How Many Times Does the SEC Have to Repeat Itself Before the World Listens?
Remember in July of this year when the Securities and Exchange Commission (SEC) said in its Decentralized Autonomous Organization (DAO) Report that "U.S. federal securities laws may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale"? No? Well, apparently no one else did either.
On December 11th, 2017, the SEC instituted Cease and Desist Proceedings against Munchee Inc., in connection with its sale of digital tokens to investors to raise capital for its blockchain-based food review platform. The SEC found that Munchee’s token sale constituted a securities offering and that because Munchee neither filed a registration statement nor qualified for an exemption from registration, Munchee was in violation of U.S. securities laws.
In the July DAO Report, the SEC took the position that: "[w]hether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction." Not surprisingly, five months later, the SEC’s opinion remains unchanged.
Munchee had hoped to raise $15 million in its initial coin offering (ICO), but stopped selling its MUN tokens hours after being contacted by the SEC on the second day of the ICO. Munchee had not delivered any tokens to purchasers, and promptly returned the proceeds (200 Ether or about USD 60,000) that it had received. The SEC decided not to impose a civil penalty on Munchee given that it cooperated with the SEC and immediately stopped the token sale when contacted by the SEC.
So what does this mean for other ICOs? To start, the SEC repeated that it meant what it said in its July DAO Report. "Tokens, coins or other digital assets issued on a blockchain may be securities . . . and if they are securities, issuers and others who offer or sell them in the United States must register the offering and sale with the Commission or qualify for an exemption from registration." More critically, however, is that Munchee provides us with some additional clarity and guidance that goes beyond the SEC’s July DAO Report.
Specifically, token issuers must be extremely attentive to, and in control of, how their tokens are being marketed. A token issuer will also need to carefully consider what type of ongoing role it intends to play in developing its business and supporting the tokens after the ICO. The SEC made clear that it had a problem with the way Munchee’s MUN tokens were being marketed. In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as a result of Munchee’s future efforts. The SEC noted that Munchee both made public statements and endorsed third-party statements touting the opportunity to profit by buying MUN tokens. Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.
The SEC further noted that Munchee explicitly stated in its White Paper that it would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens. As a result of Munchee’s statements and promised future activities, the SEC said that "Munchee primed purchasers’ reasonable expectations of profit through statements on blogs, podcasts, and Facebook that talked about profits."
We believe that a key factor underlying the SEC’s concerns was the fact that, as the SEC noted, "[p]urchasers would reasonably believe they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUN ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials."
Like many token issuers, Munchee maintained that the MUN token was a utility token and not a security. In fact, Munchee went so far as referring to the SEC’s DAO Report in its White Paper, stating that it had conducted a so-called "Howie analysis" and that "as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws." The SEC noted that the White Paper failed to include the actual analysis. This raises an interesting question as to whether the SEC would have deferred to the conclusions contained in the analysis had it been included in the White Paper.
Notwithstanding Munchee’s assertion, the SEC had no trouble determining that the MUN tokens were investment contracts and, accordingly, securities. In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s statements, the SEC was also able to conclude that those profits would arise based on the future efforts of Munchee. The SEC noted that:
The proceeds of the MUN token offering were intended to be used by Munchee to build an "ecosystem" that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit "partners" such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of MUN tokens created by the revised Munchee App and by Munchee’s ability to create an "ecosystem" – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.
The fact that the SEC focused on the ongoing efforts to be played by Munchee raises a potentially troubling question. In most cases, token issuers intend to use at least a portion of the proceeds from their token sales to further develop the token ecosystem and promote future use of the tokens. In order to assure that a token is potentially a “utility” token that escapes being pulled into the investment contract web, must a token issuer refrain from all ongoing development and promotion activities once it has concluded its ICO? We do not believe that to be the case provided that other considerations are also followed.
Had Munchee not marketed and promoted the MUN tokens in a manner that so explicitly focused on the future profit and investment potential of MUN tokens, and instead had focused on how the MUN token would be used in Munchee’s ecosystem and why the token was a critical component to using and accessing the ecosystem, the outcome might have been different. The SEC noted that Munchee advertised the ICO on message boards, social media and other forums aimed at people interested in investing in Bitcoin and other digital assets—that is, investors interested in profits—as opposed to targeting current users of Munchee’s app or “people who, for example, might have wanted MUN tokens to buy advertising or increase their ‘tier’ as a reviewer on the Munchee App.”
The reality is that, in most cases, the developers behind a token being sold in an ICO will likely play some type of ongoing role to support the token and underlying business. In and of itself, this fact is not a fatal one. However, in situations where a token has little or no functionality at the time of its sale, as was the case with Munchee, it certainly increases the presumption that the initial purchasers of the token are passive investors hoping to make a profit as opposed to those desiring to gain access to the products or services that will ultimately be provided through the token’s ecosystem. This is particularly true where, as was the case in Munchee, tokens are being offered in a broad solicitation and where the emphasis is on future upside as opposed to the token’s existing uses and functionality.
Following Munchee, we continue to believe that it is possible (albeit, not easy) to create and distribute a token in the U.S. that falls outside of U.S. federal securities laws. Such a token must be appropriately and properly structured in a manner that is not intended for passive investors but, rather, is intended and, indeed required for, the actual functioning of the token issuer’s product or platform, and where the token is required and necessary for accessing and using the product or platform. Further, consistent with the SEC’s concerns, the primary marketing focus of the token issuer should be towards the potential customers or users of the token issuer’s product or platform. Of course, such a token must also avoid other attributes that could push it into the category of a security.
Concurrently with the Munchee order, SEC Chairman Jay Clayton released a public statement on cryptocurrencies and ICOs that includes additional considerations and insights. The statement was important and useful for two reasons. First, the Chairman recognized the importance of ICOs stating "I believe that initial coin offerings – whether they represent offerings of securities or not – can be effective ways for entrepreneurs and others to raise funding, including for innovative projects." Second, he reminded the market that "replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance."
How are we smarter today than before the announcement? The SEC highlighted that the manner of sale is as critical in the securities law analysis as is the token functionality. Issuers should be especially mindful as to their blog posts and social media footprint. It is clear now that SEC is keeping a close eye on the crypto market. We expect that following Munchee, there will be ongoing efforts by practitioners to share their views with the SEC and encourage the SEC to provide further and ongoing guidance.
We leave you with the following point made by the Chairman in his public statement:
Merely calling a token a "utility" token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.
We could not have said it better ourselves.
 The Howie analysis or Howie test is the four-pronged test used to determine the existence of an investment contract, one of the types of securities covered by U.S. federal securities laws. Pursuant to the Howie test, an investment contract may be found to exist if it includes the following elements: (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profit, (iv) to be derived from the entrepreneurial or managerial efforts of others.