- U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton weighed in on cryptocurrencies and initial coin offerings (ICOs) in a major statement.
- Chairman Clayton explained that, while not all tokens may be securities under the federal securities laws, simply calling a token something else does not bring an offering outside the SEC’s purview.
- “Key hallmarks” of tokens being securities include, in the SEC’s view, when an issuer:
- emphasizes the possibility for tokens to appreciate in value or
- encourages a secondary market for tokens.
- Chairman Clayton’s statement, along with recent SEC efforts to stop certain ICOs, indicate that increased enforcement activity in this area is likely in 2018.
On December 11, 2017, SEC Chairman Clayton issued an important public statement outlining his views on cryptocurrencies and ICOs. In his statement, Chairman Clayton provided a clearer view of the SEC’s stance and offered the industry much awaited guidance on what, in the SEC’s view, constitutes a security in the context of rapidly evolving digital assets. Chairman Clayton’s remarks put the cryptocurrency and ICO community on notice that there will likely be further SEC enforcement activity in this area.
The year 2017 has seen increased focus on cryptocurrencies and ICOs from the SEC.1 On July 25, 2017, the SEC issued an investigative report (The DAO Report) concluding that a digital token, which was issued by The DAO as part of an ICO to raise capital for innovative projects, was a “security” within the meaning of the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 based on the application of existing securities law principles.2 Most recently, the SEC shut down ICOs by each of PlexCorps and Munchee Inc. (Munchee). On December 1, 2017, the SEC filed a complaint seeking a temporary restraining order and preliminary injunction to halt PlexCorps’ ICO, alleging that PlexCorps had promised purchasers “outlandish rewards” in connection with its offering of PlexCoin tokens.3 On December 11, 2017, the SEC issued a cease-and-desist order (Order) against Munchee to halt its ICO, as discussed in more detail below.4
Statement of SEC Chairman Clayton Puts Cryptocurrency and ICO Community on Notice
In his statement, Chairman Clayton noted that “concerns have been raised regarding the cryptocurrency and ICO markets.”5 While he acknowledged ICOs’ potential to be “effective ways for entrepreneurs and others to raise funding,” he also urged ICO investors to “exercise extreme caution and be aware of the risk that [their] investment may be lost.”6 Chairman Clayton’s remarks are consistent with the 2018 priorities outlined by the SEC’s Division of Enforcement (Division), which include a focus by the Division’s new Cyber Unit on the misuse of distributed ledger technology and ICOs.7
For “Main Street” investors, Chairman Clayton provided a list of questions that potential investors should ask before participating in an ICO. He cautioned investors that, “as they are currently operating, there is substantially less investor protection [in the cryptocurrency and ICO markets] than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.” He also wanted investors to know that, to date, there have been no ICOs registered with the SEC, and that the SEC has not approved any exchange-traded products holding cryptocurrencies or other related assets. While his statement warned of fraud and manipulation in the ICO markets, Chairman Clayton did acknowledge the benefits that cryptocurrencies and ICOs can provide for improving efficiencies and funding entrepreneurial ventures.
As for “market professionals,” Chairman Clayton indicated that securities lawyers, accountants and consultants need to take responsibility for analyzing whether a particular cryptocurrency or ICO token is a security. Simply calling a security something else does not in itself settle the question. Chairman Clayton focused on the importance of applying the SEC’s guidance, particularly as set forth in The DAO Report, to conduct a careful analysis of whether a cryptocurrency is a security. He explained that the determination of whether an instrument is a security must be based on the relevant facts and circumstances. The primary analysis is the Howey test, as set forth in SEC v. W.J. Howey Co.8 Throughout his remarks, Chairman Clayton referenced factors of the “Howey test,” which the SEC applied in The DAO Report and in the Order against Munchee to determine whether a security existed. The Howey test considers four factors:
- Whether there is an investment of money;
- Whether there is a common enterprise;
- Whether investors have a reasonable expectation of profit; and
- Whether profits are derived from the managerial efforts of others.
Chairman Clayton stated that “key hallmarks” of a security and of a securities offering are whether “[p]rospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others.” He cautioned issuers that simply changing the name of a cryptocurrency or the structure of an ICO would not bring an offering of securities outside the purview of the securities laws. His remarks emphasized that “calling something a ‘currency’ or a currency-based product does not mean that it is not a security” and, as in the Order against Munchee (discussed below), he made clear that “[m]erely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” Rather, the importance actually lies in the features of the cryptocurrency or ICO token and how it is presented to investors. Although Chairman Clayton conceded that not all tokens are securities under the federal securities laws (referring to a hypothetical token for a participation interest in a “book‑of‑the‑month club” as one such example), he observed: “By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.” Chairman Clayton indicated that issuers and promoters of cryptocurrencies must either (1) be able to demonstrate that the instrument is not a security or (2) be prepared to comply with applicable securities laws regarding registration, disclosure and other requirements.
SEC Orders Munchee to Cease and Desist from its ICO
In issuing the Order against Munchee on December 11, 2017, the SEC gave effect to, and put an exclamation point on, the principles set forth in Chairman Clayton’s statement. Munchee is a San Francisco-based company that operates an iPhone app where users can share reviews and photos of restaurants. According to the Order, Munchee sought to raise approximately $15 million by selling “MUN tokens” and, with this capital, Munchee intended to improve its app and to create an “ecosystem” in which MUN tokens would be used for, among other things, compensating diners for writing reviews and having restaurants pay for advertising on the app. The Order indicates that Munchee first issued MUN tokens on or about October 31, 2017, and shut down its ICO “within hours” of being contacted by the SEC staff.
In determining that MUN tokens were “investment contracts” and, therefore, securities pursuant to Section 2(a)(1) of the Securities Act, the SEC followed the Howey test, as applied in The DAO Report and as encouraged by Chairman Clayton in his remarks. According to the Order, Munchee stated in a whitepaper that the company also conducted a “Howey analysis” and had determined that “as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.” The SEC disagreed with Munchee’s determination and found that Munchee had violated Sections 5(a) and 5(c) of the Securities Act by offering MUN tokens without an effective registration statement or a qualifying exemption from registration.9
Investment of Money
According to the Order, at the time of the Munchee ICO, 4,500 MUN tokens were equivalent to 1 Ether (approximately $300) or one-twentieth of a Bitcoin (approximately $325), and approximately 40 people participated in the ICO, paying 200 Ether (approximately $60,000) in the aggregate. For purposes of the Howey test, these amounts of cryptocurrency can be deemed to be an “investment of money.”10
The concept of a common enterprise is subject to some debate and different commenters and courts champion different approaches.
Although it remains a key component of the Howey test, the Order, as with The DAO Report, omits this leg of the test. This leaves open the possibility that a token or other digital asset could be structured in a way that is not a common enterprise.
Reasonable Expectation of Profit
The Order references an October 30, 2017 blog post by Munchee entitled “7 Reasons You Need To Join The Munchee Token Generation Event,” reason 4 of which claimed that “[a]s more users get on the platform, the more valuable [users’] MUN tokens will become,” and that token holders can “watch their value increase over time.” The SEC also cited in the Order various statements made or endorsed by Munchee, which tout “gains” on MUN tokens after the ICO and the opportunity for a secondary market in which MUN tokens would be “available on a number of exchanges in varying jurisdictions.” For these and other reasons, the SEC concluded that “[p]urchasers had a reasonable expectation that they would obtain a future profit from buying MUN tokens if Munchee were successful in its entrepreneurial and managerial efforts to develop its business.” This analysis echoes Chairman Clayton’s statement that selling purchasers on the potential for tokens to appreciate in value and to be traded on a secondary market is one of the “key hallmarks of a security and a securities offering.”
Derived from the Managerial Efforts of Others
The SEC also concluded that investors would reasonably expect the efforts of Munchee and its agents to play an important role in increasing the value of MUN tokens. The Order indicates that Munchee described in a whitepaper how the $15 million would be used to develop and support the Munchee enterprise, namely by spending the offering proceeds on hiring, legal costs, app development and maintenance of the MUN token ecosystem. The Order also notes that “Munchee highlighted the credentials, abilities and management skills of its agents and employees” in Munchee’s whitepaper and elsewhere. Similarly, Chairman Clayton’s remarks confirmed that the SEC views issuers’ claims that tokens will increase in value “based on the efforts of others” as another “key hallmark” of a security.
The SEC emphasized that the court in Howey stated that the Howey test 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.” In keeping with Chairman Clayton’s statements, the SEC indicated in the Order that it would not be persuaded by an argument that virtual tokens carrying some sort of “utility” would not be deemed a security, stating that “[e]ven if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.” The SEC cited United Housing Foundation, Inc. v. Forman11 for this proposition, explaining that “whether a transaction involves a security does not turn on labelling – such as characterizing an ICO as involving a ‘utility token.’”
Munchee agreed to the Order without admitting or denying the SEC’s findings.
Cryptocurrencies and ICOs will be an important part of the SEC’s agenda in 2018. Issuers can expect to see continued scrutiny of ICOs from regulators, and should therefore be mindful of whether their virtual currencies or tokens may constitute securities under the federal securities laws. While the SEC concedes that some utility tokens are potentially not securities, issuers of utility tokens should pay particular attention to whether, in structuring the tokens’ features and offering, issuers (1) are emphasizing the possibility that the tokens will increase in value or (2) are encouraging a secondary market for the tokens. These key points, which Chairman Clayton emphasized in his statement and the SEC emphasized in its press release on the enforcement action against Munchee, represent a crystallizing of the SEC’s position. It nevertheless remains important to monitor the SEC’s enforcement actions and pronouncements as more light is shed on the ICO markets. It remains to be seen what direction the SEC will take, and whether its enforcement efforts will have a broader impact on the ICO markets. Chairman Clayton is clearly putting the cryptocurrency and ICO community on notice, and it is likely that there will be further enforcement activity in this area in 2018.
1) Other U.S. agencies have also demonstrated recent efforts to regulate the cryptocurrency markets. See, e.g., Dechert OnPoint, U.S. v. Coinbase: Virtual Currency Holders Not Outside the IRS’s Reach (discussing enforcement of an order from the Internal Revenue Service to produce records of cryptocurrency account holders); Dechert OnPoint, CFTC Staff Aligns with SEC Position on Initial Coin Offerings: Tokens May be Commodities.
2) Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017). For an earlier discussion of the SEC’s focus on ICOs, and The DAO’s tokens in particular, please refer to Dechert OnPoint, SEC Focuses on Initial Coin Offerings: Tokens May be Securities Under Federal Securities Laws.
3) Complaint, SEC v. PlexCorps, et. al. (E.D.N.Y. Dec. 1, 2017). The SEC’s complaint alleged that PlexCorps had conducted an unregistered sale of securities by raising approximately $15 million from the issuance of PlexCoin tokens, which PlexCorps described as “a cryptocurrency ... that has a value based on the current market.” According to the Complaint, purchasers of PlexCoin were promised “outlandish rewards of 1,354% in 29 days or less” – rewards that would result, in part, from the appreciation of PlexCoin’s value “based on the managerial efforts of PlexCorps’ team” and from the ability to trade PlexCoin on a secondary market. The District Court for the Eastern District of New York granted the SEC’s request in an emergency action on December 4, 2017.
4) In the Matter of Munchee, Inc., Securities Act Release No. 10445 (Dec. 11, 2017).
5) Statement on Cryptocurrencies and Initial Coin Offerings, Remarks of SEC Chairman Jay Clayton (Dec. 11, 2017).
6) Earlier this year, the SEC’s Office of Investor Education and Advocacy released investor bulletins and alerts cautioning investors about the risks of participating in ICOs, particularly the risk that an issuer may be fraudulent in its offering. See Investor Bulletin: Initial Coin Offerings (July 25, 2017); Investor Alert: Public Companies Making ICO-Related Claims (Aug. 28, 2017).
7) See Dechert OnPoint, SEC Enforcement Division Releases 2017 Annual Report as Industry Looks Ahead to 2018, for a further discussion of the Division’s 2018 priorities.
8) 328 U.S. 293, 301 (1946) (defining an “investment contract” as “an investment of money in a common enterprise with profits to come solely from the efforts of others”); see also SEC v. Edwards, 540 U.S. 389, 393 (2004).
9) The primary consequence of such a violation is liability for rescission of the purchase price of the security pursuant to Section 12(a)(2) of the Securities Act.
10) See SEC v. Shavers, No. 4:13-CV-416, 2014 WL 4652121 at *1 (E.D. Tex. Sept. 18, 2014) (holding that an investment of a virtual currency meets the “investment of money” component of the Howey test).
11) 421 U.S. 837 (holding that the purchase of stock solely for the purpose of obtaining housing would not be an “investment contract” because the purpose of the investment was not for profit).