December 11, 2017 was a day of reckoning for entrepreneurs conducting or contemplating initial coin offerings, and for securities professionals who advise them.  First, a company selling digital tokens to investors to raise capital for its blockchain-based food review service abandoned its initial coin offering after being “contacted” by the Securities and Exchange Commission, and agreed to a cease-and-desist order in which the SEC found that its ICO constituted an unregistered offer and sale of securities. On the same day, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings”, warning “Main Street” investors and market professionals about investing and participating in ICOs, and reiterated the SEC’s determination to apply the securities laws to transactions in digital tokens. These two actions are the latest in a series of steps by the SEC to send a clear message that it intends generally to enforce the securities laws with respect to ICOs that emphasize the profit potential of tokens where such profit derives from the efforts of the entrepreneurs of the underlying project.

Cease and Desist Order

Munchee Inc. is a California-based company that developed an iPhone app for people to review restaurant meals. In October and November 2017, Munchee offered and then sold digital tokens it called “MUN” to be issued on a blockchain, seeking to raise approximately $15 million to improve the app and recruit users to eventually buy ads, write reviews, sell food and conduct other transactions using MUN. On or about October 31, 2017, Munchee started selling the MUN tokens. The next day, Munchee was “contacted” by the SEC staff, probably threatening cease and desist proceedings. The message was communicated loud and clear, because within hours Munchee stopped selling MUN tokens and promptly returned to purchasers the proceeds that it had already received. In anticipation of the institution of cease and desist proceedings, Munchee submitted an offer of settlement and consented to entry of the cease-and-desist order.

Despite Munchee holding itself out as offering a utility token that is not a security, the SEC’s position was that the MUN token was a security because the totality of Munchee’s efforts relating to the ICO resulted in a purchasers’ reasonable expectation of profits from the entrepreneurial efforts of Munchee’s management team. Interestingly, Munchee’s white paper included a three page legal disclaimer stating that it conducted a Howey analysis with the assistance of counsel and concluded that its MUN utility token didn’t pose a “significant risk of implicating federal securities laws”. As the order notes, however, the white paper did not set forth the actual analysis.

The SEC’s case that Munchee’s ICO of MUN tokens was a securities offering rests largely on the following arguments:

  • Token purchasers were led to believe that efforts by Munchee would result in an increase in value of the tokens.
  • Increase in value of the MUN tokens would occur whether or not purchasers ever used the Munchee restaurant app or otherwise participated in the MUN “ecosystem”.
  • Munchee emphasized it would take steps to create and support a secondary market for the tokens.
  • Promotional efforts included blatant predictions of increase in value of the token.
  • The ICO targeted digital asset investors, as opposed to targeting current users of the Munchee app or restaurant owners regarding the utility of the tokens.
  • ICO was promoted in worldwide publications, despite the app only being available in the United States.
  • Munchee paid people to translate offering documents into multiple languages, presumably to reach potential investors in other countries where the Munchee app was unavailable.

The order asserts that in the course of the ICO, Munchie and its promoters emphasized that investors could expect that there would be an increase in value of the MUN tokens resulting from efforts by Munchie, including paying users in MUN tokens for writing food reviews, selling both advertising to restaurants and “in-app” purchases to app users in exchange for MUN tokens, and working with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users in MUN tokens.

Munchee also emphasized in the ICO that it would take steps to create and support a secondary market for its tokens, including potentially burning (i.e., taking out of circulation) a small fraction of MUN tokens whenever a restaurant pays Munchee an advertising fee and buying or selling MUN tokens using its retained holdings in order to ensure there was a liquid secondary market for MUN tokens.

Chairman Clayton’s Statement

On the same day as the Munchee cease-and-desist order, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings” directed principally at “Main Street” investors and market professionals (including broker-dealers, investment advisers, exchanges, lawyers and accountants). The Statement asserts that in the aftermath of the SEC’s July 2017 investigative report applying securities law principles to demonstrate that the DAO token constituted an investment contract and therefore was a security, certain market professionals had attempted to highlight utility characteristics of their proposed tokens in an effort to claim that the tokens were not securities. “Many of these assertions appear to elevate form over substance”, Chairman Clayton noted, and that “replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance”.

Particularly chilling for me as a securities lawyer was the following admonition by Chairman Clayton:

“On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors” (bold appears in original Statement).”

In the Statement, Chairman Clayton presents interesting hypothetical contrasting business models for the distribution of books to illustrate the difference between a utility token and a securities token. An example of what would be characterized as a utility token that’s not a security would be a book-of the-month club selling tokens representing participation interests in the club as simply an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast are interests in a yet-to-be-built publishing house where the token purchasers have a reasonable expectation of profit through the entrepreneurial efforts of the founders to organize the publisher’s authors, books and distribution networks. Chairman Clayton added that an additional circumstance contributing to a conclusion that a utility token is a security would be when promoters tout the secondary market trading potential of their tokens and the potential for the tokens to increase in value, which are “key hallmarks of a security and a securities offering”.

There should be no doubt about the seriousness with which Chairman Clayton is approaching the issue.  Toward the end of the Statement, he states that he has “asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws”.

Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs.  Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale.  In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong.  Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way.  It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit.  I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer.  I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.

On August 1, 2017, Delaware became the first state to allow corporations to record issuances, transfers and ownership of stock using blockchain technology.  Amendments to the Delaware General Corporation Law authorizing blockchain stock ledgers were passed by the Delaware State Senate and House of Representatives in June, signed by Governor John C. Carney Jr. in July and became law August 1. The amendments have enormous potential advantages for emerging companies, including cost savings, error avoidance, accuracy of ownership records and automation of administrative functions.

Blockchain is essentially an automated, decentralized, distributed database or ledger that allows participants on a given network to create an indelible, secure record of asset ownership and transfers directly and without the additional cost and delay associated with intermediaries. Each transaction is cryptographically signed and time stamped. While conventional transfers of assets typically require verification by third party intermediaries, blockchain based transfers rely on algorithms to confirm transaction authenticity.

Delaware law has required corporations to record stock transfers on a stock ledger and to maintain ownership records on the ledger. Stock ledgers are typically maintained by the corporate secretary or the company’s transfer agent who makes entries on paper or on an excel spreadsheet to reflect all transactions in the company’s stock. Under the current system, the corporate secretary or transfer agent must be notified of a stock issuance or transfer in order for the transfer to be recorded on the ledger and for the transferee to be treated as the record owner of the shares. The requirement for intermediaries to record stock transfers creates friction in the form of delay, expense and potential for error.

Prior to the blockchain amendments, Section 224 of the Delaware General Corporation Law provided that corporate records including stock ledgers could be maintained on any “information storage device”, but didn’t specifically allow for storage or recordation on electronic networks or databases, let alone any distributed electronic network or database. Section 224 has now been amended to provide that the information storage devices on which corporate records including stock ledgers could be stored may include “electronic networks or databases (including one or more distributed electronic networks or databases.”

The State of Delaware published an information sheet outlining the benefits to companies from registering issuances and transfers of shares in blockchain form, identifying three categories of benefits: cost savings, accurate ownership records and automation of administrative tasks. For privately held companies, maintaining a stock ledger on blockchain would:

  • enhance accuracy and ease management of the cap table
  • facilitate direct communications with investors
  • enable option grants to remain in sync with authorized shares
  • increase transparency of the shareholder voting process
  • prevent certain “foot faults” common to administering private companies
  • reduce likelihood of disputes

So if a corporation organizing in Delaware elects to use blockchain technology for its stock ledger, the Division of Corporations would cryptographically transfer to the company on the distributed ledger just those shares identified in the corporation’s certificate of incorporation as authorized. By doing so, the Division of Corporations establishes a perfect record of authorized shares, and the distributed ledger then reliably tracks subsequent issuances by the company and transfers by stockholders to produce a reliable record of issued and outstanding shares.

Under existing methods of share transfer and ownership recordation, an issuance or transfer could easily slip through the cracks. It’s not uncommon to discover gaps in a company’s cap table, often at the most inopportune time such as on the eve of closing a transaction, where the company inadvertently issued a number of shares in excess of the amount authorized, thus triggering the necessity for a filing under Section 204 of the DGCL to cure the defective corporate act. Blockchain based stock ledgers would eliminate this possibility.

Finally, the amendments impose certain requirements on blockchain based stock ledgers. First, electronic corporate records must be capable of being converted into legible paper form within a reasonable period of time. Second, as required of other stock ledger formats, blockchain based ledgers must be able to (i) be used to prepare a list of stockholders entitled to vote, (ii) record information required by the DGCL to be maintained in the ledger and (iii) record transfers of stock pursuant to Article 8 of the Delaware Uniform Commercial Code.

On July 25, 2017, the SEC’s Division of Enforcement issued a Report of Investigation (the “Report”) that concluded that the tokens issued in an initial coin offering (“ICO”) by a decentralized autonomous organization called “The DAO” were “securities” and that the ICO itself should either have been registered with the SEC under the Securities Act of 1933 or qualified for an exemption therefrom. Importantly, the Report does not conclude that all ICO tokens are securities or that ICOs must either be registered or satisfy the requirements for an exemption from registration. The Report provides important guidance, however, to blockchain startups and other entities seeking to raise capital in the United States through ICOs as to how to structure those offerings from a regulatory standpoint.

Initial Coin Offerings

An initial coin offering is a crowdfunding technique used primarily by blockchain startups in which the issuer sells cryptocurrency tokens or coins that entitle the purchaser to certain rights ranging from access to the issuer’s product or service once it is available (similar to pre-order based non-equity crowdfunding on sites such as Kickstarter or Indiegogo) to a share in the issuer’s profits (similar to equity based crowdfunding). Purchasers also typically have the right to resell their tokens on an online exchange. Purchasers make their contributions in the form of either fiat currency (e.g., U.S. dollars) or, more typically, virtual currency (e.g., bitcoin or ether). The offering and sale of the tokens are made directly to the public using blockchain technology to bypass conventional capital markets intermediaries and regulatory regimes. Advertising and information releases occur on the issuer’s website and on online forums such as Bitcointalk and Reddit.

Looming over the emerging ICO industry is the issue of whether ICOs are offerings of securities. Some issuers have chosen not to take the risk of offering and selling unregistered securities in the United States and have instead offered and sold ICO tokens only to non-U.S. persons. Among the most popular non-U.S. markets are Singapore, one of the first jurisdictions to adopt a regulatory sandbox and other regulatory relief initiatives for fintech companies, and Switzerland, whose “Crypto Valley” is a major center of blockchain startups. Other issuers in the U.S. have attempted to steer clear of possible regulation by limiting rights of token holders to access to products or services upon availability.

The DAO Initial Coin Offering

The DAO was a virtual entity referred to as a decentralized autonomous organization (i.e., not a corporation, LLC or other legal entity) formed to sell virtual tokens to raise capital for future projects, a variation on an investment fund.  DAO token holders would have the right to share in the earnings from the projects and could otherwise monetize their investments in DAO tokens by reselling them in online platforms serving as secondary markets.  The idea behind this virtual organization was to replace traditional corporate governance and decision making with smart contract coding on a blockchain.  But in addition to the automated governance structure, the DAO did have a human component as well in the form of “curators” who maintained ultimate control over which proposals would be submitted to and voted on by token holders and then funded by the DAO. A majority vote of the DAO token holders was required for a project to be funded.

The SEC’s Analysis

Section 5 of the Securities Act requires that every offer and sale of securities in the United States either be registered with the SEC or satisfy the requirements of an exemption from registration.  But are ICO tokens securities?  Under Section 2(a)(1) of the Securities Act, a security includes an “investment contract”, which was determined in the seminal case of SEC v. W.J. Howey Co. to mean 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.   In determining whether an investment contract exists, the investment of “money” need not take the form of cash. Investors in the DAO used ETH to make their investments. The Report makes clear that such investment is the type of contribution of value that can create an investment contract under Howey.

The Report then found that investors who purchased DAO tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise when they contributed ETH to the DAO in exchange for DAO tokens. The DAO’s various promotional materials informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment. The Report also found that investors expected profits to be derived from the managerial efforts of others—specifically, the DAO’s founders and curators. Because the investors did have an ostensible management role – voting on proposed projects — the central issue was whether the efforts of “others” were undeniably significant and essential to the failure or success of the enterprise. In this regard, the Report found that the DAO’s investors relied on the managerial and entrepreneurial efforts of the founders and the DAO’s curators to manage the DAO and put forth project proposals that could generate profits for the investors. The founders of the DAO also held themselves out to investors as experts in Ethereum, the blockchain protocol on which the DAO operated, and told investors that they had selected persons to serve as curators based on their expertise and credentials. Although DAO token holders were afforded voting rights, the SEC determined that such rights did not provide the holders with meaningful control over the enterprise because (1) their ability to vote for contracts was largely “perfunctory” (they could only vote on proposals that had been cleared by the curators); and (2) their pseudonymity and dispersion made it difficult for them to communicate or join together to effect change or exercise meaningful control.

A second major issue weighing on the ICO industry has been whether the online platforms on which ICO tokens are traded need to be registered under the Securities Exchange Act of 1934 as national securities exchanges.   Section 3(a)(1) of the Exchange Act defines an “exchange” as any group or entity that “provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange…”.  Under Exchange Act Rule 3b-16(a), a trading system meets the definition of “exchange” under Section 3(a)(1) if the platform “(1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade”. Alternatively, a platform could operate as an alternative trading system exempted from the definition of “exchange” if it registers as a broker-dealer, files a Form ATS with the SEC to provide notice of its operations and complies with the other requirements of Regulation ATS. The Report concluded that the platforms on which the DAO tokens were traded were exchanges under the foregoing Rule 3b-16(a) criteria, and thus should have been registered, because they provided users with an electronic system that matched orders from multiple parties to buy and sell DAO tokens for execution based on non-discretionary methods.

Key Takeaways

It’s unclear why the SEC determined to issue an investigative report rather than pursue an enforcement action against the DAO, its promoters and the exchanges on which the ICO tokens were traded. The underlying conclusions, however, are not surprising. Virtual currencies such as bitcoin and ether are “value” and ICOs in which purchasers have a reasonable expectation of profit through the efforts of the issuer’s promoters are securities offerings which must either be registered or qualify for an exemption. Giving investors “perfunctory” voting rights on proposals presented by promoters’ agents will not be enough to overcome a presumption that the investors expect a profit through the efforts of others. It’s worth noting that the SEC did not address ICOs of so called “access tokens” in which purchasers are given only a right to future products or services but no opportunity for profit. Such ICOs would need to be structured very carefully to ensure that contributors have no “reasonable expectation of profit”, and it’s unclear whether as a practical matter issuers will be able to raise significant amounts without offering a profit incentive. Finally, the Report puts ICO platforms on notice that electronic systems that match orders from multiple parties to buy and sell tokens based on non-discretionary methods must register either as a national securities exchange or as a broker dealer under Regulation ATS.