I am finally taking a break from writing about the on-going Tezos litigation (See In re Tezos Securities Litigation, 3:17-cv-06779-RS, N.D. Cal. 2017), and addressing an on-going question that seems to be one of the hottest topic among the Tezos communication platforms; i.e.; Telegram, Reddit, Riot, etc. As a matter of fact, this question was answered by the Tezos Foundation’s (hereinafter “TF”) weekly update on June 24, 2019. The only issue that remains is that people do not fully understand TF’s answer since it points you to a bunch of legalese, so let me break it down for the masses. Here’s the question and answer from TF’s weekly update:

Why isn’t TF doing more to get XTZ listed on exchanges?

The Tezos Foundation does not pursue exchange listings. This is not, and has never been the role of the Tezos Foundation. For reference: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets (See https://tezos.foundation/news/update-week-of-6-24)

June 24, 2019 TF Weekly Update

(By the way, this is related to the question that has been asked in many different iterations, such as, “when binance?” “when Coinbase”, “why isn’t TF doing more to get listed on exchanges?”; I think you get the picture.)

Before I start breaking this down, I need you to keep in mind that I am only going to address this specific issue (as explained above) because the United States Securities and Exchange Commission’s (hereinafter “SEC”) guidance on the crypto-currency initial coin offering framework is quite long and will be covered in-depth at a later date.

What is this guidance framework issued by the SEC and what is TF talking about? This guidance framework provided by the SEC is to, “provide a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset are securities transactions.” (See https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets, Section II. Application of Howey to Digital Assets) Explained differently, this framework is to give guidance to the public on determining whether their respective crypto-currency might be considered as a security or not by the SEC and if it is considered a security, then a large number of regulations need to be followed. This framework was created in regards to what’s called the Howey Test (See SEC v. Howey Co., 328 U.S. 293 (1946)). Even though I said this isn’t article isn’t about the current Tezos litigation, it is still related to the litigation in the sense that the main issue in the litigation is whether Tezos is considered a security or not.

Very generally, the Howey Test is based off of the 1949 United States Supreme Court Case, SEC v. Howey Company, where the US Supreme Court defined what constitutes a security. This is what we call case law and what courts look to/follow when deciding the issue of whether something is a security or not. In the Howey case, the Court stated that a security is an “investment contract”. (See SEC v. Howey Co., 328 U.S. 293 at 298 (1946); The Court stated that an investment contract for purposes of the Securities Act means a contract transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party… (Id. at 299)) Based on the Howey case, courts use a four prong/factor test. Not one prong/factor is greater than the other, but the whole is evaluated under the totality of the circumstances. The four prong/factor test are:

An investment of money With the expectation of profits In a “common enterprise” From the efforts of a promoter or third party

When you meet the criteria of all 4 factors, then it’s more than likely you have a security. When you have 3 out of 4 factors, then it becomes a bit tougher to say whether something is a security or not and the same goes for if you meet 2/4 factors, 1/4 factors and so on. The less factors you meet, then the lesser the chance it will be considered a security and the goal here is to not be listed as a security. Also, keep in mind that this analysis changes as the crypto-currency evolves and matures, and this is especially so if the crypto-currency becomes totally decentralized.

(See SEC v. Howey Co., 328 U.S. 293 (1946).; I also want to note that this is a very brief explanation of the Howey case and its factors. I had to include this to give you a reference point so that this would make a little more sense. I will break down these factors including talking about the actual Howey case and its progeny of cases that follow/came after the Howey case at a later date.)

These are just four factors defined by the US Supreme Court, however, the SEC digital framework has expanded these four prongs into 38 different factors. (See https://www.sec.gov/news/speech/peirce-how-we-howey-050919 and https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets; As explained above, I am just covering the relevant factors and will cover the rest of the factors at a later date, including the breakdown of the Howey factors.)

From Commissioner Hester M. Peirce on May 9, 2019

When TF stated that they do not pursue exchanges to list Tezos, it’s because under the SEC Framework and its interpretation of the third prong under the Howey Test, the SEC looks at whether a purchaser (potential person buying Tezos) is relying on the efforts of others (TF). To determine if a purchaser is relying on the efforts of others, the SEC points to two questions in determining whether a purchaser is relying on others and they are:

Does the purchaser reasonably expect to rely on the efforts of an AP?

Are those efforts “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?

(See https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets Section C, 1. Reliance of the Efforts of Others; AP means active participant. Active participant means person/people/group that’s furthering a project/crypto-currency development in all aspects such as software development, marketing, and anything else that pushes the project along. This is opposite of a passive investor/purchaser, whereas a investor/purchaser just purchases and watches the actions of the AP without any involvement except the purchase.)

The SEC goes on further stating, “although not one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the “effort of others”. (See https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets Section C, 1. Reliance of the Efforts of Others). The SEC then states that one of the factors it looks at is whether, “an AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: Determining whether and where the digital asset will trade. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform.” [emphasis added](Id.)

The example that the SEC gives as noted above, is why TF won’t actively pursue exchanges to list Tezos. The SEC is giving guidance on how it evaluates certain things as a security or not and gives you a direct example of something that if done will put you closer in the realm of being considered as a security. In other words, if TF arranges, or promises to arrange for the trading of Tezos on a secondary market or platform like Binance, Coinbase, and etc., then it is getting closer to being considered as a security. This doesn’t mean that it will necessarily be considered a security if TF did the above example, but it gets a lot closer to being one. Also, since the SEC is giving a direct example, it becomes much more difficult to argue different interpretations or different meanings behind their framework. Think of it this way, if the SEC just said, “an AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including”, and gave no examples, then one could argue that pursuing exchange listings is more of a ministerial role rather than managerial role and therefore it hasn’t met the third prong of the Howey factor, but since the SEC gives you a direct example, it becomes extremely difficult to argue otherwise. This is the SEC’s way of saying to the public, in case they weren’t clear enough, here’s an example of what we are talking about.

Hopefully this explanation provides a little more clarity on why TF doesn’t pursue exchange listings. It’s not that they do not want to, but more of staying complaint with the SEC and not becoming a target of the SEC like the KiK/Kin Foundation. Appearance wise, it may seem like TF isn’t doing anything, but in reality they are constrained by the SEC framework and actively preventing themselves from becoming the next SEC target. You have multiple moving pieces and the last thing you want to do is be caught in the cross-hairs of the SEC. If I had to make an educated guess on why it may seem like TF is slow to act, I would opine that they are hedging their bets in two different ways.

First, they are trying to stay within the SEC framework of not being a security. Second, Tezos is working diligently towards full decentralization, so that the Tezos Foundation is no longer the focus of efforts. However, the giant elephant in the room is the estimated $500M in the Tezos Foundation treasury, and how that can be decentralized. Working towards this decentralization would put Tezos outside the purview of being a security. As the SEC Head Commissioner Jay Clayton stated in a letter to Congressman Ted Budd on March 7, 2019, Mr. Clayton stated, “[a] digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition.” Mr. Clayton goes on further stating, “ a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.” [emphasis added] (See https://coincenter.org/files/2019-03/clayton-token-response.pdf, page 2.) What Mr. Clayton is stating in the above goes directly to my second point of why I believe TF is hedging their bets in two ways. More than likely, TF understands that if Tezos might have once been considered a security in 2017 or 2018 when mainnet launched (I am not saying Tezos was or wasn’t a security, I am saving that topic for another date), today in 2019, the Tezos network has evolved to the point of decentralization and no longer an “investment contract” under the SEC’s framework. Even though TF it still holding funds from the fundraiser, TF is issuing grants to get the Tezos network to the point of being completely decentralized so that it can remove itself out of the managerial efforts as mentioned above. This is akin to ethereum and the Ethereum Foundation. If the Ethereum Foundation were to disappear tomorrow, the ethereum network would continue functioning and that’s what I’m guessing TF is actively trying to accomplish.

SEC Commissioner Clayton’s letter to Congressman Budd

Keeping Tezos safe isn’t a game of checkers but of chess, and as Dr. Strange said in “Avengers Infinity War,” “we are in the end game now.”

As always, please do your own research regarding Tezos and crypto-currencies in general. Further, please do not rely on this article as financial advice or legal advice as this article is solely based on my opinion and for educational purposes only.

By: Alexander Liu, Esq., licensed to practice law in the State of Louisiana (Civil Law) and the State of Missouri (Common Law).