On February 14, 2019, Judge Gonzalo P. Curiel of the United States District Court for the Southern District of California reversed his November 2018 decision and granted a motion for preliminary injunction filed by the Securities and Exchange Commission (“SEC”) seeking to halt a planned initial coin offering (“ICO”) by a San Diego based company (the “Company”) and its owner in December 2018. SEC v. Blockvest, LLC, et al., No. 3:18-cv-02287 (S.D. Cal. Feb 14. 2019) (the “Order”). Judge Curiel held that the Company’s digital tokens, which were allegedly offered as part of a fraudulent ICO, met the definition of a “security” followed by courts since the Supreme Court’s decision in SEC v. W.J. Howey Co. This shift in outcome from the Court’s November 2018 decision highlights the fact-specific nature of the inquiry used by courts to determine whether a given distribution of crypto assets constitutes an offer of a security.
On October 3, 2018, the SEC filed a complaint against the Company and its owner, charging both with violations of securities registration and anti-fraud provisions under various provisions of the Securities Act of 1933 and Securities Exchange Act of 1934. Judge Curiel granted the SEC’s motion for a temporary restraining order against the Company. SEC v. Blockvest, LLC, et al., No. 3:18-cv-02287 (S.D. Cal Oct. 5, 2018); see also Shearman & Sterling LLP, SEC Obtains Temporary Restraining Order Halting Initial Coin Offering, Need-to-Know Litigation Weekly (October 16, 2018). The SEC subsequently filed a motion for preliminary injunction to halt the ICO, but at an evidentiary hearing on that motion, defendants introduced evidence which, in the Court’s view, raised a disputed issue of fact which undercut the SEC’s argument that the Company had offered “securities” as defined by federal securities laws. Specifically, the SEC’s position was centered on a theory that the Company had offered securities to thirty-two test investors and seventeen individual investors. The Company, however, introduced evidence suggesting that the pre-sale tokens were actually “test tokens” that were never sold publicly, and that seventeen institutional investors had simply made personal loans to owners of the company. Accordingly, the Court declined to issue a preliminary injunction in November 2018 based on the disputed issues of fact. See Shearman & Sterling LLP, SEC Loses Bid For Preliminary Injunction Halting Initial Coin Offering After Judge Questions Whether It Involved Securities, Need-to-Know Litigation Weekly (December 5, 2018).
In its February 14 decision, the Court denied the SEC’s motion for reconsideration to the extent that it was based on offers or promises to the thirty-two test investors and seventeen individual investors, for the reasons articulated in its original opinion. The Court went on to note, however, that the SEC had also provided an alternative theory that promotional materials posted on the Company’s website, social media account posts relating to the ICO, and a whitepaper posted online constituted an “offer” of securities, and based on supplemental briefing on the issue, the Court concluded that the Company had made an offer of unregistered securities in violation of Section 17(a) of the Securities Act of 1933.
The Court employed the U.S. Supreme Court’s Howey test, which instructs that securities are defined by “(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The Court found that the Company’s website and whitepaper constituted an invitation to potential investors to provide currency in exchange for tokens, which satisfied the first prong of the Howey test. Next, the Court found that the Company’s website promoted a “common enterprise” because it claimed that funds raised would be pooled together and profits would be shared. Finally, the Company’s website and whitepaper claimed that the investors would be “passive investors” and that the tokens would generate “passive income,” which satisfied the third prong of the Howey test. As such, the Court concluded that the SEC had presented a prima facie showing of a previous violation of Section 17(a), and therefore granted its motion for preliminary injunction of the Company’s ICO.
Judge Curiel’s conclusion that the Company’s website and whitepaper constituted an offer of a security contrasted with his ruling in November 2018 that certain test-tokens provided to thirty-two individuals did not constitute an offer of a security, but was based on the specific nature of the test-tokens as compared to the planned ICO tokens. It also bolsters the growing consensus that most ICOs will be regulated under federal securities laws, and is another win for the SEC’s position that cryptocurrencies fall within the definition of “securities.” See Shearman & Sterling LLP, Significant Judicial And Enforcement Developments In The Cryptocurrency Space, Need-to-Know Litigation Weekly (September 18, 2018); Shearman & Sterling LLP, Criminal And Civil Charges Filed In Connection With Initial Coin Offering By Centra Tech, Need-to-Know Litigation Weekly (April 10, 2018).