The Shapiro Test represents an analytical approach to defining “sufficient decentralization” and is likely the only robust attempt by any U.S. lawyer to date to define a very detailed test for whether “sufficient decentralization” has been achieved for securities law purposes. It has two variations—(1) a version with strict numerical criteria, in a form appropriate for adoption as a “safe harbor” by a regulator, and (2) a “flexible test” with more “fuzzy logic” criteria, in a form appropriate for adoption by judges with real cases in front of them. For purposes of this memorandum, I focus on a simplified version of the strict Shapiro test, which holds that “Network Maturity” or sufficient decentralization has clearly been achieved under the following conditions (though also may be achieved under less strict conditions judged under the more flexible standard):
less than 10% of the token are directly or indirectly owned beneficially by the initial development team or affiliated persons;
less than 10% of the means of determining consensus are directly or indirectly owned beneficially by the initial development team or affiliated persons;
there is substantial funding independent of the initial development team and affiliated persons available for research, development and maintenance of the Open Network protocol and software client(s), and such research, development and maintenance is not directly or indirectly controlled by the initial development team or affiliated persons; and
there are no material un-performed development covenants from the initial development team which the token purchasers relied upon or reasonably expected to be fulfilled in acquiring the token, unless the development plans have been modified through an established governance process.
It is important to note that this version of the test is focused on determining when the original token creators/sponsors have “issuer” obligations under the securities laws. It thus does not attempt to measure whether other, unaffiliated “Active Participants” may have stepped into an issuer-like role which might implicate or re-implicate the securities laws.
The flexible version of the Shapiro test accounts for the possibility of a secondary “Active Participant” and measures sufficient decentralization more broadly. The test provides that sufficient decentralization will be found if, in light of all facts and circumstances, either:
no single person or group of affiliated persons controls the open network system or the consensus, economics or software protocol/client of the open network system; or
if any person or group does control one or more aspects of the open network system, control over other aspects of the system is widely distributed among independent persons in a manner that substantially limits the controlling person's or group's ability to interfere with or alter the open network system or other persons' use and enjoyment of the open network system.
The ‘aspects of the open network system’ to be tested under the flexible test may vary depending on circumstances, but typically include all or some of: (1) validation power; (2) consensus power; (3) protocol/client power; (4) economic power; and (5) user power.
L. The Securities Metaphysics of Tokens – How Can a Token Be a Security?
Although almost everyone agrees that securities laws apply to tokens in some contexts, there has been much wailing and gnashing of teeth among cryptolawyers about exactly what this means, while on the other hand the SEC and judges have given the issue short shrift. We say ‘stock is a security’ or ‘a bond is a security,’ but how can a token be a security, when it is just a data entry on a distributed ledger maintained by a peer-to-peer network, and not a bundle of legal rights? When a token is sold pursuant to a SAFT, isn’t the SAFT (which is a legal agreement and confers rights) really the security, not the token (which might not even exist yet)? I call such questions and issues “securities metaphysics”.
Much ink could be spilled on this topic, and this memorandum is not the place for a deep discussion. However, the rest of this memo’s analysis could be very confusing without trying to explain the topic in some basic way; thus, I will cover it here in enough detail to orient a reader who has no special axe to grind on the subject but might be confused about what it means for a “token” to “be” a “security”.
In Howey, an investment contract was defined as “any contract, transaction or scheme [that satisfies the four elements of the test]”. So, an “investment contract” can be, and hence a security can be: (1) a contract (“an agreement, upon sufficient consideration, to do or not to do a particular thing”); (2) a transaction (“an exchange or transfer of goods, services, or funds”); or (3) a “scheme” (“a combination of elements that are connected, adjusted, and integrated by design,” “a systematic plan or program” or “a crafty, unethical, or fraudulent project”). Thus, whenever we say, or the SEC or a court says, a token is an investment contract security, what is really meant is one or more of the following:
all or most transactions in that token (typically, buying/selling it) are investment contract securities transactions;
the token is an integral part of an investment contract securities scheme; or
the token represents an investment contract securities contract, as it were, much like a stock certificate represents the legal abstraction of “stock” and the associated rights;
Really, the “metaphysics” are just that simple. Saying “this token is a security” is just a shorthand way of saying that the token is strongly tied to a contract, transaction or scheme that constitutes an investment contract and that therefore transactions and events involving such token will generally be subject to the securities laws.
M. Overview - Are YFI Securities?
TLDR: Although not free from doubt, based on the facts and subject to the qualifications, limitations and assumptions set forth herein, I believe YFI (or transactions therein) should not be considered to represent investment contract securities under the U.S. federal securities laws.
Key Facts: In reaching this conclusion, I regard the following facts and distinctions as highly material:
YFI was never directly or indirectly sold to raise capital or fund the research or development of Yearn Technologies, but rather was distributed freely to Yearn Technologies users on the assumption that they would be competent to make decisions about future changes through YFI votes and thus a desirable target audience for holding YFI. Although it is now common for “governance tokens” to be partly distributed to users as was done with YFI, YFI is different in that YFI was entirely distributed to users. This makes it difficult to establish a “common enterprise” between YFI holders and other persons who may be exerting efforts that would tend to drive value to YFI—such persons do not necessarily hold YFI and any YFI they do hold may be coincidental (no service-based vesting etc) and do not otherwise share in YFI profits. By contrast, many other DeFi governance tokens are initially purchased by venture capital investors through warrants, SAFTs or similar securities and the resulting capital is used to fund and promote an enterprise intended to make the token profitable, with such funding and such efforts often continuing (or reasonably expected to continue) long after the token is publicly distributed.
The Yearn Technologies were functional and had an active organic user base before YFI were created or announced—though, to be clear, the Yearn Technologies at the time of YFI distribution primarily consisted of the “Earn” product and have undergone substantial improvement and expansion since the YFI token was distributed (adding yVaults, yCover and Zap along with the mechanisms for generating Surplus System Fees).
YFI was not marketed by its creator as an investment but rather was marketed by its creator as having “0 value.” Not only did Mr. Cronje refrain from selling YFI to the public, but, knowing that YFI could be made available for purchase by those who received YFI for free, discouraged people from buying it.
Up until recently (see above regarding the Multsig and use of the Executive Treasury), research, development, deployment and marketing for the Yearn Technologies was exclusively personally funded by Mr. Cronje at significant expense. Not only were YFI not sold to raise capital for the development of Yearn Technologies, but, in fact, no “risk capital” has been raised for the development of Yearn Technologies from any type of investor. Rather, the development of Yearn Technologies is funded out of Surplus System Fees that appear to be generated from organic usage of the Yearn Technologies. In contrast, many other DeFi smart contract systems are intimately tied to venture-backed corporations that have raised millions of dollars in funding at high corporate valuations through traditional (sale of equity) financing transactions and/or token-based financings (sale of tokens or securities convertible into tokens).
There was no “founder premine” of YFI or “team allocation” of YFI. It is believed that Mr. Cronje currently holds at most a de minimis amount of YFI. All YFI was distributed to Yearn Technologies users and thus could not be used to reward Yearn Contributors. In contrast, many other DeFi smart contract systems associated with governance tokens or other blockchain-based projects associated with tokens are intimately tied to venture-backed corporations that hold (or the directors, officers and employees of which hold) a high percentage of the token—some of which may be subject to service-based vesting arrangements that continue after initial distribution to the public.
All 30,000 YFI were fully distributed very quickly—over the course of about a week—solely to users of the Yearn Technologies and associated Yield Systems. Such distribution also appears to have been fairly ‘even’ or ‘flat,’ assuming that separate Ethereum addresses correspond to separate identities. There is no “reserve” or “treasury” of unissued YFI that can be utilized in the future for grants, capital raises or other financing efforts. There is thus no development corporation, foundation or other company holding a large amount of YFI it can sell or issue in the future. There is currently the theoretical possibility of additional YFI being minted (if YFI holders approve such minting and the Multisig Holders implement such approval), but there is no pending proposal to mint more YFI; on the contrary, there is a currently pending widely supported proposal to permanently disable YFI minting.
The Yearn Contributors are not extrinsically affiliated with each other in any known way. Their sole known affiliation with each other is through their shared work on the Yearn Technologies, but they might have very different incentives among them for undertaking such work. Likewise, the YFI holders (including any persons who may be very sizeable YFI holders) are not known to be affiliated with each other in any way beyond the fact that they own YFI and (hopefully, in many cases) are organic users of Yearn Technologies. By contrast, other token-related projects are dominated by teams and investors that are extrinsically affiliated with each other through common equity-holdings in and employment by or investment in a venture-backed company, creating a natural ‘voting bloc’ (which may also be, for practical purposes, a ‘control bloc’) that prevents governance from constituting a general partnership and makes the governance tokens more likely to be securities..
A Yearn Contributor may derive profits from developing Yearn Technologies without any need or related incentive to own YFI. A developer will be incentivized to create new Strategies because, if the Strategies are accepted by vote of the YFI holders for implementation into a Vault, the developer will receive 10% of the resulting Harvesting Fees (see above). Thus, a talented developer can harness the huge pool of capital available in the Yearn vaults for his own personal profit, without caring at all whether this benefits YFI holders as such. By contrast, the typical token economy associated with other DeFi systems is more strongly designed to drive surplus system fees to the governance token—for example, in MakerDAO, surplus system fees are used to ‘buy back and burn’ MKR, whereas extrinsic participants (such as ‘Keepers’) are motivated solely by arbitrage opportunities. While such arbitrage opportunities are also indirectly funded out of surplus fees (up to a point), the role of MKR holders as “lenders of last resort” incentivizes them to manage MakerDAO in a way that minimizes the opportunities of Keepers—thus, unlike Strategy developers and YFI hodlers (who enjoy a positive-sum dynamic), MKR holders and Keepers have an at least partly zero-sum or adversarial dynamic. This was made clear in “Black Thursday,” when Keepers exploited Ethereum network congestion to acquire ETH from MakerDAO at dramatic discounts, which triggered substantial printing and auctioning of MKR to remedy the resulting deficit, thus causing substantial ‘dilution’ and market devaluation of previously existing MKR. Furthermore, in most other systems than Yearn, there is no system-based incentive for independent developers to contribute improvements—they would benefit more by “forking” the system and generating a new token, but with Yearn, the ability to utilize Yearn’s existing pool of capital is likely to be sufficiently attractive to a Strategy developer to overcome the “forking” incentive. In other words, the surplus value of Yearn Technologies is shared on a multipolar basis, and YFI is only one pole.
N. YFI Evaluated Under the Howey Test
Out of the four prongs of the Howey test, I consider YFI (or transactions in YFI) to satisfy prong one (“investment of money”) and prong three (“with a reasonable expectation of profits”). On the other hand, I consider YFI (and transactions in YFI) not to satisfy prong two (“in a common enterprise”) or prong four (“from the entrepreneurial or managerial efforts of others”) of the Howey test. Since all four elements of the Howey test must be satisfied to hold that there is an “investment contract”, I consider YFI (and transactions in YFI) to not represent “investment contracts”.
To determine whether YFI should be considered an “investment contract,” I begin by applying the Howey test in a “black-letter law” manner—that is the purpose of this section. In subsequent sections, I will analyze the issue at a deeper level, including from a policy perspective and in light of the SEC’s guidance on tokens and tests of “sufficient decentralization” that have been proposed by commentators.
Investment of Money.
YFI will likely satisfy the “investment of money” prong of the Howey test. YFI were distributed through a “liquidity mining” scheme in which users of the Yearn Technologies received YFI in proportion to the amount of value they locked up in the Yield Systems and re-hypothecated into the Yearn Technologies.
In theory, if YFI were distributed solely to past, organic users of the Yearn Technologies who had no reason to suspect they would receive YFI as a result of their use, then there might not have been an “investment of money.” Or, if it could be demonstrated that, after YFI was announced, the continuing organic users of the Yearn Technologies assigned no material value to receiving YFI and were not induced to increase their usage of the Yearn Technologies in order to obtain YFI, then such organic users, based on their organic demand, might not have made an “investment of money” to obtain YFI.
However, the facts are likely to be quite different—i.e., it is likely that: (a) many preexisting organic users of the Yearn Technologies increased their use inorganically in response to the YFI liquidity incentive; and (b) many persons who did not previously use Yearn Technologies began committing liquidity primarily in order to obtain YFI. The fact that the value of assets locked in the Yearn Technologies soared from $8 million to $400 million during the week YFI was distributed is strong prima facie evidence to this effect, as is the timing of the increased capital inflows—with most of the new capital pouring in at once during the third day of YFI liquidity mining. The prospect of receiving YFI was likely attractive because, like many governance tokens before it and despite Mr. Cronje’s protestations that it would be valueless, a reasonable person would know that YFI could potentially appreciate rapidly in value on the secondary market. Thus, many users who obtained YFI “for free” nevertheless were making an “investment of money.” Furthermore, many current YFI holders actually purchased YFI on the secondary market, which is clearly an “investment of money.”
Thus, for practical purposes, all YFI holders should be assumed to have made an “investment of money” in order to obtain YFI.
In A Common Enterprise.
In general, “common enterprise” is the most controversial and potentially confusing element of the Howey test. Federal courts recognize two tests (and two variations of one of the tests) for assessing the presence of a “common enterprise,” depending on the applicable Circuit.
“Horizontal” commonality arises from “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits. Where horizontal commonality is present, ‘the fortunes of each investor depend upon the profitability of the enterprise as a whole.’”
In SEC v. Kik, the court found the presence of a common enterprise among KIN holders by virtue of Kik having raised funds from the sale of KIN and using those funds for operations that would drive value to KIN. The court rejected two arguments which had been made by Kik against the existence of horizontal commonality, as follows:
“[T]he fact that [KIN] purchasers could sell their KIN whenever they pleased is not dispositive…[T]he key feature is not that investors must reap their profits at the same time; it is that investors’ profits at any given time are tied to the success of the enterprise.”
Unlike KIN holders, “horizontal commonality” does not exist among YFI holders because no funds were raised from YFI holders; thus, there is no pooling of YFI investors’ funds. Yes, there is a different kind of “pooling of funds” in the Executive Treasury (currently capped at a very modest $500k), which is used to fund payments to Yearn Contributors and other expenses authorized by the Multisig Holders, but this is not the kind of pooling intended to establish horizontal commonality—funds in the Executive Treasury are not the proceeds of an “investment of money” relating to YFI, but simply represent a portion of Excess Withdrawal Fees and Harvest Fees generated from use of yVaults.
“Vertical commonality” does not require pooling of funds, but requires either that “the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties” (strict vertical commonality) or that the investors are dependent on the expertise of a promoter (broad vertical commonality). An example of strict vertical commonality is persons solicited through an ad investing in a “managed account” where an expert promoter would invest funds in the account in an attempt to achieve profits and be paid a management fee based on a percentage of the resulting profits. An example of broad vertical commonality is a multi-level cosmetics marketing scheme in which the participant marketers recruited new participants—thus earning a commission—by bringing them to lavish events organized by the promoter to “foster an illusion of affluence,” where the “prospects will be galvanized into signing a contract by these ostentations”. Because the marketers were dependent for their commissions on the promoter organizing and funding these events, there was “vertical commonality” between the marketers and the promoter.
In considering whether “vertical commonality” applies to YFI, we must first ask an important question—who is the alleged “promoter” with whom YFI holders could share a common enterprise? Well, the following individuals and groups are the most plausible “suspects” for potentially being promoters:
Andre Cronje, the original developer of the Yearn Technologies.
The Multsig Holders, who started out having signature authority over the minting function for YFI and, after the passage of YIP 41, have temporary broader discretion to tap the Executive Treasury funds for funding Yearn Contributors and managing ministerial matters related to the Yearn Technologies.
The Yearn Contributors who are paid out of the Executive Treasury to write and deploy code for additional or improved Yearn Technologies.
None of the foregoing persons appear to me to fall under the role of “promoters” as contemplated by the Howey test to establish vertical commonality with YFI holders. Let us consider them one-by-one:
Mr. Cronje does not receive any payment or otherwise have a direct financial stake in YFI or the Yearn Technologies. At most, one could argue that he could have some diffuse expectation that if the Yearn Technologies succeed wildly, he will receive financial rewards—either in recognition of his past achievements or to induce him to continue working on the project. However, as previously noted, he has apparently declined all compensation, even passing donated YFI along to other Yearn Contributors. Thus, he does not have narrow vertical commonality with YFI holders. Additionally, YFI holders are not reliant on the ongoing expertise of Mr. Cronje, because he has trained additional Yearn Contributors, and such Yearn Contributors are paid for their work out of accrued Executive Treasury funds. Thus, Mr. Cronje is not in broad vertical commonality with YFI holders. Mr. Cronje is also not one of the Multisig Hodlers.
The Multisig Holders in their capacity as such do not receive any sort of ‘profit-sharing’ or commissions as a result of their work and do not act as a ‘promoter’ but primarily authorize the spending of funds out of the Executive Treasury. Their role is essentially that of providing secure transaction-signing for matters involving certain Yearn Technologies smart contracts which require flexibility (and hence occasional manual intervention). YFI could skyrocket in value and the Multisig Holders would not benefit in any material way, except to whatever extent some of them might also coincidentally be YFI holders. Thus, there is no strict vertical commonality between the Multisig Hodlers and YFI holders.
YFI holders are currently dependent on the Multisig Holders in a sense—without their signatures and attention, funds cannot be spent and various ministerial actions cannot occur. However, the YFI holders are really dependent on having some Multisig Holders—not these specific ones. If the current Multisig Holders became inactive, the YFI holders could vote to appoint new ones—and, in fact, this happened once before, when YIP 40 – “Replace inactive multisig signers”—was passed by YFI holders to remove four inactive Multsig Holders and replace them with four new Multisig Holders. Being a Multisig Holder does not require entrepreneurial expertise, but simply requires being a semi-trusted and highly active yearn community member who has a basic grasp of private key management and use of Ethereum wallet software. Thus, although there are some potential arguments that “broad vertical commonality” exists between the Multisig Holders and YFI holders, because the relevant efforts of Multisig Holders are ministerial (non-entrepreneurial), I think such arguments are relatively weak and that the better reasoning is that Multisig Hodlers are not in broad vertical commonality with YFI holders.
The Yearn Contributors are similarly situated to the Multisig Holders, except that: (a) some of them do receive (flat, not profit-based) compensation for their work (out of the Executive Treasury); and (b) they might be less easily replaced than Multisig Holders, due to their significant (and rare) expertise. We here speak strictly of Yearn Contributors who have ongoing compensation commitments from the Executive Treasury (the “Retained Yearn Contributors”), and assume that there is no vertical commonality between YFI holders and other types of Yearn Contributors (many of whom are sporadic volunteers or (in some cases) bounty hunters). The Retained Yearn Contributors in their capacities as such are situated similarly to the Multisig Holders in that, although they are paid out of Surplus System Fees, they do not have a contingent profit interest in the Surplus System Fees, but simply receive fair market compensation for their work, essentially on a cash basis.
As with the Multisig Holders, there is a somewhat stronger argument that Retained Yearn Contributors share broad vertical commonality with YFI holders. Nevertheless, because YFI holders could vote to stop Yearn Contributors’ compensation or shift it to new Yearn Contributors, and the YFI holders have access to funds out of the Executive Treasury for such purpose, I do not regard YFI holders as being so dependent on Yearn Contributors that they are in vertical commonality. Moreover, as will be discussed below, by far the most important determinant for YFI value at the present time is whether effective new Strategies are created, and third-party developers (other than the Retained Yearn Contributors) have an adequate incentive to create new Strategies sua sponte in order to potentially receive 10% of the resulting Harvest Fees.
In summary, out of the persons most likely to be “promoters” of a YFI-related enterprise (Mr. Cronje, the MultiSig Holders and the Retained Yearn Contributors), there are no good arguments to establish “strict vertical commonality” between such persons and YFI holders, and there are reasonable but (in my opinion) weak arguments for establishing “broad vertical commonality” between such persons and YFI holders. Furthermore, even if “broad vertical commonality” exists between YFI holders and one or more of these persons, many courts and practitioners would take the view that “broad vertical commonality” is not the proper method of applying the Howey test’s “common enterprise” element and that strict vertical commonality or horizontal commonality must be demonstrated—I believe those types of commonality are clearly absent.
With the Reasonable Expectation of Profits.
“Profits” under the Howey test refers to “either capital appreciation resulting from the development of the initial investment…or a participation in earnings resulting from the use of investors’ funds.”
YFI acquirers will have a reasonable expectation of profits from YFI. Because staking YFI can enable the owner to collect a portion of Excess Withdrawal Fees and Harvest Fees, the more popular the Yearn Technologies become, the more capital will be committed to them and the more fees will accumulate. Furthermore, because YFI holders can vote on how Surplus System Fees are used and other maters relating to the governance of the Yearn Technologies, YFI may be valuable for acquiring influence over the Yearn Technologies and the pool of capital committed to the Yearn Technologies. For example, a venture capital fund might be very interested in acquiring a large amount of YFI in order to be able to influence governance to support yVaults that supply liquidity to other protocols those venture capital funds are invested in. Thus, an influential YFI holder or “YFI whale” would be in a position to sway use of the Yearn Technologies and Executive Treasury funds toward creating synergies with the fund’s other investments. This would make YFI more valuable not only in the hands of such a fund, but also in the hands of an ordinary investor, since funds might want to acquire additional YFI on the secondary market in order to acquire this influence, and that creates upward demand pressure which should lead to upward market price movement.
Several additional factors also create a reasonable expectation of profits from YFI:
1. A portion of Surplus System Fees are used to fund the Executive Treasury, and the Executive Treasury is used to fund further research and development. The results of such research and development—for example, of additional yVault Strategies—could increase the actual value of YFI, and secondary market speculation on such research and development could also increase the speculative value of YFI.
2. Because third parties have an independent incentive to create new Strategies (they will receive 10% of Harvest Fees), YFI holders could reasonably expect YFI value to increase as such developers respond to this incentive by creating attractive new Strategies that generate more Harvest Fees and thus increase the value of YFI (since YFI stakers will be entitled to a portion of the Harvest Fees).
3. Existing YFI holders or other persons acting opportunistically could buy YFI and heavily market to the masses: (a) YFI’s investment potential (creating a Ponzi-like speculative frenzy that delivers profits to YFI holders through artificially increased price); or (b) the usefulness of the Yearn Technologies, which would increase the use of yVaults and thus increase the amount of Excess Withdrawal Fees and Harvest Fees that can be claimed by YFI holders.
An illustration of how an expectation of profits (whether or not reasonable) can be created in a decentralized fashion can be found from the early history surrounding YFI. A twitter personality known only as “@bluekirbyfi” associated himself with Yearn and YFI while apparently lacking any prior affiliation with the Yearn Contributors, prepared a website about Yearn and YFI (learnyearn.finance) intended for a general audience, and generally promoted Yearn and YFI to the public. Unlike Mr. Cronje’s and the other Yearn Contributors’’ communications about YFI, @bluekirbyfi’s communications were much more price-oriented. For example, @bluekirbyfi’s documents emphasize that “$YFI rallied by more than 4,000% within days of release,” “$YFI is a valuable, highly speculative asset [with] strong liquidity support on major DEX and CEX platforms with millions in trading volume per day” and “when you stake your $YFI to vote in governance, you earn a percentage of fees…” @bluebirkyfi also advertised that “YEARN is extremely profitable” and “YEARN has hundreds of millions in TVL”. @bluekirbyfi also invited readers to consider the fees accumulated by the protocol to date and then “extrapolate” after taking into account he passage of time, “upgrades (better UI, insurance)”, “new products (leveraged stablecoins, more vaults)” and “the growth of DeFi + tokenized BTC” and “just try to put a number on the amount of rewards you’ll earn with just 1/30,0000th”. @bluekirbyfi also promoted a meme that YFI would reach a price of $100,000 and then YFI holders would meet for “drinkies” in Tokyo.
These types of statements are highly concerning in the context of a securities law analysis. They are similar to statements cited by the SEC in pursuing other tokens as representing investment securities. Our own provisional view in this specific instance is that these statements, by themselves, should not be sufficient to generate a reasonable expectation of profits in a Howey sense because: (a) in the critical early periods when YFI were being distributed and YFI had a large price run-up, such statements did not exist and Mr. Cronje made opposite statements (emphasizing zero value and YFI’s intended governance use); and (b) @bluekirbyfi is not a Yearn Technologies developer and presents no reasonable appearance of being able to contribute to or finance the technical development of Yearn Technologies, thus his statements should be reasonably construed as puffery, not as covenants or promises or even as deeply informed and realistic predictions.
However, the situation is still more complex because, on September 5, 2020, the Multsig Holders, pursuant to their authority under YIP41, following discussion and a kind of soft polling of presumed YFI holders in the yearn governance forums, approved @bluekirbyfi to receive $7k/month for “communications ops”. While @bluekirbyfi’s communications ops role has since been terminated (providing at least colorable evidence that his price-oriented marketing was not the type of activity intended to be rewarded out of Executive Treasury) and many of his statements about YFI have disappeared due to deletion of his twitter account, I note his history of partly-community-subsidized YFI price promotion as both a potentially material weakness in the view that YFI is not a security, and, more importantly, a cautionary tale suggesting that it is possible for YFI to turn from a non-security into a security if YFI holders or others begin aggressively promoting it as an investment—particularly if such persons are compensated in connection with such work out of the Executive Treasury.
Predominantly from the Managerial or Entrepreneurial Efforts of Others.
Next, we consider whether any profits reasonably expected for YFI would derive predominantly from the managerial or entrepreneurial efforts of others.
In analyzing the “efforts of others,” we must bear in mind what “efforts” are considered relevant under the Howey test. The “efforts of others” need not be the sole efforts contributing to the investors’ profits. Indeed, the investors themselves may contribute material profit-making efforts, but may still be owed the protections of the securities laws if “under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities [with] the promoter’s contribution in a meaningful way” or the efforts of the promoter or active participant were “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,’ as opposed to efforts that are more ministerial in nature”. Thus, federal courts have often found that an investment contract is present even in situations where the investors must contribute fairly extensive efforts to realize their profits—for example, in a multi-level marketing scheme, recruiters’ efforts to recruit new participants and receive a commission may be extensive, but such recruiters may still be relying predominantly on the entrepreneurial or managerial efforts of a promoter if receiving the commission depends on the promoter’s ability to, so to speak, ‘seal the deal’ that has been teed up for the promoter through the recruiter’s efforts. Similarly, in the token context, the fact that there might be a ‘timing the market’ factor or “market forces” factor to selling the token at a good price to achieve profits does not exclude the possibility that the token holder is relying predominantly on the managerial or entrepreneurial efforts of others.
An additional nuance to “the efforts of others” arises from a federal court Circuit split regarding the interpretation of Howey as applied to sales of viatical settlement contracts—i.e., fractional interests in non-variable life insurance contracts. The gravamen of the circuit split is whether the “efforts of others” prong of Howey can be satisfied where the promoter exerted significant entrepreneurial efforts only prior to the sales of the viaticals, with all post-sale efforts of the promoter being merely ministerial. In SEC v. Life Partners, Inc., the D.C. Circuit concluded that that “efforts of others” were not present in this circumstance. By contrast, in SEC v Mutual Benefits Corp., decided after Life Partners, the 11th Circuit concluded that the “efforts of others” were present in this circumstance.
With those points noted, now we must again ask: “Which others?” To answer that, we refer back to our list of persons (+1 extra, this time) who could conceivably be alleged to be “promoters” or other “active participants” for YFI or the Yearn Technologies:
Andre Cronje, the original developer of the Yearn Technologies.
The Multsig Holders, who started out having signature authority over the minting function for YFI and, after the passage of YIP 41, have temporary broader discretion to tap the Executive Treasury funds for funding Yearn Contributors and managing ministerial matters related to the Yearn Technologies.
The Retained Yearn Contributors (who write and deploy code for additional or improved Yearn Technologies, etc.).
Other YFI holders—e.g., “YFI whales,” if any, who are very active in governance and, in effect, dominate it with the intention to drive value to YFI.
All of these persons exerted or exert or will exert efforts that would reasonably be expected to create, enhance or increase YFI profits. However, that in itself does not satisfy the Howey test. We must ask whether these efforts are “the undeniably significant ones.”
Additionally, we must think about how the foregoing persons’ efforts could connect with what we have identified as the main value drivers for YFI. Only if “the efforts of others” connects with a significant reason for “expected profits” can the Howey test be satisfied. These value drivers are: (1) increased adoption (due to marketing or any other factor) of the Yearn Technologies, regarding in more total value locked and greater fees paid to YFI holders; (2) increased usefulness of YFI for influencing the Yearn Technologies and how the Executive Treasury is spent; (3) innovations in the Yearn Technologies or Strategies that increase yields from assets locked in the Yearn Technologies and thus result in more fees paid to YFI holders (as well as more adoption, which itself is also a value driver—see “(1)”); and (4) increased positive market speculation on the price of YFI.
1. Mr. Cronje.
At the present time, it would appear unreasonable to expect continuing significant entrepreneurial or managerial efforts from Mr. Cronje that would predominantly contribute to YFI profits and form the basis of a YFI investment thesis. Mr. Cronje is not believed to hold a material amount of YFI or to have any arrangement with any person that would provide him with a share of rising profits of YFI; thus, he lacks a material relevant financial inducement to exert such efforts. Unlike some other Yearn Contributors, Mr. Cronje is not employed or contracted to provide any development services relating to the Yearn Technologies. Furthermore, Mr. Cronje has indicated that “yearn…doesn’t need [him]” and that “the YFI team has to take it over…they have ~20+ full time employed and very well paid people”. From time to time Mr. Cronje has also indicated chagrin with the public pressure he’s faced and the resulting media reports have painted him as potentially ceasing to work on DeFi in general or Yearn Technologies in particular.
Thus, the only potentially reasonable argument that Mr. Cronje’s efforts are “the undeniably significant ones” would need to be based on his prior efforts. It is true that Mr. Cronje was instrumental in developing the Yearn Technologies in their current form. Thus, if one accepts the 11th Circuit’s view that “pre-purchase entrepreneurial efforts” can count under Howey, then one could potentially argue that Mr. Cronje’s efforts remain relevant. The argument would be that Mr. Cronje’s expertise and skill are so highly regarded that when people invest in YFI, they do so solely or primarily as a bet that Mr. Cronje designed the Yearn Technologies and YFI so well that YFI is essentially intrinsically profitable by design. However, even if we assume the 11th Circuit’s view of the Howey test is right (which is debatable), and further assume that some people do invest on this basis (which is also debatable) and further further assume that expecting any token to increase in value purely because some already-deployed code is extremely well designed is reasonable (which is also also debatable), Mr. Cronje’s efforts should still not be deemed to be the “undeniably significant” ones because: (1) DeFi is extremely fast-moving, and thus even a system that was designed two months, one month, or even a week ago by the greatest genius on earth to be extremely profitable cannot reasonably be expected to continue to be profitable for any significant amount of time—which in fact is borne out by the history, which showed yields through Yearn Technologies to be sky-high for a short time and to have now declined very rapidly; and (2) the Yearn Technologies are evolving rapidly and continuously through the work of other Yearn Contributors, meaning that even Mr. Cronje’s past efforts will account for a diminishing portion of the code and are not a reasonable basis for expecting profits. Thus, we do not view Mr. Cronje’s efforts as “the efforts of others” for Howey.
2. The Multisig Holders. The current Multisig Holders are essentially enthusiastic early “community members” interested in the Yearn Technologies. Based on an examination of their public Ethereum addresses by a Yearn Contributor interviewed by the author, the Multisig Holders collectively hold less than 100 YFI (i.e., less than 0.3333% of all YFI), and only some, not all of them, hold YFI. Their primary function is to implement the will of YFI holders (who can vote to remove any of them at any time). Any discretionary authority granted to the Multisig Holders by YFI holders (such as through YIP 41: ‘temporarily empower multisig’) is limited in scope, is temporary, is revocable and appears quite ministerial in nature. Other than “banteg,” who is the most highly paid full-time Yearn Contributor, all Multisig Holders appear affiliated with other projects and occupations and are not paid a “salary” to work on Yearn; thus, it is unreasonable to expect that they will devote a major proportion of their time or effort to the Yearn Technologies beyond signing transactions that comply with YFI holder directives regarding spending of funds out of the Executive Treasury. Several Multsig Holders have received modest one-time “grants” individually equal to $3,000 or less out of the Executive Treasury, which are likely financially immaterial. In short, the efforts of the Multisig Holders are likely “merely ministerial,” and they are unlikely candidates for being considered “promoters” or “active participants” from whom YFI holders could reasonably expect “undeniably significant entrepreneurial efforts” to render YFI profitable.
3. Yearn Contributors Who Are Paid From the Executive Treasury. The Yearn Contributors who are paid from the Executive Treasury to continue marketing, researching, developing, maintaining and implementing the Yearn Technologies could (arguably) reasonably be expected to increase YFI profits, but I do not view their efforts as the kind of “entrepreneurial efforts” contemplated by Howey. Their “salaries” approved for spending out of the Executive Treasury are modest and in line with (or possibly under the line of) market compensation for developers of comparable experience. While they do exert significant efforts, it is unclear that these efforts are “entrepreneurial or managerial”—for example, they do not appear to collectively or individually undertake typical executive efforts such as fundraising, negotiating strategic partnerships, recruiting key talent or product marketing (beyond social media and forum posts explaining technological updates)—they write software. They do not have “grants of YFI” or “YFI options” or other YFI-related compensation rewards, whereas most entrepreneurs have these types of grants (whether in stock or tokens), tied to service-based vesting or performance milestones. However, some of them received an outright gift of YFI from Mr. Cronje and could still hold some or all of such YFI, thus maintaining a continuing incentive to increase the value of YFI. There is no evidence, however, that YFI ownership was a factor in them being selected for development work by the YFI holders—rather, it is their technical skill, and not any shared incentive to make YFI increase in price, that appears to have been valued. The Executive Treasury has only modest funds--$500k at any given time—to pay Yearn Contributors, which is far below the amounts typically raised by companies worthy of high stock valuations. The paid Yearn Contributors are at the mercy of YFI holders and lack the governance powers that would be held by the founding team of a typical venture-capital-backed startup, this making them more similar to “at-will employees” than “entrepreneurs” or “managers.” Thus, while not free from doubt, the many differences between the Yearn Contributors and type of entrepreneurial team that would be employed and highly incentivized by a well-funded, traditionally organized start-up cast heavy doubt on whether any reliance on their continuing efforts as a basis for profits in YFI would be reasonable or of the nature intended to be covered by the securities laws.
4. YFI Whales / Activist YFI Investors. Currently I am unaware of any YFI “whales” / large holders who have taken a “managerial or entrepreneurial role” so significant that it would generate a reasonable expectation of profits on the part of other, smaller YFI holders. In theory, however, this could be a phenomenon that emerges in the future. For example, a Joe-Lubin-like YFI holder with enormous YFI holdings could emerge and form an enterprise primarily devoted to enhancing the value of YFI—in such a case, particularly if there were not also unaffiliated persons exerting efforts of a similar level of significance, an “expectation of efforts” from this “Active Participant” of the kind contemplated by Howey could arise.
Howey Test Conclusion
In summary, under a relatively plain / black letter reading of the Howey test, there are strong (although not absolutely certain) arguments that YFI do not constitute investment contract securities. Yes, YFI holders have “invested money” in YFI and have a “reasonable expectation of profits” from YFI, but there is no issuer, promoter or other active participant managing a common enterprise with the YFI holders and supplying “essential managerial or entrepreneurial efforts” tied to YFI value. Rather, the contributions to YFI’s value come from a community of participants who have diverse relevant incentives and motivations for participating and are not intrinsically or extrinsically affiliated either with each other or with YFI holders beyond their shared interest in the Yearn Technologies.
O. YFI Considered under Official and Unofficial Howey Exceptions and Policy Considerations
A straight / plain application of the Howey test does not always correctly determine whether an investment contract exists. The securities laws are sensitive to policy issues and policy-based distinctions. After all, even Bitcoin itself—the cryptocurrency most widely agreed not to constitute a security—could be argued to be a security under a simple-minded reading of the Howey test, or could be argued to sometimes be a security and sometimes not on a perhaps overly professorial reading of the Howey test. It is important to keep in mind, though, that, even in the policy context, the overarching purposes of the securities laws—investor protection and market protection—will tend to put a strong thumb on the scale toward a man-made investment vehicle such as a token being a security.
Do Acquisitions of YFI Fall Under the ‘Consumptive Use’ Exception under Forman?
Under the Forman consumptive use exception “when a purchaser is motivated by a desire to use or consume the item purchased – ‘to occupy the land or to develop it themselves,’—the securities laws do not apply.” The following are cases or SEC no-action letters in which the consumptive use exception has been applied:
the sale of stock in a condominium association, where the purchase of stock was a precondition of purchasing the condo, purchasers had to be prospective residents of the condo, the stock was not transferable without the condo, there was a fixed ratio of shares to each condo, the shares did not confer separate voting rights, and, in the limited circumstances in which the shares could be sold, their sale price was effectively capped at the original vale of the condo;
the sale of an entire business, like a restaurant or liquor store, where the purchasers intended to run the business after the acquisition;
the purchase of a share of “stock” or “redeemable membership certificate” which constituted annual membership dues affording the purchaser access to and use of country club facilities or a hunting preserve, where the membership interest would not appreciate, could not be resold and did not pay interest;
the sale of tokens (Quarters) on Ethereum redeemable for the right to participate in e-sports tournaments, where: (a) no funds from Quarters sales would be used to build the technology and such technology would be fully functional and the Quarters immediately usable for gaming at the time when Quarters were sold: (b) transfers of the Quarters would be restricted to whitelisted developer addresses for the purposes of playing games; (c) Quarters would be made continuously available to gamers in unlimited quantities at a fixed price; (d) the purchase price of Quarters would be correlated to the market price of playing the games; and (e) the Quarters would be marketed and sold to gamers solely for consumptive use;
the sale of tokens on a private, permissioned, centralized blockchain network and smart contract infrastructure, where such tokens were redeemable in order to obtain chartered jet use and (a): no funds from token sales would be used to develop the relevant technologies, each of which would be fully developed and operational at the time any tokens were sold; (b) the tokens would be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold; (c) transfers of tokens would be restricted to the permissioned, closed blockchain run by the organization; (d) tokens would be sold for $1 per token perpetually and represent an obligation of the organization to supply air charter services valued for $1 per token; (e) any repurchases of the tokens would be for less than $1; and (f) the token would be marketed in a manner emphasizing the functionality of the token and not the potential for increase in market value of the token
Nearly all of these cases share features in common. Most notably, the assets in these cases were not merely potentially usable for a consumer purpose, but in fact were sold in transactions that could only be reasonably interpreted to primarily have a consumer intent, and included structural limitations such as transfer restrictions and artificially capped upside that precluded material investment upside.
We have already discussed the uses of YFI for governance. Although it is likely some people acquired YFI exclusively because they “enjoy governing” or are users of the Yearn Technologies who wish to vote YFI to keep it the way they like it, given the enormous run-up of price on YFI in the secondary market, it is almost a certainty that many YFI acquirers are acquiring YFI for an investment purpose—ordinary ‘consumers’ simply do not spend multiple tens of thousands of dollars for the right to vote on something, especially if they do not have a swing vote! Thus, I do not view the Forman consumption exception as being applicable to YFI; however, the lack of applicability of the Forman exception does not entail that YFI is a security.
Would Failure to Cover YFI Under the Securities Laws Create a Systematic Loophole in the Securities Laws?
One interesting way of reasoning about the securities laws, which we believe is implicit in how many judges reason about them, is through the technique of reductio ad absurdum: if, from the standpoint of the Congressional purposes embodied in the securities laws, the consequences of a failure to apply the securities laws to given set of circumstances would be absurd, then the securities laws should apply to that set of circumstances. Such an absurdity would arise, for example, if the way in which a token was issued or sold accomplished roughly the same purposes for the issuer as doing a registered securities offering but without providing investors and markets the protections of the securities laws: in effect, the issuer would be getting all of the benefits of a securities offering with none of the legal costs. The term “ICO” vividly demonstrates this by analogy to the term “IPO”—if an ICO serves roughly the same purpose (raising capital for the venture and/or providing liquidity for founders/early investors by fostering a secondary market), then if ICOs are not subject to the securities laws, companies will just stop doing IPOs, because IPOs are subject to far greater regulation and scrutiny and provide investors with many more rights and remedies.
This appears to us to be an implicit theme underlying the cases the SEC has pursued most vigorously and adversarially: Kik and Telegram. Both were venture-capital backed companies with existing product lines, which, in theory, would be likely candidates in the future for IPOing to generate a liquidity event for their investors and founders. By creating a “utility token” which can be integrated with their existing products and become, such companies would be generating a secondary-market proxy or index for the value of their products (the more demand for their products would rise, the more demand for the token would rise). If such a “scheme” were not subject to the securities laws, then many companies would undoubtedly opt for this method of tapping ‘retail capital’ instead of the legally onerous and expensive method of a registered securities offering. Far fewer investments would be subject to the protections of the securities laws and to SEC supervision, and the purposes of the securities laws would be dramatically undermined. From the standpoint of the Congressional goals of the securities laws, this is an absurd result, and thus suggests that the opposite conclusion should be reached—i.e., such token schemes are under the purview of the securities laws and when such public offerings of tokens are made, SEC registration of the offering is required.
The situation with Yearn and YFI is very different from this type of Telegram / Kik pattern, for several reasons. At a fundamental level, it is hard to view issuing YFI as an alternative to a registered securities offering. First, the issuance of YFI was not a method of raising capital for a venture—it was not sold for fiat or other crypto, and did not create funding that could be used to build a product or a business—thus, the issuance of YFI did not achieve the capital-raising purposes of a registered securities offering (sometimes referred to as “raising risk capital”). Secondly, because there was no pre-allocation of YFI to Mr. Cronje or other developers, and there were no venture investors who acquired YFI by contributing capital, the issuance of YFI did not achieve the private-to-public liquidity-creating purposes of a registered securities offering. The success of Yearn / YFI, such as it is, arose from a surprising confluence of factors that are atypical of both the causes and effects of a registered securities offering, and the history of Yearn / YFI does not provide a clear, reliable roadmap for other companies or projects to follow in order to gain the benefits of a registered securities offering without the burdens of one. Thus, a judge or regulator declining to cover Yearn and YFI under the securities laws would not frustrate the purposes of the securities laws.
Is the Yearn Community, or are the Yearn Software systems, or are the relevant value creation mechanisms “Sufficiently Decentralized” such that the Securities Laws should not apply to YFI?
No one knows what “sufficiently decentralized” means, but it’s provocative—gets the people going. Let’s review some approaches that have been articulated to date.
Under the Hinman approach (which we believe is also followed to a great extent by the SEC staff), “a digital asset transaction may [not] represent a security offering [i]f the network on which the token…is to function is sufficiently decentralized – where purchasers would [not] reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts…[OR] when the efforts of the third party are no longer a key factor for determining the enterprise’s success [and thus] material information asymmetries [have] reced[ed]…[and thus] the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult and less meaningful.”
The yearn ecosystem presents a close to ideal example of a situation in which investors may continue to have a reasonable expectation of profits from the efforts of others, but where “the others” are so informally associated and have such a diversity of motives, affiliations and incentives that it would be quixotic “to identify [one or more of them] as an issuer or promoter to make the requisite disclosures”. For the most part, the securities laws are designed to apply to, and impose disclosure obligations on, business entities—a corporation can register securities with the SEC, provide disclosures, and have its securities trade. The absence of a business entity associated with a token certainly does not guarantee that the token is not a security—otherwise it would be too easy to evade the securities laws merely by running a traditional business as an unincorporated association. However, when there is just nothing at all like a business entity or coherent organization involved, it is very hard to argue that the securities laws are meant to apply. After all, even the SEC staff would almost certainly regard a Form S-1 filed by “@bantg, @devops199fan and @bluekirbyfi et. al.” or “the unincorporated voluntary and temporary association of the holders of a private key to this smart contract, the few people paid out of that smart contract and some fanbois who hang out in Telegram” as exceedingly difficult to deal with. The SEC probably would not want to approve a registration statement covering this type of unincorporated association. With yearn, there just really isn’t an “issuer” or a “promoter” or “active participant” with sufficient unity and structure for the SEC or a judge to logically impose the burdens of SEC reporting upon.
Furthermore, YFI satisfy many of what I call the “green flags” from the SEC’s Investment Contract Framework:
YFI holders are able to use the token for its intended function (governance).
Mr. Cronje did not distribute YFI until the Yearn Technologies were operational and did not use funds from selling YFI to develop the Yearn Technologies (indeed, YFI were not sold so there were no such funds—and protocol fees were not turned on yet at the time of distribution, so the increased usage due to YFI’s introduction did not create such funds either).
The Multisig Holders, Yearn Contributors and others contributing most to the value of YFI do not, as far as I can tell, have access to material, non-public information about YFI or its value, because not only the Yearn Technologies, but, crucially, the development efforts around them, are public. If, in the early stages of ideation on software development improvements by Yearn Contributors, the information that such software change is a possibility may temporarily be “non-public”—that information is also not inherently material, because until the proposed changes have been approved by YFI holders, they are unlikely to impact the value of YFI, and might never be implemented at all. On the other hand, one potentially serious form of “material non-public information” would be the discovery of a critical security flaw. This information could be abused by insiders—e.g., to short YFI or withdraw value form yVaults ahead of the rest of the market. On the other hand, because of the public nature of blockchain environments, this same information about a vulnerability could be discovered by anyone with the requisite technical talent—there is no inherent advantage to being a paid Yearn Contributor. Furthermore, “insider trading” theories are usually predicated on the theory of ownership of confidential information by the employing company—here, there is no such company, and no one to ‘own’ the confidential information that could be ‘insider traded on’. Thus, we view information asymmetries of the kind contemplated by the securities laws to be absent and count this as a “green flag.”
Mr Cronje started out as being critical to the value of YFI and now he is not critical because development efforts have become decentralized.
YFI was marketed by Mr. Cronje in a manner that emphasized its functionality—governance—and not the potential for the increase in market value—indeed, it was described by him as having “0 value” and he admonished people not to buy it and disclaimed any intention to have it be listed on an exchange.
YFI are seemingly dispersed across a diverse user base, instead of being concentrated in the hands of a few that can exert influence over the application.
Peirce’s Network Maturity Test.
Under Commissioner Peirce’s safe harbor test, the Yearn Technologies should be considered to have achieved “Network Maturity” and thus YFI should not be considered to eb a security because both of her independent criteria are satisfied (note: it is only necessary under her test to satisfy either of the two criteria):
(i) the Yearn Technologies are not controlled and are not reasonably likely to be controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control; and
(ii) the Yearn Technologies are functional, as demonstrated by the ability of holders to use tokens for the transmission and storage of value, to prove control over the tokens, to participate in an application running on the network, or in a manner consistent with the utility of the network.
I assume the fact that YFI satisfy this test is self-evident from prior parts of the memo; thus, I will not elaborate on this particular test.
With yearn, we arguably have already had “the Bahamas test” applied and passed in real life. Mr. Cronje’s level of involvement has significantly decreased, and there are media reports (albeit exaggerated) that Mr. Cronje has stopped working on yearn. Although YFI lost some value during this period, it was also moving with the market to an extent, and, if Mr. Cronje really were crucial, then widespread rumors that he had abandoned the project would presumably have affected YFI value even more powerfully. Meanwhile, the Yearn Contributors have continued making swift progress on development and YFI holders continue making and remaining informed about and voting on proposals.
Shapiro Decentralization Tests
YFI passes my strict version of the sufficient decentralization test because, as far as I can tell (albeit based on public information and with limited investigatory resources):
Far less than 10% of YFI are directly or indirectly owned beneficially by the initial development team (Mr. Cronje, or we can even count the current Yearn Contributors and the Multsig Holders if you want) or any other affiliated persons--even on Etherscan, the largest externally owned account holds less than 1% (albeit it is always possible that a given owner could split his YFI among many addresses).
For the same reason, less than 10% of the means of determining consensus are held by the Initial Development Team or any affiliated persons—because YFI themselves are the means of determining consensus;.
There is substantial funding independent of the Initial Development Team and any affiliated persons which is available for research, development and maintenance of the Yearn Technologies (i.e., the Executive Treasury--$500k), and such research, development and maintenance is not directly or directly controlled by the Initial development Team or any affiliated persons (Mr. Cronje does not direct development—ultimately, development is a collaboration between YFI hodlers and Yearn Contributors (some of whom are paid out of the Executive Treasury, some of whom are volunteers, others of whom will likely be paid by Strategies, etc.)).
In this case, I will assume the flexible version of the Shapiro test is met, based on various factors mentioned throughout this memo that should have self-evident relevance to applying the flexible version.
YFI Considered In Light of SEC v. Telegram and SEC v. Kik
YFI is distinguishable from GRAMs and KIN, which were held to be part of an illegal securities scheme (Telegram) or held to be securities illegally sold to the public (Kik).
Telegram sold GRAM-convertible instruments (token purchase agreements) to venture capital investors to finance the development and launch of the Telegram blockchain technologies. Telegram planned to distribute the GRAMs to the public through the investors so that GRAMs would become more widely distributed. The Telegram opinion held this to be a prohibited securities underwriting arrangement and enjoined the distribution of GRAMs to investors on the grounds that distribution of the tokens constituted an essential element of the overall scheme to violate the securities laws. Thus, the “investment contract” at issue was held to be the overall scheme in which the GRAMs played an integral part.
Unlike in Telegram, there are no venture capital investors in Yearn and, unlike Grams, YFI were not sold pursuant to convertible instruments like a SAFT. In fact, YFI were not “sold” in the traditional sense at all and no capital was raised from their distribution. Thus, Yearn / YFI do not fall under the holding of Telegram.
In Kik, the tokens themselves—KIN—were held to be securities because they were sold to the public in a capital-raising transaction that met the elements of Howey. The court cited a number of factors in support of its conclusion that KIN were securities, including marketing by Kik’s CEO in pre-distribution ‘road shows’ insinuating that KIN had significant investment value, the lack of initial usefulness of KIN and the large allocation (30%) of KIN reserved for Kik’s treasury. As discussed above in our Howey analysis, all of these factors are absent regarding the public distribution of YFI to users of the Yearn Technologies, and thus Yearn / YFI do not fall under the holding of Kin.
P. Future Regulatory Outlook
Yearn is a fascinating experiment and phenomenon, novel even by ‘blockchain industry’ standards. Due to the open and spontaneous nature of its community organization, how the project—and YFI holders’ role within it—will evolve is very difficult to predict. Some development paths could result in changes that would make it more appropriate than currently to regulate YFI as a security.
An entirely separate memo could be written on YFI governance models. Here, I have barely scratched the surface of some interesting questions and issues (for example, whether YFI confer legal rights or merely have a fuzzier significance arising from the non-legally-enforceable norms of the Yearn community). However, I will briefly sketch, at a high level, how Yearn/YFI governance should work for YFI to be regarded as non-securities into the future and for Yearn in general to be less likely to become subject to traditional financial regulations:
YFI holders, through voting, should establish the short-term and long-term strategic priorities for Yearn. If anyone involved in the Yearn community is exercising something like “business judgment” or “entrepreneurial efforts”, it should be the YFI holders in their capacities as such. To provide a metaphor: If Yearn were to be like some kind of corporation, then it should be like a closely held corporation with YFI holders as both the board of directors and shareholders of that corporation—accountable to themselves for managing “the enterprise of Yearn”. Passive YFI holding should be discouraged and active YFI holder participation should be encouraged.
The manner in which YFI holders express themselves could differ from time to time, but one reasonable and efficient model—which has been prototyped, so to speak, by the temporary grant of authority to the Multisig—is constrained delegation. In carefully worded proposals, YFI holders should delegate time-limited, narrowly scoped and revocable authority to other persons—the Multisig Holders and/or various Yearn Contributors—to execute on well-defined strategic priorities. It is important that these delegations not be too broad, vague or long lasting—if they are, then the delegates will become fiduciaries and will be undertaking efforts that place YFI at risk of being securities. Instead, the efforts of the delegates should be largely ministerial. Yes, their efforts might increase the value of YFI—but that is not because they are preoccupied with YFI value, but because they are executing the YFI-value-enhancing plans established by YFI holders.
The Multisig Holders and Yearn Contributors should make day-to-day operational decisions in order to implement the strategic priorities established by YFI holders.
In general, the Yearn community should continue with its relative avoidance of formalism and traditional organization—avoiding creating quasi-permanent ‘officer roles’ and bureaucratic committees and procedures. The Yearn community’s self-governance should be relatively fluid and non-hierarchical. The more the Yearn community is structured into traditional organizational forms, the more likely it is that a group or persons could end up being the right kind of collective to be considered an SEC-reporting ‘Active Participant’; conversely, the more non-traditional, spontaneous and mutable the Yearn community is, the less its activities will fit into the mold intended to be covered by traditional financial regulations.
Well, such are one man’s thoughts on future Yearn governance. I look forward to see what the future might hold, and suspect it will likely offer some surprises for all of us!
EXHIBIT A - DEFINED TERMS
“Ethereum” means the Ethereum mainnet and the consensus blockchain for such mainnet (networkID:1, chainID:1) as recognized by the official Go Ethereum Client on the date hereof.
“Executive Treasury” aka “Treasury (Executive)” aka “ychad.eth” means the bytecode deployed to address 0xFEB4acf3df3cDEA7399794D0869ef76A6EfAff52 on Ethereum. Also known as ‘the multisig’ or ‘the multisig treasury’. The Executive Reserve is used to pay for various operational expenses, including developer compensation and community grants—spending must be authorized by the Multisig Holders, pursuant to more general authorization from YFI votes.
“Governance Contract” aka “Governance Treasury” means the bytecode deployed to address 0xBa37B002AbaFDd8E89a1995dA52740bbC013D992 on Ethereum. The Governance Contract is where YFI holders may stake their YFI to vote and receive a portion of Surplus System Fees out of the Vault Treasury.
“Multisig Holders” means the persons lawfully holding the private keys enabling spending of funds from the Executive Treasury.
“Treasury Reserve Target” is the minimum $ amount of value targeted to be held in the Executive Treasury—currently $500k. When the Treasury Reserve Target is met or exceeded by the funds in the Executive Treasury, Surplus System Fees begin streaming to the Vault Treasury.
“Vault Treasury” aka“Treasury (Vault)” means the bytecode deployed to address 0x93A62dA5a14C80f265DAbC077fCEE437B1a0Efde on Ethereum. Surplus System Fees are sent to the Vault Treasury after the Executive Treasury has accrued the Treasury Reserve Target. The Vault Treasury temporarily holds the Surplus System Fees before allocation to the Governance Treasury.
“YFI” means the tokens with name “yearn.finance” and the symbol “YFI”, the supply and balances of which are tracked by the bytecode deployed to address 0x0bc529c00c6401aef6d220be8c6ea1667f6ad93e on Ethereum.
ENDNOTES / SOURCES:
 The ‘lending’/’borrowing’ dichotomy may be a misleading term for what is done with protocols like Compound, as the activity does not involve contractual promises of repayment. The yearn documentation nevertheless uses it occasionally, for lack of better intuitive terminology. See Jake Chervinsky, “DeFi Protocols Don’t Do ‘Lending’”.
See https://gov.yearn.finance/t/governance-overhaul-and-future-rewards/5131 For example, “YFI holders govern the Yearn ecosystem and are eligible to receive a portion of protocol profits. Therefore, YFI represents a right to govern the platform and a claim on earnings….”(https://docs.yearn.finance/developers/deployed-contracts-registry).
Note: the Yearn Technologies are broadly and freely licensed under the GNU Affero General Public License v3.0. Thus, it is possible for anyone to deploy an alternative instance of the Yearn Technologies, and Mr. Cronje has even encouraged people to do so (“How to deploy your own yearn.finance”). In discussing a fork of the Yearn Technologies that could possibly be controversial or infringe the rights of YFI token holders, we speak not just of any fork, but one designed to deprive YFI hodlers of the powers and benefits they receive in connection with the current deployment.
U.S. Securities and Exchange Commission v. Kik Interactive Inc., No. 1:2019cv05244 - Document 88 (S.D.N.Y. 2020).at p. 10 (“an ongoing contractual obligation is not a necessary requirement…”)
Note: this is a simplification. From a user-facing perspective, all that is ever withdrawn from the vault is some number of the tokens of the kind that vault is designed for. For a user to receive profits from the vault means that, when the user withdraws from the vault, the user has more of that token than the user originally deposited. This can occur because the Strategy seeks to buy or earn that same token through various DeFi protocols. However, on a fiat-denominated basis, ‘profits’ would be different and depend not only on performance of the Strategy, but also the general market performance of the relevant token.
Tcherepnin v. Knight, 389 U.S. 332, 336 (1967): “[W]e are guided by the familiar canon of statutory construction that remedial legislation should be construed broadly to effectuate its purposes. The Securities Exchange Act quite clearly falls into the category of remedial legislation. [Footnote 10] One of its central purposes is to protect investors through the requirement of full disclosure by issuers of securities, and the definition of security in § 3(a)(10) necessarily determines the classes of investments and investors which will receive the Act's protections.”
United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975). See also SEC Paragon Coin Order (https://www.sec.gov/litigation/admin/2018/33-10574.pdf): “In analyzing whether something is a security, ‘form should be disregarded for substance,’ Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), ‘and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.’ Forman, 421 U.S. at 849.
Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).
SEC v. Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005)
Securities & Exchange Commission v. Edwards, 540 U.S. 389, 124 S. Ct. 892, 157 L.Ed.2d 813 (2004),
 See Wuliger v. Christie, 310 F. Supp. 2d 897, 904 (N.D. Ohio 2004) (declining to follow Life Partners and observing that the decision has “not altogether been embraced by other circuits”) and SEC v. Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005) (rejecting the pre- and post-purchase approach used by the D.C. Circuit in Life Partners).
United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975).
SEC v. Telegram Grp., 2020 WL 1430035 (S.D.N.Y. March 24, 2020)
 But cf. Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019) (holding that “the ATB Coin qualifies as an ‘investment contract’ under the Howey test”).
Note: the court did not consider whether “vertical commonality” was present since the Second Circuit uses the “horizontal commonality” variant of the “common enterprise” test)
 Gabriel Shapiro, “Defining Decentralization for Law” and “An open letter to SEC Commissioner Peirce on token safe harbors”
 M. Todd Henderson & Max Raskin, A Regulatory Classification of Digital Assets: Toward an Operational Howey Test for Cryptocurrencies, ICOs, and Other Digital Assets, 2 Colum. Bus. L. Rev. 443, 461 (2019).
Note: the description of the Shapiro test has been slightly modified for purposes of this memo, since it was originally formulated as a “safe harbor” involving various procedural formalities; for purposes of this memo, it is the underlying concept of decentralization and not such formalities which matter.
See “SEC v. Kik” above.
See “SEC v. Telegram” above.
 For an overview of the ‘token certificate’ model for representing securities, see Gabriel Shapiro, “Tokenizing Corporate Capital Stock”.
 “YFI [is] a completely valueless 0 supply token. We reiterate, it has 0 financial value. There is no pre-mine, there is no sale, no you cannot buy it, no, it won’t be on uniswap, no, there won’t be an auction. We don’t have any of it…And just because we feel we didn’t stress it enough, 0 value. Don’t buy it. Earn it.” – Andre Cronje, “YFI”
See Robert Stevens, “Exclusive: YFI’s Andre Cronje is tired, broke and close to quitting DeFi”, Decrypt
 Mr. Cronje is believed to have received donations from a large YFI holder equal to approximately 100 YFI during September 2020, but to have quickly distributed such YFI to various members of the Yearn community, with no vesting or other conditions. Mr Cronje also has no right to receive YFI as compensation in the future. The same is true of all other Yearn Contributors—they did not receive pre-allocated YFI and do not have a right to receive YFI tokens in the future based on their efforts.
 Of course, certain Yearn Contributors could coincidentally also be Yearn Technologies users who received YFI in their capacities as such.
See e.g. SEC v. Kin at 13: “Kik had a unique incentive to increase demand for Kin because it retained for itself 30% of the tokens created.”
(quoting nansen.ai data).
 Various Yearn Contributors may hold YFI acquired because they also happened to be users of Yearn Technologies during the distribution week or because they received re-donations of YFI from Mr. Cronje. This is not a source of extrinsic affiliation in the sense considered here, but rather is a coincidence.
 The SEC v. Kik case provides a relatively recent example—Kik, a venture-backed company, retained 30% of KIN, awarded KIN to employees (who also held equity) and sold KIN to Kik’s equity investors. Extrinsic-alignment-by-stock-ownership creates the basis for the emergence of a dominant token control bloc because: 1. equity holders in the company would reasonably be expected to vote together on issues materially affecting the value of the company’s equity, but might vote differently if they only held tokens; and 2. equity holders in the company can more easily coordinate with one another than ordinary governance token holders—who are largely pseudonymous and otherwise unaffiliated—can coordinate with each other. Thus, systematic extrinsic affiliations create information and control asymmetries which implicate the policy concerns of the securities laws. See SEC Release No. 81207 / July 25, 2017 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934:The DAO: “The pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control. Investments in The DAO were made pseudonymously (such that the real-world identities of investors are not apparent), and there was great dispersion among those individuals and/or entities who were invested in The DAO and thousands of individuals and/or entities that traded DAO Tokens in the secondary market—an arrangement that bears little resemblance to that of a genuine general partnership. Cf. Williamson v. Tucker, 645 F.2d 404, 422-24 (5th Cir. 1981). These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.”
 However, see above regarding why even the distribution of tokens for free can, under certain circumstances, constitute an “investment of money.” Hypothetically, a free distribution of YFI to organic users only would not have constituted an “investment of money,” even though the typical “airdrop” does constitute an investment of money. With YFI, there was no “premine” of YFI and thus no security-issuer-style benefit to Mr. Cronje from creating a secondary market in YFI. Indeed, Mr. Cronje actively discouraged the development of a secondary market in YFI by advising the public that YFI had 0 value and that persons should not buy YFI but only obtain it for free incidentally to use of the Yearn Technologies.
(quoting nansen.ai data).
See Maura K. Monaghan, An Uncommon State of Confusion: The Common Enterprise Element of Investment Contract Analysis, 63 Fordham L. Rev. 2135 (1995). Available at: https://ir.lawnet.fordham.edu/flr/vol63/iss6/6
SEC v. Kik at 9.
SEC v. Glenn W. Turner Enterprises, 474 F.2d 476 (9th Circuit 1973).
SEC v. R.G. Reynolds Enterprises, Inc. 952 F.2d 1125 (9th Circuit 1991)
See e.g. Ryan Borneman, “Why the Common Enterprise Test Lacks a Common Definition A Look Into the Supreme Court's Decision of SEC v. Edwards”
Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).
SEC v. Kik at 12: “Howey contemplates that an investor is ‘led to expect profits solely from the efforts of the promoter or a third party.’ However, the Second Circuit ‘ha[s] held that the word ‘solely’ should not be construed as a literal limitation; rather, we ‘consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.’ ‘ United States v. Leonard, 529 F.3d 83, 88 (2d Cir. 2008) (quoting SEC v. Aqua-Sonic Prods Corp., 687 F.2d 577, 582 (2d Cir. 1982)).”
SEC v. Aqua-Sonic Prods. Corp, 687 F.2d 577, 582 (2d Cir.1982).
 SEC, “Framework for ‘Investment Contract’ Analysis of Digital Assets,” quoting SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir.), cert. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. 2d 53 (1973).
See e.g. R.G. Reynolds, op. cit.
See SEC v. Kik at 11: “[T]he fact that [Kin] purchasers could sell their Kin whenever they pleased is not dispositive…the key feature is not that investors must reap their profits at the same time; it is that investors’ profits at any given time are tied to the success of the enterprise.” [Note: this was raised by the court in the context of discussing “common enterprise,” because that is how Kik’s lawyers raised it as a defense, but we see the same reasoning as equally relevant to ‘efforts of others’.]
SEC v. Life Partners, Inc., 102 F.3d 587 (D.C. Cir 1996).
SEC v Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005).: “While it may be true that the "solely on the efforts of the promoter or a third party" prong of the Howey test is more easily satisfied by post-purchase activities, there is no basis for excluding pre-purchase managerial activities from the analysis. . .Significant pre-purchase managerial activities undertaken to insure the success of the investment may also satisfy Howey…Indeed, investment schemes may often involve a combination of both pre- and post-purchase managerial activities, both of which should be taken into consideration in determining whether Howey's test is satisfied. Courts have found investment contracts where significant efforts included the pre-purchase exercise of expertise by promoters in selecting or negotiating the price of an asset in which investors would acquire an interest. See Sec. Exch. Comm'n v. Eurobond Exch., Ltd., 13 F.3d 1334 (9th Cir. 1994) (involving interests in foreign treasury bonds); Gary Plastic Packaging Corp. v. Merrill Lynch, Inc., 756 F.2d 230 (2d Cir. 1985) (involving interests in certificate of deposit program); Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027 (2d Cir. 1974) (involving investments in warehouse receipts for whiskey).”
Note: We do not condone these sensationalistic news stories, but cite them as potentially relevant to affecting YFI holders’ “reasonable expectations”: See “YFI’s Andre Cronje is tired, broke and close to quitting DeFi”; “Yearn.Finance’s Creator Says He’s Quit DeFi, but Project Has Bench Strength”; “'It doesn't need me': yearn.finance's Andre Cronje on the protocol's path to decentralization”
 “Yearn.finance (YFI) yields are plunging: is this a risk for the Ethereum DeFi darling?”
Note: The Multisig Holders could easily own additional YFI unknown to the public. However, if they did, it would be irrelevant, since the purpose of the Howey test is to examine an ordinary investor’s reasonable expectations, which in this case would necessarily be based on public information.
See “Faculty on Point – Professor Joseph A. Grundfest on Bitcoin: Is it a Security?”
 Chandler v. Kew, Inc., Fed.Sec.L.Rep. (CCH) ¶ 96,966 (10th Cir. 1977); Bula v. Mansfield, Fed.Sec.L.Rep. (CCH) ¶ 96,964 (D.Colo. 1977)
 Dunwoody Country Club v. Fortson, 243 Ga. 236 (Ga. 1979); Libaire v. Kaplan, 395 F. App'x 732 (2d Cir. 2010)
Pocketful of Quarters, Inc. – Response of the Division of Corporation Finance – July 25, 2019
Is a fixed cap of 30,000 tokens better for establishing YFI as a non-security?
this post alone could save people tens of thousands of dollars in legal costs.
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