December was a great month for ICO guidance.
On December 11, the Securities and Exchange Commission (“SEC”), the U.S. federal agency at the forefront of ICO regulatory developments, published its Cease and Desist Order against Munchee Inc., purveyors of an iPhone restaurant review app with a $15 million ICO, for selling unregistered securities in violation of Sections 5(a) and 5(c) of the Securities Act of 1933 (“Securities Act”). On December 13, ICO participants in Centra, a crypto-debit card company with proponents like Floyd Mayweather and DJ Khaled, filed a class action U.S. District Court of Southern Florida alleging Centra committed the very same SEC violations via its $30 million coin offering. And on December 21, ATB, fielded a like-minded class action complaint in the Southern District of New York for its blockchain-based payment system and estimated $24 million ICO. All of this on top of the recent—and compounding—Tezos litigation marks an eventful month for the intersection between ICOs and their regulatory bodies.
This post analyzes the Munchee story; the next will tackle Centra, then ATB.
In reaching its conclusion that Munchee violated the Securities Act, the SEC applied the “Howey Test,” the most common test for determining whether ICO tokens, for example, are investment contracts. The Howey Test stems from a seven-decade-old Supreme Court case, SEC v. W. J. Howey Co., 328 U.S. 293 (1946), and its progeny, and essentially analyzes whether a sale involves an:
(1) investment of money (or other consideration)
(2) in a common enterprise, with
(3) profits to come solely or primarily from the efforts of others (i.e. participants in an ICO, for instance, may have a reasonable expectation of profits based on the ICO proprietors’ entrepreneurial or managerial efforts).
Any sale that meets these qualifications—all of them—is a sale of securities. And any offering or sale of securities, per Sections 5(a) and 5(c) of the Securities Act, must be registered with the SEC (or exempted from registration) to be lawfully offered for sale or sold. Following the SEC’s Cease and Desist notice to Munchee, and in anticipation of SEC proceedings, Munchee settled with the SEC, unilaterally terminated every one of its contracts of sale with its ICO participants, and returned all of its $15 million in ICO proceeds.
Since the Howey Test’s applicability to ICOs and the tokens they hock is relative to the sort of token, business, and sale that occurred, SEC guidance on this subject via a third party such as Munchee may be useful to those planning ICOs of their own.
Facts & Passage
Munchee offered and sold “MUN tokens” (Ethereum based crypto coins) in a general solicitation that included potential U.S. investors—and in doing so, met the first two elements of the Howey Test. In terms of the third element, the SEC asserted that Munchee instilled a reasonable expectation of future profit (based upon Munchee’s future efforts) in its ICO participants. In the leadup to its ICO, via its white paper and online posts, Munchee publicized that it would:
(a) continuously revise its app;
(b) use the ICO proceeds to create an “ecosystem” of restaurant reviews and shares that would, in turn, increase the value of the MUN tokens; and
(c) foster a secondary trading market for MUN tokens shortly after the completion of the offering and prior to the creation of the ecosystem.
Finally, these efforts were entirely reliant on Munchee (as opposed to the ICO participants) since, at the time of the ICO, “no other person could make changes to the Munchee App or was working to create an ‘ecosystem’ to create demand for MUN tokens,” per the SEC.
So, said the SEC, Munchee passed the third element of the Howey Test, and the Howey Test itself.
A primary key to Munchee’s fact pattern and Howey passage was Munchee’s timeline. Munchee sold MUNs before they were fully functional in the way Muchee’s marketing promised, meaning, before the “ecosystem” that the Munchee squad said would stimulate MUNs’ value was operational. This founded the SEC’s argument that MUNs were securities, whose value hinged solely on the future efforts of Munchee and the future profits those efforts may—or may not—yield.
Another key: Munchee’s tokens themselves were also problematic. Certain ICOs seek to fail the Howey Test—namely its third, future profit/future effort prong—and avoid the SEC’s regulatory reach by deeming their ICO token a “utility token,” which, they say, provides future access to a platform, or to another service or product. Munchee went this route, going so far as to assert in its white paper that the company conducted a “Howey analysis” and assure readers that “as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws,” as cited by the SEC. However, the SEC pointed out, Munchee never published this analysis.
Legitimate utility tokens may well be outside the definition of securities, but not all organizations necessarily sell legitimate utility tokens. Take Munchee, for example. Per the SEC, whether MUNs were utility tokens was unclear. First, “[w]hile Munchee told potential purchasers that they would be able to use MUN tokens to buy goods or services in the future after Munchee created an ‘ecosystem,’ no one was able to buy any good or service with MUN throughout the relevant period.” Indeed, it wasn’t until 2018 and 2019 that Munchee planned to incorporate the token into the Munchee App.
And anyway, continued the SEC, “[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.” Labels don’t matter, said the SEC, and dubbing a token as “utility” doesn’t obscure “the economic realities underlying a transaction.” Concludes the SEC: “All of the relevant facts and circumstances are considered in making that determination.”
ICO runners of the future can take at least the following pointers from the available details of Munchee’s demise:
1. Show your work. If you have a great argument why your token is a utility token and not a security or why your ICO failed the Howey Test, deploy it.
2. Don’t rely on labels. When assessing whether you’re selling a security, consider the entire transaction scenario, including the reasonable expectations, marketing, and economic realities floating around your ICO.
3. Align your marketing. If your ICO and the purported utility of your tokens pivots on the embrace of a specific marketplace—i.e. the restaurant industry—it may look odd if your organization does not market within that sphere, but instead to typical securities investors and even hedge funds. Munchee, according to the SEC, “likened MUN to prior ICOs and digital assets that had created profits for investors, and specifically marketed to people interested in those assets – and those profits – rather than to people who, for example, might have wanted MUN tokens to buy advertising or increase their ‘tier’ as a reviewer on the Munchee App.”
Next up: Centra, ATB, perhaps more...