Digital token issuers caught up in the onslaught of U.S. Securities and Exchange Commission investigations finally received some encouraging news regarding their token sales’ exposure to federal securities laws. On Tuesday, November 27, Judge Gonzalo Curiel of the Southern District of California issued the first opinion rebuffing the SEC under the Howey test. In denying the SEC’s motion for a preliminary injunction — after initially granting a temporary restraining order — the court held that the commission had not provided enough information to deem Blockvest’s token a security. The decision is a narrow one, based mainly on the parties’ differing factual accounts of what information the limited number of token purchasers relied upon. But it reminds token issuers and exchange operators that they can successfully push back against regulatory agencies in court.
Blockvest developed a token it called BLV for testing its not-yet-operational cryptocurrency exchange platform. It expected to issue tokens in three tranches: a private sale; a presale; and a $100 million public ICO to launch December 1, 2018. According to Blockvest, it only issued BLV tokens to a small set of “test investors,” and never sold or used BLV outside the Blockvest platform. The company alleged that the test investors were accredited, well-informed and sophisticated, and that the goal was to develop separate, functional utility tokens for the actual offering. Apparently, the company also made no money from the sale of BLVs. The SEC disagreed but was unable to offer sufficient evidence to convince the court that a preliminary injunction should issue.
In October, the SEC brought a lawsuit against Blockvest and its owner/operator for securities fraud under the Exchange and Securities Act and for selling unregistered securities. Judge Curiel granted the SEC’s request for a temporary restraining order on October 5, based on the SEC’s version of the facts. The complaint alleged that Blockvest fraudulently advertised its planned ICO as having the blessing of the SEC, the Commodities Futures Trading Commission, the National Futures Association and a fictitious regulatory body it fashioned as the “Blockchain Exchange Commission.” Blockvest admitted that “mistakes were made” and did not attack those claims.
However, the company did engage the SEC on its classification of BLV tokens as securities, arguing they do not meet the prevailing three-part test set forth in the 1946 case SEC v. W.J. Howey Co. To qualify as an “investment contract — and thus a “security,” subject to registration rules — Howey requires that an asset sale involve (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits produced by the efforts of others. The court agreed with Blockvest that SEC had not proven that prongs (1) and (3) were met. The court did not address the “common enterprise” prong in any detail.
Investment of Money
Analysis on this prong is usually perfunctory, as it is almost always satisfied where an exchange of value for tokens took place. The Blockvest opinion, however, frames the question not in terms of the purchaser’s intent when committing funds, but according to what the purchasers were offered and thus relied upon — i.e., what Blockvest communicated to the carefully vetted, informed, sophisticated test investors that contributed to the campaign. The court ultimately based its order on the SEC’s failure to meet its evidentiary burden. But the opinion suggests that the focus of the “investment of money” analysis is on something token issuers can control: their advertising.
Expectation of Profits
This prong is often the focus of a Howey analysis. But here, again, the court held that because the factual accounts differed so drastically, it could not conclude that BLVs were securities without proper discovery.
Since 2017, the SEC and other regulatory agencies have taken a targeted interest in blockchain and other distributed ledger technologies. The commission expanded its enforcement activities in 2017 from clearly fraudulent investment schemes to apparently legitimate issuers of utility tokens and, most recently, secondary markets for these virtual assets. That trend continued in 2018. In its annual report, issued earlier this month, the SEC’s Division of Enforcement reported over a dozen stand-alone enforcement actions in the distributed ledger space. And while the Director of Corporate Finance William Hinman’s June 14 comments suggest the hypothetical possibility of a non-security utility token, the commission clearly still sees enforcement actions and resulting settlement as a “path to compliance” with federal securities laws for token issuers.
Unique facts and lack of substantive analysis on the Howey prongs probably make this a narrow opinion. But it is encouraging for a few reasons. First, the decision acknowledges that tokens may entitle the holder(s) to certain property or other rights, potentially indicating an acceptance of tokens as consumable commodities instead of securities. Second, it provides a well-supported argument that the “investment of money” prong may be analyzed based on the issuer’s statements and advertising, not the subjective intent of a purchaser to receive financial gain. And third, it serves as a reminder that courts can and will hold the SEC to its burden of proof, instead of accepting outright the SEC Enforcement Division’s allegations that a token is a security.