Are Friend.tech keys securities?

Friend.tech, the first popular app on Coinbase’s corporate Ethereum roll-up Base, allows users to purchase ‘shares’ in X (formerly Twitter) influencers. It also allows them to buy access to a special chat wherein other speculators deposit ETH and trade to increase or decrease their allocation to the influencer.

Basically, Friend.tech is similar to BitClout, or its predecessor Income Sharing Agreements. However, given the millions of dollars at stake, attorneys are already questioning whether the app’s founders or influencers actually offered these shares as securities without registering their offering with the Securities and Exchange Commission (SEC), as required by law.

Friend.tech shares (now called ‘keys’) represent fractional ownership of Friend.tech influencers’ X profiles and most people bought them in the hopes of making money.

Keys also grant users the opportunity to chat with other keyholders. In these chats, users may discuss any topic but, unsurprisingly, many choose to focus on the price of keys. Let’s recap.

Four signs of possible Friend.tech securities

Suspicious item #1? Friend.tech renamed its ‘shares’ as ‘keys.’ Not only that, the project’s founders quickly toned down investment-focused language after the project attracted millions of dollars and they personally raced into six-figure profits.

Suspicious item #2? Influencers sell early keys on a bonding curve that forcibly increases the price of keys — the same mechanism used by BitClout. Introductory prices of keys are ‘bonded’ to a mathematical curve set by a quadratic algorithm that rewards early purchasers, forcing later entrants to pay higher prices.

An up-only bonding curve is an alternative to an automated market maker (AMM). Rather than depositing collateral into a liquidity pool and allowing users to buy tokens from an AMM on any regular DeFi platform, Friend.tech’s bonding curve guarantees that the sales price of keys increase for a prescribed allotment and length of time. Once purchased from the influencer on the bonding curve, the price of keys can fluctuate through secondary, peer-to-peer transactions.

Suspicious item #3? Keys are tradable. One of the hallmarks of a security is its purchasers’ desire to resell it on secondary markets — like exchanges — at advantageous prices. Because keys are Ethereum-based assets on Base, they can be bought and sold with bids and offers.

Suspicious item #4? Many influencers advertised the ability of keyholders to participate in the growth financially. Although the revenue-sharing attributes of keys were never clear — and might not exist, at least formally — many influencers spoke in ways that might lead a reasonable investor to believe that they would share in the future revenue of their influencers’ X profile.

X pays certain influencers a percentage of ad and subscription revenue. Many influencers also operate other social media businesses.

In addition to influencers’ nebulous aspersions to revenue-sharing with their keyholders, keys also directly generate payouts from Base trading fees.

The Howey Test of Friend.tech

As a result, many people have understandably questioned the security of keys. Laura Shin deliberated this with lawyers on her popular podcast, Unchained. Shin hosted J.W. Verret, who teaches forensic accounting and corporate securities and banking law at George Lawson Law School and has represented clients who had cases brought against them by the SEC. Shin also hosted Jason Schwartz, tax partner and co-head of the Digital Assets and Blockchain Practice at Fried Frank.

From the SEC’s perspective, it matters how Friend.tech’s founders and influencers promoted each offering of keys. Specifically, it uses the Howey Test, which says an asset sale counts as an investment contract if it passes four conditions:

1. An investment of money,
2. in a common enterprise,
3. with a reasonable expectation of profit,
4. to be derived from the efforts of others.

Shin, who has colleagues at Unchained who are Friend.tech investors via Dragonfly and other venues, conveniently takes the stance that keys are probably not securities. Verret also speculated on a defense he might present if a Friend.tech member was charged with selling unregistered securities, seemingly making the case that keys might not meet all the conditions of the Howey Test. He referred specifically to the ‘common enterprise’ and ‘derived from the efforts of others’ prongs.

Read more: Friend.Tech hype dies down as transactions and users drop 90%

Social membership or unregistered securities?

Are keys just the equivalent of buying a membership in an exclusive club? Fans might be interested in buying keys because they want a moment’s attention from their favorite celebrity or influencer in a private chat room. These purchasers might not care about making a profit.

Nevertheless, the Howey analysis is a broad, generalized test of the expectations that a “reasonable investor” would have of the offering. Pointing to examples and anecdotes can form part of a legal defense, but the final test is for a generic class of average investors.

Only time will tell whether a class of investors or the SEC decides to press Friend.tech founders or influencers in court. The SEC might sue, although it usually takes at least a year — and sometimes seven years — for commissioners to file a lawsuit.

Some people, such as Shin’s colleagues at Unchained who invested in Friend.tech through vehicles like Dragonfly, believe keys aren’t securities. Others predict legal trouble for Friend.tech promoters.