First Federal Court Decision Suggesting that ICO May Not be a Security

December 11, 2018

Introduction 

In the ongoing case of SEC v. Blockvest, the U.S. District Court for the Southern District of California denied the Securities and Exchange Commission’s (SEC) request for a preliminary injunction against Blockvest, LLC and its founder (Blockvest).1 The ruling is the first of its kind in that the court held that the SEC failed to show that the digital assets offered by Blockvest were “securities” within the meaning of the federal securities laws. Although the ruling is not a final decision on the merits and the case will now proceed to discovery, the decision is important for issuers of initial coin offerings (ICOs) because it emphasizes that the manner in which digital assets are marketed and sold is key to the determination of whether the assets are a security. 

The SEC has alleged that Blockvest violated the registration requirements and antifraud provisions of the Securities Act of 1933 (Securities Act), as well as the antifraud provisions of the Securities Exchange Act of 1934. Blockvest challenged the claims by arguing that the tokens it sold to investors to test its Blockvest Exchange platform are not securities. Blockvest asserted that its “BLV tokens” were offered solely for the purpose of testing its platform, which was never open for business, and that no tokens were actually given to the investors. The SEC argued that although the BLVs were utility tokens for use of the platform, the “intent of the offering was to fund Blockvest’s future business.” 

According to the SEC, Blockvest falsely claimed that its ICO was “registered” and “approved” by the SEC, the Commodity Futures Trading Commission and the National Futures Association. The order also describes a “fictitious regulatory agency” named the Blockchain Exchange Commission (BEC) which Blockvest allegedly created to legitimize its offering. The BEC’s seal and mission statement were “nearly identical” to those of the SEC, and Blockvest provided the address of the SEC’s headquarters as that of the BEC’s office. 

Despite these allegations of fraud, the court found that the SEC did not meet its burden to show “(1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.” 

In considering the first requirement, the court found that the SEC did not demonstrate that investors who purchased the BLV tokens were “led to expect profits solely from the efforts of the promoter or a third party,” as required by the seminal case of SEC v. W.J. Howey Co.2 This finding was based on the fact that the SEC and Blockvest “provide starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test BLV tokens.” This evidence – how the BLV tokens were actually offered and sold – is key to determining whether they are a security, and therefore whether Blockvest’s ICO violated the federal securities laws. The court concluded that it could not make such a determination “[a]t this stage, without full discovery and [resolving] disputed issues of material facts.” Accordingly, the court denied the SEC’s request for a preliminary injunction. It is anticipated that the case will proceed to discovery and further proceedings on the merits. 

While this decision is significant because the court identified facts that bear on whether an ICO should be deemed an offer or sale of a security under the federal securities laws, it is worth noting that Blockvest argued that its BLV token was still in the “development phase” and that this was understood by the token recipients. The court appeared to accept the assertion that Blockvest issued the tokens for testing purposes only, despite Blockvest’s admission that it intended to complete a final issuance of tokens after testing was complete. The court’s application of the Howey test in deciding the SEC’s motion for a preliminary injunction expressly referred to “test BLV tokens” and “test investors.” If the SEC is able to establish that Blockvest offered BLV tokens for other than testing purposes, the court’s application of the Howey test may come out differently. 

Footnotes 

1) In early October, the court entered an ex parte temporary restraining order (TRO) that, among other things, froze the assets of Blockvest, its founder and its affiliates. The TRO was vacated when the court denied the SEC’s preliminary injunction motion.
2) 328 U.S. 293, 298-99 (1946) (setting forth the test for whether an offer is an investment contract and therefore a security under the Securities Act).