The Securities and Exchange Commission filed and simultaneously resolved an enforcement proceeding against Munchee Inc., for conducting an initial digital coin offering constituting the unregistered offer or sale of securities. Munchee agreed to cease and desist from its violations to settle this matter. It was not required to pay any fine. The company voluntary returned all funds it had received from token purchasers – US $60,000.
On the same day the SEC issued its Munchee order, SEC Chairman Jay Clayton released a personal statement addressing cryptocurrencies and ICOs (click here to access). Although acknowledging that some cryptocurrencies may not be securities, he cautioned “market participants against promoting or touting the offer and sale of digital coins or tokens without first determining whether securities laws apply to those actions.” Solely labeling a token a utility token or currency is not sufficient, he said. Generally, Mr. Clayton noted, “[t]okens 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.”
Munchee had developed an iPhone application for persons to review restaurants. Beginning in October 2017, it offered and sold digital tokens – known as MUNs – to be issued on a blockchain to raise US $15 million to fund further development of the app. According to the SEC, Munchee claimed in its promotional efforts that MUN tokens would rise in value as a result of the firm’s managerial efforts, and that MUN tokens would be traded on secondary markets. Holders of MUN tokens would not receive any income or dividends from Munchee. Although Munchee described utility benefits of possessing MUNs in promotional materials and other marketing efforts, (e.g., the more MUNs a person held, the more MUNs it would receive for writing restaurant reviews), the principal benefit of holding MUNs was the potential for appreciation of their value through Munchee’s entrepreneurial efforts. As a result, concluded the SEC, MUN tokens were securities and Munchee’s offer and sale of MUN tokens without filing a registration statement with it (absent a bona fide exemption) was illegal.
According to the SEC, “[d]etermining whether a transaction involves a security does not turn on labeling – such as characterizing an ICO as involving a ‘utility token’ – but instead requires an assessment of ‘the economic realities underlying a transaction’.”
In his statement, Mr. Clayton also cautioned broker-dealers and other market participants who authorize their customers to transact in cryptocurrencies to ensure that such activities do not undermine their anti-money laundering and know-your-customer obligations. Mr. Clayton indicated that his statement was his own, and did not reflect the views of any other commissioner or the SEC.
On the same day Mr. Clayton issued his statement, Commodity Futures Trading Commission Chairman J. Christopher Giancarlo issued a parallel statement commending Mr. Clayton’s writing and reminding market participants that, “the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority.” (Click here to access Mr. Giancarlo’s statement.)
UK Regulator Publishes Input on Distributed Ledger Technology and ICO Guidance
The UK Financial Conduct Authority published responses to its April 2017 discussion paper on distributed ledger technology. (Click here for a copy of the FCA’s feedback summary; click here for further background in the article “Financial Conduct Authority Seeks Comments on Proposed Distributed Ledger Technology Regulation” in the April 16, 2017 edition of Bridging the Week.)
Generally, persons responding expressed support for FCA’s “technology-neutral” approach to regulation and welcomed FCA’s “open and proactive approach to new technology,” including its Sandbox and RegTech initiatives. Respondents believed current FCA rules were sufficient to accommodate applications of new technologies, including the use of DLT by regulated entities.
Respondents also agreed with FCA that issues regarding ICOs must be considered on a case-by-case basis. As part of its feedback publication, FCA included a specific annex setting forth regulatory considerations for ICOs, including that digital tokens issued as part of ICOs could be securities, and that persons issuing or selling securities must comply with relevant regulatory requirements.
Legal Weeds: Last July, the SEC published a Report of Investigation concluding that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement.
The SEC’s Report followed an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by Slock.it UG, a German corporation, were securities subject to the SEC’s registration requirements.
(Click here for background in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issue in Accordance With US Securities Laws” in the July 26, 2017 edition of Between Bridges.)
There is nothing in the Munchee order or Mr. Clayton’s statement that is fundamentally inapposite to guidance given in the SEC’s DAO Report. However, these two new writing make it clear that marketing a digital token as a utility token and untethering a token from the earnings of a company are not sufficient to make the token a non-security. A cryptocurrency will still be regarded as a security if its holders purchase the token with the expectation that it will rise in value principally based on the managerial efforts of others.
Indeed, Munchee considered application of the DAO standards to its ICO. (Click here to access the Munchee White Paper – see page 3.) However the firm incorrectly concluded that, since MUN digital tokens were "utility tokens," their issuance in an ICO did not "pose a significant risk of implicating federal securities laws." Unfortunately for Munchee, the SEC considered the substance of the firm's tokens, not their form.
Compliance Weeds: In his statement, Mr. Clayton sounded an ominous warning to advisors in the ICO space. Given that the determination of whether a particular cryptocurrency is a security depends on the facts and circumstances, Mr. Clayton indicated (in bold) that, “[o]n this and other points where the application of expertise and judgment is expected, I believe that the gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities.”
The highlighting of this sentence in bold should not be dismissed lightly. Although a personal statement, Mr. Clayton is clearly indicating that, in connection with each ICO, advisors must assess whether a relevant token is a security. In considering this, advisers must evaluate what would be the principal motivation for someone to purchase the cryptocurrency – is the token to be a medium of exchange like a fiat currency (and thus a virtual currency and not a security)? Is the token inextricably tied to use of the underlying project (and potentially a utility token not subject to securities law requirements)? Or is the token principally a vehicle to profit from the underlying project (and thus, likely a security)?
In analyzing whether a cryptocurrency is a utility token or a security, Mr. Clayton provided two examples: a digital token that represents an interest in a book-of-the-month club and permits holders to receive future publications is likely not a security. However, a digital token is likely a security if it will help fund the development of a publishing house to sign-up authors and publish books with all infrastructure to be developed in the future and the holder expects to realize appreciation in the value of his/her tokens through their resale. According to Mr. Clayton, "[i]t is especially troubling when the promoters of [ICOs] emphasize the secondary market trading potential of these tokens."
This seems like a bright line test. However, the challenge for brokers and traders transacting in cryptocurrencies is determining when cryptocurrencies that might have been born principally as a security begin functioning mostly, if at all, as a virtual currency.