Category: What is a Security?

Yes, A Cryptocurrency Can Be a Security

Earlier this week, a federal judge denied a claim that a cryptocurrency is not a security under the federal securities law. The judge didn’t say that it was a security. Instead, he ruled that a reasonable jury could conclude that the cryptocurrency is a security.

This ruling comes from the SEC enforcement action against RECoin, the first cryptocurrency backed by real estate. It wasn’t really. RECoin never hired a broker, lawyer, or developer to acquire the real estate investments advertised in the offering of RECOin.

Maksim Zaslavskiy, the principal behind RECoin, is not strongly arguing that there was not a problem with RECoin. At this point he’s arguing that it’s not a securities problem and the SEC should leave him alone.

The ruling is not surprising. The Securities and Exchange Commission has been saying for months in public announcements and enforcement actions that ICO tokens can be securities. (although the SEC did say that Bitcoin and Ether are no longer securities.)

This one federal court judge has agreed with the SEC on this, so one point to the SEC.

The judge jumped right into the Howey test and the definition of an “investment contract.” That is a “contract, transaction, or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits solely from the efforts of the promoter or third party.”

As for the first prong, Zaslavskiy argued that the parties did not invest money in RECoin. They merely transferred from one medium of currency to another. The judge notes that money does not necessarily mean cash, any exchange of value is enough.

In the second prong, giving out tokens instead of stock or bonds does not make it any less a common enterprise. The tokens were supposed to be pooled to invest in real estate.

The marketing materials serve up the third prong. They pitched the RECoin as an attractive investment opportunity which grows in value. There was no element of control given to the token holders.

Zaslavskiy argues that RECoin should be considered a currency, which falls outside the definition of a security.

“He also overlooks the fact that simply labeling an investment opportunity as “virtual currency” or “cryptocurrency” does not transform an investment contract—a security—into a currency.”

The judge found no basis behind the argument, because no real estate, coins, tokens or currency of any sort ever existed in the enterprise.

It’s slowly coming, but people will start going to jail for these fraudulent coin offerings.

Sources:

Bitcoins Are Not Securities

In a completely unsurprising statement, a high-ranking official at the Securities and Exchange Commission said that Bitcoins are not securities. William Hinman, Director, Division of Corporation Finance at the SEC, gave detailed speech on cryptocurrency.

When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey. That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. … In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.

Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.

In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.

It seems clear that the SEC’s default position on Initial Coin Offerings is that they are securities offerings. The coin promoters are not offering oranges for sale, but interests in the orange grove.

I did find it interesting that Mr. Hinman indicated that even if the ICO was an illegal securities offering, eventually the cryptocurrency could evolve into not being a security. Eventually, you are not exchanging interests in the orange grove, but exchanging actual oranges. He went to the next biggest coin platform: Ether.

And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

As for the rest of the coin and ICO universe, Mr. Hinman offered up six factors to consider:

  1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  4. Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

That is just for coins based on being able to buy some future service. If the digital coin includes some profits interest in the coin network, it’s always going to be a security.

The other factor to take into consideration is the trading platform for the digital coins. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. If the platform just handles Ether and Bitcoin, it’s okay based on the Hinman speech. Those two are not securities. Others are still suspect.

What is left out is the whether Bitcoin, Ether, or any of the other non-security digital coins are commodities or currency.

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Compliance Lessons from Star Wars – Rebels

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. Star Wars is about the rise of the evil galactic empire and the rebels who fight against it. I think some Bitcoin advocates are trying to be the rebels who portray the the Federal Reserve as the evil Galactic Empire. The battle is for freedom of money.

“This is a fantastic fundamental hedge and store of value against autocratic regimes and banking infrastructure that we know is corrosive to how the world needs to work properly,” said Chamath Palihapitiya, the founder of Social Capital and an early Bitcoin investor. “You cannot have central banks infinitely printing currency.”

In response to that, I give you this picture of the Treasury Secretary showing a new sheet of money to his wife dressed in Darth Vader garb. (Add a helmet and it’s complete)

Of course the Treasury is not the Federal Reserve and this printed money is not the same as the Federal Reserve buying bonds with money pulled out of thin air. Since we have entered a post-factual world in Washington, I’m not sure we need to let facts get in the way of a great picture.

The underlying technology of Bitcoin, blockchain, is a brilliant shared ledger. It has the ability to replace some proprietary databases of transactional information. I’m less interest in Bitcoin itself. Digital currency moves control of the currency from the central banks to computer servers.  While currency can be inflated be the central banks, Bitcoin is limited to a slow creation on the servers running blockchain.

As a naysayer, I failed to see the rise of Bitcoin. If I had a bought a few bitcoins when I first looked down my nose at it, I would have made a pile of cash.

The Federal Reserve, at the heart of the Galactic Empire, has pushed Bitcoin aside. Janet Yellen, the current Chair of the Board of Governors of the Federal Reserve System on Wednesday called Bitcoin a “highly speculative asset” and “not a stable source of value”, and “it doesn’t constitute legal tender.”  In response, Bitcoin did not back down and the exchange rate stayed stable. The empire would have to find other ways to attack cryptocurrency.

The rebellion has grown from Bitcoin to other cryptocurrencies. They are launching their attacks in Initial Coin Offerings. No initial coin offerings have been registered with the Securities and Exchange Commission as the sale of securities. They are operating outside the oversight of the SEC, failing to give purchasers/investors the protections that come with SEC registration and oversight.

If you invested in an ICO, should you be worried that the offering might be targeted by the SEC? Yes, you should be worried. That ICO is Alderaan and the SEC has the Death Star. A million voices will scream out about the injustice. So much real money and false value will be destroyed.

The SEC stopped an ICO this week for Munchee. Munchee was seeking $15 million to improve an existing iPhone app for restaurant meal reviews and to create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens. The company emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens and it would take steps to create a secondary market for the tokens.  As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others. The Munchee ICO was an illegal IPO.

The Empire of regulatory oversight has many factions. This week the IRS won a case against Coinbase, one of the largest digital currency brokers. The IRS claimed that virtual currency gains have been underreported based on the disproportionate number of taxpayers reporting gains from Bitcoin compared to the number of Coinbase account holders. Coinbase has approximately 5.9 million customers and has provided $6 billion in Bitcoin exchanges. However,  the IRS has identified only 800 to 900 taxpayers in each of the years from 2013 through 2015 who reported gains or losses that the IRS believes are “likely related to bitcoin.”

The battle will rage on. Rebel cryptocurrency against the regulated dollar. Which will allow you to buy a coffee at Dunkin Donuts? and which will you use?

See Tom’s posts:

Is a TIC a security?

TIC refers to Tenancy in Common, not the blood-sucking insect. A TIC is a completely legal way of owning real estate that has been around for hundreds of years. When one of the parties owning real estate dies, that ownership interest passes to that owner’s heirs. The alternative is joint tenancy, in which case when the part owner dies, the remaining owners get that ownership interest. If you’re married, you probably own your home in a joint tenancy. (There is also a tenancy by entirety for married couples that operates like a joint tenancy, but also limits the sale of an interest without your spouse’s consent.)

There is a market for TICs in commercial real estate because of Section 1031 of the tax code that allows for tax-deferred exchanges. If you sell commercial real estate and don’t want to pay taxes immediately on the gain, you can buy a replacement piece of real estate and defer the gain. The problem is finding a replacement and finding one at an equivalent price. Fractional TICs were developed allowing an owner to more easily achieve tax-deference.

The problem with TICs has always been avoiding the treatment of the interest as a security. This goes back to the Howey definition of a “investment contract” as “investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.”

For a fractional TIC, there is a common enterprise. The investor’s ownership interest is combined with the other fractional owners. There is an expectation of profit. Given that the real estate needs to be managed, there is generally some sponsor exerting some level of control over the real estate on behalf of the TIC owners. A lessee does not want to have to negotiate of dozens of TIC owners when entering into a lease.

The key is giving the TIC owners enough control so that they are not solely relying on the “managerial efforts of others” for the real estate investment to be successful.

Many TIC investments involve real estate with a long lease to a credit tenant. So even though the TIC owners have a say in management, there is little management that needs to be done.

One of the dangers to the sponsor is that the TIC owners will claim that the TICs are securities, giving the TIC owners additional right, if the investment goes south.

That is what happened in the Highwoods case in Durham, North Carolina. NNN Realty bought a property, largely leased to a credit tenant and set up a TIC syndication.

To avoid the treatment of the TICs as securities, the affiliated agreements granted some control to the TIC owners. The Management Agreement for the Durham Property gave the TICs the ability to hire and fire the property manager, the leasing agent, and the asset manager. It also allowed the TICs to control the Durham Property’s expenditures by approving budgets. However, firing the asset manager, an affiliate of the sponsor, involved paying expenses and would trigger a default under the mortgage loan.

The TIC owners claim that they were induced to purchase interests in the Durham Property by materially false statements or omissions in a private-placement memorandum concerning the probability that the Durham Property’s primary credit tenant would renew its leases. The primary credit tenant’s leases were critical to the Durham Property’s value, as demonstrated when that tenant later terminated its leases and the Property went into foreclosure.

The lawsuit was filed in North Carolina so the challenge to the TICs as securities was based on North Carolina law.

North Carolina’s Rule 06A.1104(8)(a) requires both a “common enterprise” and “the expectation of profit to be derived from the essential managerial efforts of someone
other than the investor.” “Essential” management does not necessarily connote “exclusive” management. 18 N.C. Admin. Code 06A.1104(8)(a) (emphasis added). Rule 06A.1104(8)(b) does not expressly require a “common enterprise,” but it contemplates a scenario where at least a portion of the value provided by the investor is subjected to the risk of an enterprise in which the investor “does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.”

The PPM stated as a risk-factor on reliance on management:

[a]ll decisions regarding management of the Company’s affairs . . . and the management of the Property, will be made exclusively by the Manager, the Property Manager and their Affiliates, and not by any of the Members or the Purchasers. Accordingly, no person should purchase LLC Units unless that person is willing to entrust all aspects of management of the Company to the Manager and management of the Property to the Property Manager.

The court realized that the documents around the ownership of the TIC gave the TIC more control than that risk factor warns.

The court looked to SEC v. Merchant Capital, LLC  (483 F.3d 747) involving the treatment of general partnership interests as investment contracts under the federal securities laws. That court came up with six factors that would make a general partnership interest more like a limited partnership interest or investment contract:

(1) the partners’ ability to elect the managing general partner was not meaningful, because the vote had to be made at the time of investment, and the promoter was the only nominee;

(2) the limitation on removing the managing general partner for cause by unanimous vote effectively meant that the managing general partner could not be removed;

(3) the various investors were geographically diverse and had no meaningful opportunity to develop relationships;

(4) the investors’ potential liability was limited to the amount that each investor invested, with no vicarious liability for the acts of other investors;

(5) the right to approve expenditures, while facially significant, was diluted by the managing general partner’s ability to control information;

(6) the investors had no particular expertise in the business in which they invested.

The NNN court found these factors instructive and ruled the TIC interests could qualify as securities. The court denied the summary judgment on this issue request by the sponsor.

On appeal, the North Carolina Secretary of State and the North American Securities Administrators Association want the appellate court to rule that the TICs are securities in this case.

So clearly, TICs can be securities.

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Can Concert Tickets Be Securities?

WFAN morning show co-host Craig Carton was arrested for scamming investors out of $5.6 million. His ploy was a fraudulent ticket resale business. He promised the ability to deliver face-value tickets to concerts by Katy Perry, Justin Bieber, Metallica and Barbra Streisand. According to the Securities and Exchange Commission, he used the investors’ money to repay gambling debts.

The case has attracted attention because of the high-profile of Mr. Carton. It attracted my attention because I was curious if it was a securities law violation.

Mr. Carton has not responded to the SEC charges and is also subject to parallel criminal charges. I looked at the SEC complaint to see how it handled the threshold question of whether securities were involved, accepting the charges as true for educational purposes.

Using the Howey test to determine if there is an investment contract, we look at the four factors:

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

As usual, 1 and 4 are the easy prongs. Investors gave Mr. Carton money with promises of getting more back. The SEC cites a presentation with a per deal average of 2.2X and 187% IRR.

The investors were just putting up money and relying on Mr. Carton to execute on the acquisition and resale of tickets. That should leave the fourth prong satisfied.

The complaint points to two separate schemes, one with an individual and a second with a hedge fund.

According to the SEC’s complaint, the scheme with the individual investor involved only that individual investor and not a pooling of money. There is a split among the courts about the “common enterprise” prong of the test. Some courts look toward a pooling of money. Some are just satisfied if the success of the investor depends on the promoter’s expertise. The complaint is in the Second Circuit which places a heavy reliance on a pooling of money to meet the common enterprise prong.

As to the individual investor, there may be some grounds to argue that it was not a securities transaction and therefore outside the scope of the SEC. That would still leave Mr. Carton with the criminal charges of wire fraud, etc.

As to the hedge fund scheme, the investment document was, at least in name, structured as a loan. The operative document was a Revolving Loan Agreement. There is little to discern in the complaint about whether it was a loan in name only and a was really a “security” that would give the SEC jurisdiction. If it’s a loan, that may be outside the definition of “security” and we never get to “investment contract” test in Howey. Again, the scheme would still subject Mr. Carton to criminal charges of wire fraud and bank fraud.

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Initial Coin Offerings and the Securities Laws

Regulators have been trying to figure out what to do with the new currencies coming to the marketplace. Bitcoin was the vanguard, bringing its blockchain technology into the public’s view. The Securities and Exchange Commission has issued a Report of Investigation that provides some insight into when these currencies and their rollouts are going to violate securities law.

I find Bitcoin’s distributed ledger technology called the blockchain to be intriguing. Bitcoin as a currency has its problems. The wild swings in its conversion rate make it look more like a commodity than the steady values expected of a currency. In the US we have distinct regulatory structures between commodities and securities.

(Speaking of currency, if you have some extra currency then use it to fight cancer. Support my Pan-Mass Challenge Ride.)

The SEC took a close look at the initial coin offering of DAO Tokens to see if it violated securities laws. The first test was whether the DAO Tokens were securities. The short answer is yes.

The hurdle with rolling out new virtual currencies is getting enough into circulation at launch to make them useful of enough to act like a currency. Bitcoin has been out long enough and is widely used enough that it has passed this hurdle. But the first person with a Bitcoin couldn’t do much with it.

I think it’s important to note that the DAO Tokens that are the subject of the report are not the virtual currency. The DAO Tokess were used to fund the enterprise that was intended to fund projects involving the Ether currency and the Etherium blockchain.

The DAO was essential a venture capital organization and the DAO tokens were the capital commitments. Fund managers will tell you right off the bat that the partnership interests in a venture capital fund are securities.

In looking at the DAO tokens, the SEC went right to the Howey test.

Participants invested money. Of course, cash is not the only way to invest. For the DAO tokens, the investors used Ether which has value and easily meets this prong of the test.

Participants had a reasonable expectation of profits. The DAO organization was set up as a venture capital endeavor and explicitly stated that DAO token holders would share in profits from any of the projects that generated revenue.

The difficult part of the prong was the “managerial efforts of others.” DAO token holders had voting rights but the promoter, Slock.it, was key to moving the enterprise forward according to the SEC. DAO would have “Curators” instead of managers who would chose the projects for voting by the DAO token holders.

Slock.it chose the initial batch of Curators.  Token Holders could vote to replace a Curator. But the decision to send the proposal to a vote is subject to approval of the Curators.  Curators had the responsibility and power to “(1) vet Contractors; (2) determine whether and when to submit proposals for votes; (3) determine the order and frequency of proposals that were submitted for a vote; and (4) determine whether to halve the default quorum necessary for a successful vote on certain proposals. Thus, the Curators exercised significant control over the order and frequency of proposals, and could impose their own subjective criteria for whether the proposal should be whitelisted for a vote by DAO Token holders.”

The SEC went on further to conclude that the DAO Token voting rights are closer to those of corporate shareholder, than an active participant in the management.

If the DAO Tokens are securities then the whole securities law regulatory regime applies unless there is an exemption for the offering of the DAO Tokens. The sponsors took no steps to limit the offering in a manner consistent with a offering exemption.

In the end, it was not the initial coin offering that was a problem, it was the offering of interests in the organization behind the coins that was a problem.

Sources:

The Pan Mass Challenge has many choices for those looking to participate and raise money to fight cancer. I have a friend who is a virtual rider. Due to injuries she is not ready to spend hours on a bike. I’m not a virtual rider. Not only am I riding the two days of the Pan Mass Challenge, I’m adding an extra Day Zero and riding 75+ miles just to get to the start of the Pan Mass Challenge.

Help me fight cancer by donating your real currency through one of the links below.

Thank you,
Doug

Can a California Note Be A Security?

Debt instruments can be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Federal law uses some variation of the factors stated in S.E.C. v. Howey Co., 328 U.S. 293 (1946) n analyzing whether an instrument is an “investment contract” and therefore a security.

California also has a “risk capital test” to test whether an investment is a security.  That test came out of Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961).

The risk capital test, articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski (1961) 55 Cal.2d 811, 815 describes:

  1. an attempt by an issuer to raise funds for a business venture or enterprise;
  2. an indiscriminate offering to the public at large where the persons solicited are selected at random;
  3. a passive position on the part of the investor; and
  4. the conduct of the enterprise by the issuer with other people’s money.

The test reflects the court’s assessment that the term “security” is defined broadly in order “to protect the public against spurious schemes, however ingeniously devised, to attract risk capital.” (Id. at p. 814.)

The instrument in question in the Black  case was a note that provided:

“(a) In the event the real property located at 177 and 200 North Edgewood Lane, Eagle, Idaho is sold by Borrower, the amount of interest shall be based on the percentage of profits minus expenses Borrower receives from the sale; or “(b) In the event Borrower develops said real property, Lender shall receive two (2) lots based on the tentative map to be selected by Lender. “(c) In the event that neither (a) or (b) take place before one year from the making of this note, the principal together with interest at the rate of ten percent (10%) shall become due and payable at the election of Lender.”

Mr. Black was arguing that the note failed the risk capital test because it was a heavily negotiated agreement and not one that was intended to offered to the public at large. It failed the second prong of the risk capital test.

According to California’s Sixth Appellate District in People v. Black (page 12):

“It is generally accepted that both the risk capital and federal tests may be applied, either separately or together; a transaction is a security if it satisfies either test.”

Black’s argument that it was not a security under Silver Hills failed to find traction. But the court still found that the note was not a security under the Howey test.

The California court found that repayment of the note was not wholly dependent on the efforts of Mr. Black. There was other collateral that may have allowed for some repayment of the note.

Surprisingly, the court comes back to include the nature of the transaction being individually negotiated and not being intended for wide distribution as factor in reaching its conclusion. Although the court rejected Mr. Black’s argument that the Silver Hills risk capital test is muted mooted by the federal Howey test, it seems to still include it in reaching its conclusion.

Perhaps, the court and Mr. Black should have looked at the formula used by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”. Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

Sources:

Is The SEC “Kicking and Mutilating The Corpse”?

I have a written a few stories on the SEC’s case against Louis Schooler and his firm, Western Financial Planning Corp. The Securities and Exchange Commission brought charges against them for a real estate investment scheme. Schooler was selling general partnership interests that owned real estate using what looked like inflated valuations.

hylas

By default general partnership interests are not securities, but the judge found that a general partnership could be an investment contract (and therefore a security) if one of three factors is present.

(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;

(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or

(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Schooler has continued to fight the decision, but has been hit with having to pay $150 million in disgorgement.

The SEC took an additional approach and sought to bar Schooler from the securities industry. That raised my eyebrow because Schooler does not think he is in the securities industry. He is claiming to be selling real estate interests. I’m not sure how much the bar would work. It’s a bit of a circular argument.

It does not seem to matter because Schooler decided to take some time off and go sailing in the South Pacific on his Hylas 42 sailboat: Entertainer. I’m sure that the many people who lost money in Schooler’s investment scheme have some bad thoughts of that image of him sailing alone in the tropical breeze.

Those investors are likely believing in karma now. Schooler did not appear for the ruling. He has gone missing in the South Pacific.

That did not stop the SEC from finalizing the industry bar. It also lead to his lawyer’s charge that the SEC’s Enforcement Division “is acting out of pure vengeance and spite, akin to not only killing a person, but kicking and mutilating the corpse.”

The SEC’s response:

“[T]here has been a report that Schooler’s yacht ran aground on a reef in or around Tahiti, no remains were recovered, and no death certificate has been issued. At present the U.S. State Department considers Schooler to be missing rather than dead.

I’m sure that there are many, like me, wondering if this is straight out of a movie. Did Schooler set up an elaborate scenario to fake his own death? Latitude 38 says some circumstances of the shipwreck are suspicious.

Neither scenario does anything to help those who lost money by investing with Schooler.

Sources:

 

 

Turning a Slimy Internet Scheme Into Securities Fraud

Charles Scoville wants to help you get better traffic to your website. He does it through the slimy method of paying people to click on an ad for your website. But he added in a revenue sharing system. The SEC decided that the slimy method had turned securities fraud.

traffic monsoon

There are many, many, many platforms for falsely generating traffic to your site. HBO’s Silicon Valley used a click farm to generate user activity increases for its fictional product.

The Scoville platform, Traffic Monsoon, is mostly a traffic exchange. Users/members agree to click on other members’ websites and they agree to click on your website through AdPacks. Business owners buy ad packs and get visitors and banner clicks in return. Members get paid to click. There are a few levels of AdPacks and services for sale.

Traffic Monsoon took things a step further to get members clicking more and paying more for the AdPacks. The platform offered “revenue sharing.”

When you purchase an AdPack combo advertising campaign for $50, you’ll receive 20 clicks to your banner, 1,000 traffic exchange credits, and a revenue sharing position.

When you click a minimum of 50 ads in our traffic exchange and remain on the websites for 5 seconds each, you’ll qualify yourself for 24 hours to share in site profits.

By paying for the more expensive AdPack, you get to share revenue or share in site profits. The problem is how you define revenue and profits.

Traffic Monsoon treated the purchase of the AdPack as revenue. The sale of these accounted for 99% of the company’s revenue. There were very few third parties enticed to the site looking for pay to click activity.

According to the SEC Complaint, as of May 16, 2016, Traffic Monsoon had sold 15,225,689 AdPacks. For each such AdPack, however, it must deliver 1,000 visitors, amounting to 15 billion visitors total. As of July 24, 2016, however, the Traffic Monsoon website states that the company had “delivered 1,618,996,340 visitors.

In February, PayPal froze the company’s accounts because it had the earmarks of a Ponzi scheme. According to the SEC’s complaint it is a Ponzi scheme.

The SEC’s jurisdiction is limited. It will need to prove that the scheme involves securities. It does a better job pleading the case that this involves securities than other past complaints involving matters that may not be securities.

  • Members pay a premium price for the revenue sharing AdPacks.
  • Member funds are aggregated into a common pool.
  • The payment of returns is almost entirely dependent on Scoville’s ability to sell AdPacks.
  • Members have no role in managing Traffic Monsoon enterprise.
  • The interests are not registered.
  • The members are not required to be accredited investors.

The SEC needs to prove that the AdPack arrangement was essentially an investment contract. That leads back to some derivation of the Howey case to determine if there is an investment contract, and look at whether there is:

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

Whether Traffic Monsoon calls it “revenue sharing” or “site profits” it looks like its revenue sharing system could be considered a security.

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Fraud, But Is It Securities Fraud?

Although the Securities and Exchange Commission gets blamed for not bringing enough fraud claims, it’s jurisdiction is limited to securities fraud. When I see a real estate case filed by the SEC I pay attention. The case against Richard W. Davis, Jr. brought the “What is a Security?” questions out.

mountains

The SEC alleges that Richard W. Davis Jr. breached his fiduciary duty and had conflicts of interest using investor money to enter into transactions with entities he beneficially owned or controlled.  The SEC further alleges that Davis made false or misleading statements to investors before and after they made their investments, failed to inform investors of their losses, commingled funds and took more management fees than was allowed.

Davis sold interests in two funds and he marketed them as investing in “hard assets” like real estate and mineral rights. I will assume those interests are securities. Mr. Davis would have needed to comply with the private placement requirements. According to the complaint, he did not do so.

The complaint labels the funds as “pooled investment vehicles” within the meaning of Rule 206(4)-8(b) of the Advisers Act, 17 C.F.R. § 275.206(4)- 8(b):

(b) Definition. For purposes of this section “pooled investment vehicle” means any investment company as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7))

To be an “investment company”, the pooled fund would need to invest in securities. A pooled fund that invests mostly and directly in real estate would fall outside the definition of an investment company.

The complaint is short on the details other than the bad acts alleged by the SEC. The issue is not contested since Mr. Davis agreed to settlement.

Sources:

Mountains National Bison Range Montana
By Jaix Chaix
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