On December 11, 2017, Munchee Inc., a California-based developer of a restaurant app, shut down its initial coin offering (“ICO”) after the Securities and Exchange Commission (“SEC”) issued a Cease and Desist order. SEC Chairman Jay Clayton subsequently issued a statement highlighting the SEC’s general concerns with cryptocurrencies and ICOs. The order and Chairman Clayton’s statement shed new light on whether a token issued in the context of an ICO is a security.

Munchee ICO

Munchee wanted to raise US$15 million to fund the growth of its restaurant review app by selling MUN tokens to investors. In October 2017, the company published a white paper describing its plan to issue MUN tokens and how they would be used to develop the app. Investors could purchase tokens using Bitcoin or Ether during the token sale. Munchee estimated that 75% of the ICO proceeds would be used to hire employees, 15% would be used for app maintenance and 10% would be used for legal fees.

Munchee marketed MUN tokens as being “utility tokens” only. Once Munchee had built out its ecosystem, tokenholders could receive MUN tokens for writing restaurant reviews and advertise on the app by paying in tokens. Munchee;s marketing appeared to be consistent with the Simple Agreement for Future Tokens (SAFT) framework, under which “functional utility tokens” are more likely to pass the Howey test and not be considered securities.

However, the SEC issued a Cease and Desist order to prevent the Munchee token sale before tokens were delivered to investors. The SEC investigation concluded that contrary to Munchee’s representations, MUN tokens were in fact securities. The SEC’s reasoning highlights three areas of analysis applicable to ICOs:

  • The SEC’s analysis of whether a token is a security will follow the case law using a “flexible rather than a static” approach. Simply labelling something a utility token is not enough to definitively ensure that securities laws do not apply.
  • The SEC keyed in on Munchee’s emphasis in its white paper that the MUN tokens could rise in value and be traded on a secondary market. These representations suggested that investors would purchase the tokens with an expectation of profits. Significantly, Munchee’s token offering documents were translated into additional languages which enabled the company to reach investors in areas the app was not even available.
  • Munchee’s plan to create a MUN token ecosystem suggested to the SEC that investors were heavily dependent on the efforts of Munchee’s founders and staff for the tokens they purchased to increase in value. This meets an important Howey test prong for determining whether the tokens were an investment contract (that is, investors could expect profits from the efforts of the promoters) and therefore securities.

SEC Staff concluded that Munchee’s public token distribution violated federal securities laws. However, Munchee was able to escape further sanction by cooperating with SEC Staff and promptly returning money to investors who purchased tokens.

SEC Chairman’s Statement

The SEC Chairman’s statement on cryptocurrencies and ICOs demonstrates that SEC Staff are closely monitoring ICOs. The SEC Chairman’s statement is particularly concerned with the protection of “Main Street” investors. Potential investors are encouraged to ask questions about the token issuer, the uses of the funds, whether there are financial statements or other disclosure, whether the offering has been structured to be compliant with securities law, and what legal rights they will have in the event an ICO goes wrong. They are also reminded about the risks posed by cross-border ICOs as it may be difficult to recover funds which have been moved to a different jurisdiction with a different regulator.

The SEC is also concerned with how market professionals such as lawyers, consultants and broker dealers act in the cryptocurrency space. The SEC Chairman’s statement encourages these professionals to familiarize themselves with the SEC’s investigative report into ICOs as well as subsequent enforcement actions taken by the SEC. In the view of the Chairman, “by and large, the structures of initial coin offerings… involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.” Industry professionals should keep this in mind when advising on ICOs or token sales.

Lessons

The SEC’s cease and desist order regarding the Munchee ICO and statement by SEC Chairman Clayton show that the SEC is highly attuned to the risks posed by ICOs. Canadian regulators are also closely monitoring developments in the ICO space, as discussed in our earlier posts regarding the applicability of Canadian securities laws to cryptocurrencies and the Ontario Securities Commission’s approval of the first ICO in Ontario.

More often than not, conducting an ICO will engage securities legislation. In Canada, a security includes an “investment contract”. In determining whether a coin/token is an investment contract, a four-prong test is applied, being does the coin/token involve: (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profit (iv) to come significantly from the efforts of others. Advertisement of a coin or token as a software product or utility token is not relevant in determining whether a coin or token constitutes a “security”.