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A real estate developer is building a new hotel. Having a third person invest their money in the developer’s business in exchange for a share in future profits from rental, lease, or sale of the hotel to end customers constitutes an investment contract. This is because the (expected) profits come from business operations of the developer and their commitment to come good on their promise to investors. Investment contract is considered a security by the US law.
In contrast, buying the hotel building (or a part of it) from the developer, in any phase of its (in)completeness, including a phase where there is just the land, is not an investment contract and is therefore not a security. Whether there are guests waiting in line for to hand over their cash to whomever operates the hotel at the time makes no difference. The important difference is that the buyer is not investing into the developer’s business, the buyer is instead simply acquiring a property interest to do with it as they see fit.
Transfer of Risk
Had Howey (as in Howey Test) had offered to sell his orchard without simultaneously stipulating that he manage the business of growing fruits for his investors (in a separate yet related agreement), his offer would have also been to sell his land and the test would probably bear another person’s name following a similar venture.
The underlying reasoning behind US securities laws is that, regardless of the specific security type, there is a transfer of risk from seller to buyer. Aside from investment contracts, this is particularly observable with future and forward contracts and the related difference in legal treatment when there is a physical delivery of the underlying asset vs. a settlement in cash. With physical delivery neither party bears any risk other than the counterparty breaching the contract, in which case their interests are protected by the law, meaning that there is no lawful transfer of risk from one party to the other taking place.
Software Is No Exception
Distributed applications on blockchain, along with their models; white papers, yellow papers and other types of documentation are just software – a form of intellectual property. The legal treatment when it comes to its creation, extraction of value, ownership, and the transfer thereof is similar to that of tangible property such as a hotel building.
An analogy to investment contracts with distributed application development in mind is the one in which developers sell and investors purchase tokens that bear expectation of profit resulting from business operations of the seller (seller being a formal or informal entity). The operations include marketing and licensing the software to end customers, or in case of a distributed application, having the software itself collect fees and distribute revenues. Settlement of such a transaction transfers the seller’s business risk to the buyer, who by virtue of taking risk becomes an investor in the seller’s business. This is the explanation as to why the transaction in question is a form of investment contract and consequently a security – at least under the US law.
Transfer of Property Interest
However, in a case when the buyer does not invest in business operations of the development team and therefore has no expectation of profit thereof, but instead, simply acquires the intellectual property itself on “AS IS” and “AS AVAILABLE” basis, the settlement leaves no obligation or promise on the part of seller unfulfilled.
With purchase of a software copyright (or an undivided fractional interest therein), the buyer is aware that under applicable copyright laws they are buying the right to implement, modify, license and otherwise extract value from the acquired intellectual property and any deriving work thereof. The buyer is also aware of their obligation to share any profits resulting from their extraction of value from the software or the deriving work with other copyright holders if any. Lastly, the buyers are aware that it is their responsibility to exercise due diligence prior to purchasing the copyright, and that upon putting the software at buyer’s disposal the seller has no other obligations or duties toward the buyer and there can be no expectation of profit arising from any of the seller’s future actions.
Therefore, purchasing a copyright does not constitute an investment contract. The copyright holders are the only ones who are entitled to (but not obliged to) lawfully extract value from the property and they have no obligations toward each other, other than to share profits that result from their own extraction of value. If copyright holders construct software and/or derive work from it (including any of its implementations/versions/forks) so that it performs this extraction of value by charging its users and distributing royalties to its copyright holders automatically, the overall solution becomes even more secure and less prone to errors.
Naturally, a new copyright holder is completely free to transfer their undivided fractional interest in copyright (their portion of software ownership) to other persons.
Some development teams preclude token holders from any rights (intellectual or other) to avoid undesirable interpretation from regulatory bodies. The model of transferring copyright with tokens as proof of undivided fractional interest therein does not only offer better protection for the token holder, it’s far more efficient legally. The transfer of copyright gives a specific, unquestionable, and measurable value to the copyright-token owner in return for their funds. Last but not least, copyright is not a security.
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