Since the first successful blockchain test case, BitCoin, there have been many attempts to leverage distributed ledger technology. One of the most exciting and controversial of these applications is the Initial Coin Offering (“ICO”). Generally, an ICO, similar to an Initial Public Offering (“IPO”), seeks to raise money from the general public in order to fund a project or business venture. However, unlike IPOs, which have a long history and an extensive regulatory scheme which guide and facilitate the process of raising money from the general public, ICOs operate in a regulatory gray area. Proponents of the concept claim that ICOs are not subject to securities laws because, in lieu of offering traditional equity shares, ICOs purport to offer “Utility Tokens.” However, it is clear that, until the SEC offers guidance to the contrary, companies planning to issue tokens on a blockchain should be extremely wary of structuring any offering in reliance on categorization of such tokens as Utility Tokens. To this end, it is important for companies seeking to leverage this new and exciting technology to seek out experienced legal counsel when raising capital or introducing new products or services.

Background

All securities offered and sold in the United States must be registered with the Securities and Exchange Commission (the “SEC”) or qualify for an exemption. Attempting to avoid the issue altogether, the majority of ICO issuers have taken the position that the interests they are offering are not securities. They have done this by labeling these interests “Utility Tokens.” A Utility Token is a digital token that provides the token’s holder access to the issuer’s product or service. Savvy Utility Token issuers explicitly state that the tokens are not being offered as an investment opportunity but rather merely as a presale of a product or service. The thinking is that holding a token out as a non-security makes it a non-security. This line of reasoning has potentially disastrous implications.

The SEC Enters the FinTec Realm

In 2013 the SEC formed the Digital Currency Working Group (which has since been renamed the Distributed Ledger Technology Working Group) in order to study blockchain. In July 2017 the SEC first asserted its authority to regulate ICOs when it determined that the “DAO” tokens issued by Slock.it were securities within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC stated publically for the first time that ICOs can be securities offerings and therefore be subject to securities laws, holding that “the U.S. federal securities law 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.”¹

The SEC also explained the best test for determining whether or not a token is a security. It held that the correct test is the traditional four-part “investment contract” analysis from the well-known Supreme Court case, SEC v. Howey.² The Court in Howey held that a transaction is an “investment contract” if:

1. it is an investment of money,
2. in a common enterprise,
3. with an expectation of profits from the investment,
4. where those profits are derived primarily from the efforts of others.

While the SEC declined to take action against the DAO issuers even though DAO appeared to be a relatively straightforward case,³ the SEC sent a clear shot across the bow of the blockchain and FinTech communities: Regulation is coming.⁴

Munchee: the Cautionary “Utility Token”

In December 2017, the SEC intervened and stopped the ICO of Munchee, Inc. (“Munchee”).⁵ Munchee was a California-based tech company that created an iPhone application for users to review restaurants and meals, similar to the better-known app and website, Yelp.⁶ Munchee offered and then sold digital tokens (“MUN” or “MUN token”) that were going to be issued on a blockchain. Munchee conducted the offering of MUN tokens to raise approximately $15 million in order to improve the app and to recruit users to buy advertisements, write reviews, sell food, and conduct other transactions using MUN.⁷ In connection with the offering, Munchee described the way in which MUN tokens would increase in value as a result of Munchee’s efforts and stated that MUN tokens would eventually be traded on secondary markets.⁸

The MUN White Paper referenced the DAO Report and stated that Munchee had done a “Howey analysis” and that “as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.”⁹ The MUN White Paper, however, failed to put forth any such analysis.

On the Munchee Website, in the MUN White Paper, and elsewhere, Munchee described the MUN “ecosystem.” Munchee would pay users with MUN tokens for writing food reviews and would sell both advertising to restaurants and “in-app” purchases to app users in exchange for MUN tokens. Munchee said it would work with restaurant owners so that diners could buy food with MUN tokens and restaurant owners could reward app users in MUN tokens. The underlying theory was that, as a result of the growing MUN ecosystem, MUN tokens would increase in value.

Applying Howey, the SEC found that:
[a]mong other characteristics of an “investment contract,” a purchaser of MUN tokens would have had a reasonable expectation of obtaining a future profit based upon Munchee’s efforts, including Munchee revising its app and creating the MUN “ecosystem” using the proceeds from the sale of the MUN tokens.¹⁰

Based on the associated marketing materials, the SEC determined that MUN’s purchasers would have a reasonable expectation of profits from holding or trading MUN, regardless of whether or not they used the tokens or participated in the MUN “ecosystem.” The SEC further noted that Munchee’s marketing did not target existing users of the app and instead promoted the offering “in forums aimed at people interested in investing in Bitcoin and other digital assets.”¹¹

The SEC’s decision to take action against Munchee and the MUN token makes it clear: even if a token has a utility function, it may still be a security.¹²

The SEC’s Refrain: ICOs are Presumptive Securities

SEC Chairman Jay Clayton has made several statements in his personal capacity asserting that most ICO tokens are securities, including his “Statement on Cryptocurrencies and Initial Coin Offerings,” which was released on the same day as the Munchee announcement:

A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed. Said another way, 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.
[…]
[C]ertain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. 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.¹³

Chairman Clayton went on to specifically criticize companies that try to take advantage of the excitement surrounding this emerging technology by “[changing their] name to something like ‘Blockchains-R-Us.’”¹⁴ He then added that, “[w]ith respect to these two scenarios, I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws [. . .].”¹⁵

The Possibility of an Evolutionary Status

Despite the preceding analysis and the ultimate conclusion below, there is some basis for hope that the SEC remains open to the possibility of a genuine, non-security Utility Token. In response to Congressional questioning, Director William Hinman, of the Division of Corporation Finance, outlined the following criteria for a Utility Token:

We certainly can imagine a token where the holder is buying for its utility and not an investment, and in those cases, especially if it’s a decentralized network in which it’s used and there are no central actors who have information asymmetries or where they would know more than token investors.¹⁶

While Director Hinman seems to accept the theoretical possibility of true Utility Tokens, he went on to say that: “[i]t’s quite hard to have an initial sale without having a securities offering, which is why the Chairman [Jay Clayton] has noted that the initial sale of these may require compliance or exemption.”

Conclusion

It is clear that, until the SEC offers guidance to the contrary, companies planning to issue tokens on a blockchain should be extremely wary of structuring any offering in reliance on categorization of such tokens as Utility Tokens. To this end, it is important for companies seeking to leverage this new and exciting technology to seek out experienced legal counsel when raising capital or introducing new products or services.

 

¹Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81, 207 (July 25, 2017).
²SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
³The DAO tokens closely resembled equity shares in a company and presented a rather cut-and-dry example of ICOs-as-securities. Supra Note 1.
⁴Between DAO and Munchee, Inc., SEC actions focused primarily on fraudulent ICOs, including charging Maksim Zaslavskiy and his companies, REcoin Group Foundation and DRC World, with fraud.
⁵Press Release 2017-227, U.S. Sec. & Exch. Comm’n, SEC Emergency Action Halts ICO Scam (Dec. 4, 2017).
⁶“Armed with complaints about restaurant review platforms and observing consumer trends toward visual user experiences, Munchee launched a simple mobile app for restaurant reviews that centered around food photography. The UX would discourage what they called low-quality reviews that addressed non-food factors and false reviews (as it’s much harder to fake a review if you have to produce a photo).” Chapin, Andrew J., What Went Wrong with the Munchee ICO, TheStartup (April 11, 2018), available here. Munchee began developing the app in late 2015 and launched the app in the second quarter of 2017. Munchee and its agents controlled the content on multiple web pages, including its website, an additional site where it posted Munchee’s “white paper,” a Twitter account, a Facebook page, and posts on various message boards. Order Instituting Cease and Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933, Making Findings, and Imposing a Cease-and-Desist Order, In Re Munchee, Inc., Securities Act Release No. 10,445 (Dec. 11, 2017), available here.
⁷Supra. In Re Munchee, Inc. at 3, 4.
⁸Id.
⁹Id.
¹⁰Id. at 4.
¹¹Id.
¹²Id. Specifically, the SEC indicated that creating a robust secondary market for a token could lead the SEC to classify a token that might otherwise be considered a Utility Token as a security. The SEC also pointed to the “hype machinery” that is used in conjunction with ICOs – specifically that the “manner of sale” can create the expectation of profit.
¹³Public Statement U.S. Sec. & Exch. Comm’n, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), available here.
¹⁴Opening Remarks at the Securities Regulation Institute (Jan. 22, 2018), available here.
¹⁵Clayton Opening Remarks, supra Note 13.
¹⁶Aaron Stanley, SEC Official Offers New Hope for Utility Tokens in Congressional Testimony, Forbes (April 28, 2018), available here.