On December 11, 2017, the Securities and Exchange Commission announced cease-and-desist proceedings against Munchee Inc., a software application developer and issuer of digital tokens in an initial coin offering (generally referred to as an ICO). After being contacted by the SEC staff, Munchee stopped the offering and refunded investors that had participated in the offering. The cease-and-desist order is available here.
The proceedings—based exclusively on the securities registration provisions of the Securities Act of 1933 (the “Securities Act”)—are notable because prior SEC enforcement efforts, targeting cryptocurrencies and digital tokens, had focused on curtailing alleged or potential fraud or tokens with equity-like attributes (such as the recent investigative report involving tokens offered by a virtual organization known as “The DAO”). Our recent client alert on previous SEC and related litigation activity, including the DAO investigation, is available here.
The Munchee proceedings expand the SEC’s demonstrated areas of focus beyond digital tokens that reflect obvious equity-like attributes. The settlement demonstrates that the SEC staff is scrutinizing the marketing efforts of and statements made by issuers in ICOs, as well as the promise of profits from the potential appreciation in the value of its digital tokens. In the SEC’s view, the promise of utility and the absence of explicit equity-like characteristics were not sufficient to overcome the investment contract test outlined in the seminal case SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Munchee consented to the SEC’s cease-and-desist order without admitting or denying the findings, and no other remedies were imposed. The SEC staff explained that the absence of a civil penalty reflects that Munchee “stopped the ICO quickly, immediately returned the proceeds before issuing tokens, and cooperated with the investigation.”
In the DAO report, the SEC explicitly stated that “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.” The Munchee order reflects additional clarification of the SEC’s current view with respect to the type of facts and circumstances that may result in a digital token or other cryptocurrency being deemed a security. In particular, the SEC noted that the existence of a legitimate, non-investment utility of the tokens was not sufficient to avoid classification as an investment contract (the Munchee token permitted users and restaurants to use the tokens to buy food, purchase advertisements, or make other in-app purchases). Indeed, the “economic realities underlying a transaction” should be assessed, because an investment contract under Howey is a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299.
The SEC order describes the following facts and circumstances in concluding that the offer and sale of MUN tokens constituted a violation of Sections 5(a) and 5(c) of the Securities Act:
- Public Solicitation Efforts – Munchee offered MUN tokens to the general public, posting information about the tokens on Munchee Web Pages, including on a blog, Facebook, Twitter, and BitcoinTalk. In our view, the SEC considered the facts and circumstances surrounding Munchee’s marketing activities when evaluating both (i) whether the token constituted a security, and (ii) whether the offer constituted a general solicitation.
- Statements Regarding Appreciation in Value – In its White Paper describing the MUN tokens, Munchee described ways in which MUN tokens would appreciate in value, the creation of secondary markets for MUN trading, and how Munchee would use the proceeds of the ICO to develop its business and its application.
- Discount Structure – Munchee offered discounts of 15% and 10% on the offering price to early purchasers of the token.
- Absence of Disclosed Securities Law Analysis – Though Munchee asserted in its White Paper that it had performed a Howey analysis and had concluded that there was no significant risk of implicating the federal securities laws, the analysis itself was not included in that paper. In our view, the absence of such a discussion was more of an atmospheric or optics issue for the SEC, rather than a strictly technical interpretation of facts relevant to the Howey test.
- Absence of Current Utility – While MUN tokens would theoretically reflect some utility in the proposed “ecosystem” for earning and using the tokens, no investor could use the tokens immediately after purchasing them, as the features had not yet been developed.
- Statements Relating to Appreciation through Increased Adoption Rates – The MUN offering included statements that discussed potential price appreciation of the tokens over time, because the proposed MUN “ecosystem” would include opportunities for earning tokens (users could write reviews to earn MUN) and spending tokens (restaurants could exchange MUN for advertisements, and users could buy food or make in-app purchases), creating value for the token as more users and restaurants adopted the platform.
- Statements Relating to Appreciation through Scarcity – Munchee also created a finite quantity of MUN tokens and proposed “burning” or retiring MUN tokens after their use, creating artificial scarcity to increase the price of the tokens.
- Link Between Token’s Appreciation and Managerial efforts of Munchee – The appreciation of the token’s price depended, in part, on the managerial efforts of those at Munchee, who highlighted the credentials, abilities, and management skills of its agents and employees.
- Endorsement of Third Parties – In addition to its own marketing efforts, Munchee posted links to third-party endorsers of MUN, including a YouTube video discussing the pre-sale of MUN tokens. Like the first point above, in our view the inclusion of third-party endorsements was relevant to both the SEC’s application of the Howey test and the question of whether a general solicitation occurred.
- Targeted Investor Base – Munchee and its agents targeted people with an interest in cryptocurrencies and ICOs, rather than those directly involved in the restaurant industry. Munchee promoted MUN on forums like BitcoinTalk.org, which are accessible worldwide, even though the Munchee application was only available in the U.S.
The SEC did not clarify whether any of these factors were dispositive individually or collectively and did not provide any guidance with respect to weighting the individual facts as part of their decision. But the breadth of the relevant factors is significant. Accordingly, digital token and cryptocurrency issuers should pay careful attention to not only the structure of their token, but also to their marketing efforts to mitigate the risk that the SEC will deem the offering to involve the sale of a security.