GUEST BLOG: Inversions by Aegis Frumento Esq

April 11, 2019


by Aegis J. Frumento, Partner, Stern Tannenbaum & Bell

We entered World War I desperately needing pilots. In 1917 the Army ordered over 5,000 Curtiss JN-4 biplanes, affectionately called the "Jenny," to mass-train a generation of flyboys. The Army let the Post Office have a few of them -- both planes and pilots -- and on May 15, 1918, scheduled airmail service began between Washington and New York.

Airmail soon became irresistible, and the Post Office had to hire private flyers to meet the demand. At about the same time, in November 1918, the War ended sooner than expected. The Army dumped thousands of surplus Jennies on the market, where you could buy one for $300. Newly-trained but out-of-work pilots took them barnstorming across the still-rural country. Some of them also carried mail, and those early mail carriers eventually became the airline industry.

On May 14, 1918, the Post Office commemorated the next-day's launch of its airmail service by issuing a 24-cent postage stamp showing a Jenny. That morning, William Robey bought a sheet of 100 stamps for $24. Robey, a stamp collector, saw at once that all the Jennies on his sheet were flying upside down.

Robey took his stamps and left as fast as he could. Postal inspectors soon discovered the error and recovered all misprinted sheets, except Robey's. He owned the only so-called "Inverted Jennies" that ever made it into private hands. He sold the sheet for $15,000 (about $250,000 today), quickly recouping his $24 investment 625 times over.

Over the century, all but two from Robey's original sheet had been accounted for. Some of them were cruelly abused; one was sucked through a vacuum cleaner. But last September, one of the two long-missing examples showed up in a bank deposit box, where it had lain undisturbed for almost 100 years. It was in pristine condition. In November it sold at auction for $1.6 million.

All of which is to say, strange things happen when we put stuff into the world. Something created for one purpose can easily end up in a wholly different one. The Jenny started out as a military trainer, became war surplus junk, then an airmail carrier from which sprang the aviation industry, and is now a treasured museum piece when not highlighting an old-time airshow. A 24-cent postage stamp intended to be stuck to a letter so it could be flown from Washington to New York morphed, through a printer's error and the passage of time, to fly into the stratosphere as one of that strange asset class called "collectibles." Today, one Inverted Jenny can buy you a fleet of small airplanes.

But Jennies, real or inverted, are still things. Humans tend to adapt things to fill needs, and needs change like the weather. Things so rigidly designed they cannot easily be adapted to other purposes -- French chateau-styled McMansions come to mind -- are doomed to obsolescence when need and taste inevitably swing away from them. To be timeless is to be protean.

I often wonder about the timelessness of new things, all so strictly designed for their one and only intended purpose. Whatever I had stored on floppy disks is now lost to me. No one sends -- much less saves -- intimate letters anymore, though I suppose sexts do live on forever somewhere. And what can you do with last year's smartphone other than use it as a coaster?

This reverie envelopes finance as much anything. As we've discussed in the past, the new thing de jour is whatever results from blockchain ledger transactions. A transaction recorded on a blockchain irrevocably empowers the holder of a private cryptokey to transfer to the holder of another key the ability to transfer to someone else some specific quantity of whatever the blockchain is keeping track of. That transferred "thing" is technically an "unspent transaction output," but we commonly call it a "coin," because coins are physical things and our brains aren't equipped to understand non-physical things like "unspent transaction outputs."

A cryptocoin can represent anything that can be counted, which is about as protean as it gets. Last year the SEC issued its report on The DAO demonstrating that when a cryptocoin represents a passive interest in the economic fortunes of an entity, then it is a "security" under the federal securities laws. The SEC also concluded that bitcoins and ether had achieved the status of "currency," because people primarily used them as media of exchange. If a cryptocoin represents a thing you can use in the real world -- like gold or barley -- or if you trade it using futures contracts and options, then it can be deemed a "commodity." Chairman Jay Clayton also mused that over time a cryptocoin could evolve from one thing to another as its real-world use changed. A cryptocoin that today is a security could become a currency tomorrow, and I suppose vice versa.

We now have some insight into yet another category of cryptocoin -- the "token." In the simplest terms, a token is a stand-in for cash, designed to be more useful for its purpose than cash would be. Many of us still remember subway tokens, bought for cash and used as cash, but more easily digested by old turnstiles than dimes and quarters, especially when dimes and quarters were no longer enough to pay for a ride. Postage stamps are tokens. You buy them for cash and you use them to pay for mail services instead of taping coins or dollar bills to your envelope. Inverted Jennies started out as tokens, before they became something else entirely.

A token, by anyone's definition, is not a security, but it took an SEC no-action letter to assure us. Turnkey Jet (TKJ) leases private business jets. It decided to set up a private blockchain and issue tokens to its members in order maximize the efficiency of its operations.\TKJ's members include end-users, jet brokers, and other air transport companies. Each TKJ token is worth a dollar, and TKJ says it will always be worth a dollar, even if the cost of air travel increases. Once purchased, they are refundable only at a discount. Members can use the tokens only to pay for air charter services, not to invest in TKJ. The tokens can be transferred, but only to other TKJ members. TKJ will market the tokens only as a way to pay for air services, and not as an investment opportunity.

Given all those caveats, the SEC had no trouble allowing TKJ to issue its tokens without registering under the securities act. so we now have two points of reference from the SEC. On the one end, The DOA report, augmented by public statements and enforcement actions against ICOs, clearly delineates when a cryptocoin is a security. Now, on the other extreme, we know what attributes a coin must have to be a token, not a security. Those are useful signal beacons, but there is still a lot of uncharted territory in between.

The TKJ token avoids being a security because its smart contracts are designed to freeze its attributes for all time. The TKJ token is programmed to ensure that it can only be used to purchase air charter services, that its value is fixed at one dollar, and that it can only be transferred to another TKJ member. That seems enough to ensure it can never be a security.

But "never" is a long time. Don't underestimate the ability of humans to become entranced by an oddity. One can well imagine that those bitcoins that can be traced directly back to the original 50 that Satoshi Nakamoto mined in the Bitcoin genesis block a decade ago might someday be considered rarer than an Inverted Jenny. It is possible, though I can't say how, that even a straitjacketed TKJ token could in time suffer an air-change into something rich and strange.

In the meantime, to ground us (so to speak), here's how it feels to fly a real Jenny, right-side-up.

Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.