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By: Matthew Gertler, Senior Analyst and Counsel
- On December 11, the SEC issued a cease-and-desist letter to Munchee, the creators of an iPhone app, ordering that the company stop its ICO for failing to file a registration statement or qualifying for an exemption from registration.
- The SEC did not impose a civil penalty after it considered the quick remedial actions taken by Munchee.
- Following the precedent it set with regards to the DAO token, the SEC again used the Howey Test to determine whether a particular token was an “investment contract”.
- How an ICO is marketed to prospective purchasers appears to be a factor considered in determining whether purchasers at an ICO are expecting to profit from the work of others or from being able to use or access a particular ecosystem or service.
- Even if MUN tokens had a practical use at the time of the ICO, it would not have precluded the token from being a security.
- Exchanges were once again put on notice that they need to comply with U.S. securities laws if they facilitate the trade of tokens deemed to be securities.
On December 11, the Securities and Exchange Commission (SEC) imposed a cease-and-desist order (the Order) against Muchee Inc. (Munchee), the creator of the Munchee App, a restaurant and meal review iPhone application, for the unlawful sale of securities without filing a registration statement or qualifying for an exemption relating to its ICO. This is not the first time that the SEC provided guidance on how it will regulate cryptocurrencies.
Of relevance is the Report of Investigation of the DAO Token (the DAO Report), where the SEC determined that the DAO token was an offering of unregistered securities. In making this determination, the SEC used the Howey Test, which is the test used to determine whether something is a type of security called an “investment contract”. An investment contract is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” This test has three elements: (1) investment of money, (2) expectation of profits, and (3) that the profits be derived from the efforts of others.
This is not an easy analysis and the answer is not always clear, which is why such analyses need to be performed by qualified attorneys with relevant experience and expertise. On one end of the spectrum we have the DAO token, which is likely a security under the Howey Test. I have not met an attorney who would argue otherwise, but I suppose it is possible that such attorneys exist.
At the other end of the spectrum we have bitcoin, which is unlikely to be considered a security. Firstly, all bitcoin issued was mined, meaning that there was no investment of money, thereby failing the first element of the Howey Test. Secondly, on the same day as the Order, SEC Chairman Jay Clayton made a Public Statement noting that “Fraud and manipulation involving bitcoin traded in interstate commerce are appropriately within the purview of the CFTC”. Although the statement is Mr. Clayton’s own and does not reflect the views of the SEC, he made a similar statement, as reported by the Wall Street Journal, in November when he said “When you depart from the bitcoin or the ethereum, and you get into the tokens, the hallmarks [of securities] become pretty clear”.
Many tokens fall somewhere in between the DAO token and bitcoin and the Order explains that “All of the relevant facts and circumstances are considered in making that determination” and that “the emphasis should be on the economic realities underlying [the] transaction.” Here, Munchee sold MUN tokens for bitcoin and ether. Bitcoin and ether qualify as “investments of money” for purposes of identifying an investment contract. This satisfies the first element of the Howey Test.
With regards to the second element, it is reasonable to suspect that MUN token purchasers expected to profit from their purchase of MUN tokens. For example, Munchee made public statements or otherwise endorsed other people’s public statements about being able to profit from the purchase of MUN tokens. One such example was a Facebook post in late October that linked to a third-party YouTube video where Munchee wrote a comment saying “199% GAINS on MUN token ICO price! Sign up for PRE-SALE NOW!”. Another example was a blog post on October 30, which said that “As more users get on the platform, the more valuable your MUN tokens will become.”
The final question is whether the profits were to be derived from significant effort by Munchee or anyone else. In its marketing materials, including in its White Paper, Munchee explained that it would create an ecosystem where the MUN token would reward engagement within the Munchee App, sell advertisements and in-app purchases for MUN tokens, and the company would work with restaurant owners to potentially enable MUN tokens to be used to purchase food. Moreover, the Order noted that Munchee represented that MUN tokens would be tradeable on at least one U.S.-based exchange within 30 days of the ICO. Both the creation and development of a future ecosystem, as well as the efforts required to get the MUN listed on exchanges supported the notion that purchasers were relying heavily on the efforts of Munchee to profit from a purchase of the MUN token.
The way the ICO was marketed also appears to support that MUN token purchasers were looking to profit from the efforts of Munchee rather than from the ability to participate in the future Munchee ecosystem. The Order noted that Munchee neither focused marketing efforts of the ICO towards current users of the Munchee App nor did it advertise the ICO to the restaurant industry to promote how the tokens could be used to advertise on the Munchee App. Munchee also did not advertise the ICO through the Munchee App. Instead, Munchee promoted the MUN token in forums aimed at people investing in digital assets, including BitcoinTalk.org. Additionally, the ICO was promoted to people worldwide who could not use the Munchee App because the app was only available in the U.S.
There are a few key takeaways from the Order. First, the SEC has once again used the Howey Test to determine whether an ICO was an unregistered offering of securities without qualifying for an exemption. Second, how an ICO is marketed to prospective purchasers is a factor to be considered in determining whether such purchasers are expecting to profit from the work of others or from being able to use or access a particular ecosystem or service. Third, even if MUN tokens had a practical use at the time of the ICO, it would not have precluded the token from being a security. Fourth, the SEC did not impose a civil penalty after it considered the quick remedial actions taken by Munchee. Finally, exchanges were put on notice that they may be liable under U.S. securities laws if they facilitate the trade of security tokens without being registered as a national securities exchange.
We discussed the impact on exchanges following the DAO report here. In summary, exchanges may be in violation of U.S. securities laws if they facilitate the trade of even a single token that is deemed to be a security. Accordingly, if an exchange were to be shut down for allowing the trade of security tokens, it could potentially impact tokens that are not deemed to be securities if these exchanges represent a significant percentage of trading volume of such non-security tokens.
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