The Original Public Meaning of Investment Contract

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Edward Lee is a Professor of Law at the Santa Clara University School of Law, starting in August 2024. This post is based on his recent article forthcoming in the U.C. Davis Law Review.

The Securities Act of 1933 defines “security” by identifying twenty examples of financial instruments or interests that constitute securities. “Investment contract” is the thirteenth example. It has assumed outsized importance in the Securities and Exchange Commission’s (SEC’s) enforcement actions against entities that have made public offerings of unregistered securities. Yet, nearly a century since the 1933 Act’s passage, the meaning of “investment contract” is still contested.

Nowhere is that more apparent than in the SEC’s ongoing enforcement actions against so-called “crypto asset securities”—a term nowhere in the Securities Act, but one that the SEC has used broadly to describe cryptocurrencies and non-fungible tokens (NFTs) in various actions. According to the SEC, these crypto assets are securities if they are “investment contracts” under the seminal case of SEC v. W.J. Howey Co., in which the Supreme Court interpreted the term in 1946. Under SEC Chair Gary Gensler’s expansive view, most cryptocurrencies are investment contracts. Even an NFT for a Pokémon card might be.

In “The Original Public Meaning of Investment Contract,” I provide historical research of newspapers and dictionaries before and contemporaneous with the enactment of the Securities Act of 1933. This historical research calls into question the SEC’s expansive approach. The research shows that “investment contract” was not a technical term or legal term of art, or neologism created by Congress or state legislatures. The reason Congress didn’t provide a definition of “investment contract” is simple: Congress didn’t create “investment contract.” People did. The term dates back as early as the 1800s, and was based on the ordinary meaning of “investment” and “contract.” People sold investments in contracts—the contract itself was the vehicle for a person’s investment. When Congress enacted the 1933 Act, it adopted the meaning of “investment contract” commonly understood by people at the time. Recognizing this key insight provides clarity—and an important limit—to the term.

The Original Public Meaning of Investment Contract in 1933

Starting in the 1800s, business entities advertised offerings of their “investment contracts” in newspapers. On January 17, 1887, for example, the real estate business the Davidson Company offered its “investment contracts” in an ad published in the St. Paul Daily Globe. The ad explained: “we make investments in St. Paul real estate … under our ‘Investment Contracts,’ whereby the party investing is guaranteed his (or her) money back and 6 per cent interest and a share of the profits.” Other real estate investment ventures offered similar investment contracts, which often targeted nonresidents. Even though some offerings, like the Davidson Company’s, purported to purchase the real estate in the name of the investor, the land sale was in name only (as was the case in Howey). People were buying, not land, but instead, the contract—or the contractual right of receiving “a share of the profits” made by the offeror from its venture.

The term “investment contract” was not limited to real estate ventures. The term was used broadly to apply to an array of investments, including contractual offerings in bonds, insurance, mining businesses, and general, unspecified investments, such as the one offered by the American Contract Co. Often, the ad for the offering stipulated the amount of profits the contracts would putatively yield to investors—for example, the Davidson Company ad “guaranteed his (or her) money back and 6 per cent interest and a share of the profits.” Newspaper ads also sought the hiring of salesmen to sell “investment contracts.” And newspaper articles in the early 1900s reported state and federal prosecutions of fraudulent “investment contracts.”

By 1920, when the Supreme Court of Minnesota first considered a case involving the meaning of “investment contract” in the state’s blue-sky statute, State v. Gopher Tire & Rubber Co., the term had a well-established meaning: its ordinary meaning. As the Court explained, “The placing of capital or laying out of money in a way intended to secure income or profit from its employment is an ‘investment’ as that word is commonly used and understood.” Although the Court did not define “contract,” there is no indication that the word meant anything other than the ordinary meaning of contract. Indeed, the Court described the certificates at issue in the case in contractual terms: the offeror’s “certificates are like stock in that they give their holders the right to share in the profits of the corporation.” As the Court recognized in two subsequent cases in 1923 and 1927, the state’s blue-sky law regulated “offers to the public of investment contracts evidencing a right to participate in the proceeds of a venture.” Such offerings solicit “the public … to invest money in the contracts [the offerors] propose to sell.”

In 1946, when the U.S. Supreme Court interpreted “investment contract” in the Securities Act in Howey, the Court expressly adopted its contemporaneous meaning “as used by Congress,” a term “the meaning of which had been crystalized by this prior judicial interpretation [Gopher Tire]” in 1920. Indeed, as analyzed above, newspaper articles and advertisements before the passage of the 1933 Act show that “investment contract” was a term commonly used in public discourse to refer to a contract offered as an investment.

Under the original public meaning, an investment contract involves a certain type of quid pro quo: individuals “invest money in a common enterprise,” the quid, in exchange for “the expectation that they would earn a profit solely through the efforts of the promoter,” the quo. Or, under Gopher Tire’s formulation that the Howey Court quoted, one invests “money … to secure income or profit from its employment” by the offeror. Put simply, an investor pays money for the right to the offeror’s profits.

Examining the economic reality and substance of a scheme, such as the land sale plus service agreement in Howey, allows courts to look at what the scheme, in fact, does in operation. The form of an instrument is not dispositive. Of course, it does not have to be titled “investment contract” to be an investment contract. The substance of the financial arrangement is key. The offering of an investment contract may be implied based on the facts, including the conduct, course of dealing, and representations of the parties. But the examination of economic reality under Howey does not allow the courts to ignore the text of the Securities Act—or the original public meaning of investment contract. If the facts indicate there was no offering of a contractual right to receive a share of the offeror’s or venture’s profits—what the Supreme Court described as “the shares in the enterprise”—the economic reality is there was no investment contract under the 1933 Act. Every Supreme Court decision finding an investment contract has involved such a contractual right, as summarized by the Brief of Securities Law Scholars as Amici Curiae in Support of Coinbase’s Motion. To interpret “investment contract” more broadly to situations completely lacking any such offering of a contractual right would impermissibly read the word “contract” right out of the statute. And it would violate “the core administrative-law principle that an agency may not rewrite clear statutory terms to suit its own sense of how the statute should operate.”

Adhering to the original public meaning of the Securities Act accords with the Supreme Court’s general approach to statutory interpretation. As the Court recently explained, “[t]his Court normally interprets a statute in accord with the ordinary public meaning of its terms at the time of its enactment.” Otherwise, courts “would deny the people the right to continue relying on the original meaning of the law they have counted on to settle their rights and obligations.” This principle serves both due process and the rule of law by providing people with clear notice of the scope of securities law—and by providing a limit to the SEC’s enforcement power.

Requiring Securities Registration of Artwork NFTs Constitutes a Prior Restraint

Nowhere is the need for such transparency apparent than in the SEC’s ad hoc treatment of NFTs. During the boom in the emerging market for NFTs, when sales volume hit $27 billion in 2021, the SEC issued no public guidance on whether NFTs are securities that must be registered before their public sale. NFTs create a new type of property in and embodiment of digital artworks and other creative expression, and offer digital artists a nascent market for their artworks. The SEC’s silence left people in the dark. Then, in the span of just two weeks in 2023, the SEC announced the settlements of enforcement actions against two NFT projects for allegedly selling a collection of NFTs as unregistered securities to the public. The SEC concluded that the NFTs operated as “investment contracts” and were therefore securities under Howey. In both actions, SEC Commissioners Hester Peirce and Mark Uyeda dissented, disagreeing with the SEC’s overbroad classification of the NFTs. They admonished: “The Commission should have grappled with these questions long ago and offered guidance [to the public] when NFTs first started proliferating.”

The SEC’s orders ignored the First Amendment problem that arises when the SEC regulates NFTs involving artworks or creative expression protected by the First Amendment. Both NFT projects subject to the SEC orders involved artistic works: their artworks were embodied in their NFTs, which included pictorial and graphical images (keys depicting various symbols, and numerous cat characters for an animated series, respectively). And both NFT projects had plans to create artistic expression as their business: Impact Theory was developing an online game, and Stoner Cats, an animated web series featuring the cat characters. To require securities registration of artwork NFTs before an artist can distribute them to the public raises a serious First Amendment problem—and most likely constitutes an unlawful prior restraint in violation of the artist’s freedom of expression. A digital Pokémon NFT is just as much protected expression as a physical Pokémon card. Restraining the sale of either until the government approves its publication is a prior restraint in violation of the First Amendment.

Adhering to the original public meaning of “investment contract” avoids this First Amendment problem. Artwork NFTs are not investment contracts because they typically do not entitle, by contract, their holders to share the profits solely generated by the NFT project. Instead, the NFTs typically convey ownership in an embodiment of an artwork. Artwork NFTs are “original collectibles,” as Cassandra Hatton, a senior vice president at Sotheby’s who has overseen the sale of many NFTs, explained in Amy Whitaker and Nora Burnett Abrams’ book, The Story of NFTs: Artists, Technology, and Democracy.

And the mere expectation of appreciation in the value of an artwork, whether embodied in NFTs or canvas, doesn’t create an investment contract any more than the appreciation in Barbie dolls, Birkin bags, Nike sneakers, Pokémon cards, Rolex watches, and Picasso paintings. Even if people who invest in these collectibles reasonably expect an appreciation in value—i.e., profits—from their respective makers’ efforts, such as in developing their brands and returning value to their collectors, that speculative expectation of profit doesn’t turn these collectibles into investment contracts. The economic realities of buying collectibles are different in kind from investing in investment contracts. Buying a rare Barbie, even if purchased from Mattel as an NFT expecting it will appreciate, is different from buying a right to a business’s profit. The former lacks the contractual right to profits that the latter has.