On November 27, 2018, the United States District Court for the Southern District of California denied the Securities and Exchange Commission’s motion for a preliminary injunction to block an initial coin offering, finding the Commission did not meet its burden of showing the digital token in question was a security. Although this appears to be the first Federal decision against the Commission on the question of whether a token is a security under the Howey test, and may encourage some issuers with the resources to do so to resist SEC enforcement efforts, the order is extremely narrow in scope and is not likely to deter the Commission’s ICO enforcement efforts or shed much light on when if ever a token is not a security.

The issuer in this case, Blockvest LLC, is purportedly seeking to develop the “first licensed and regulated tokenized crypto currency exchange and index fund based in the U.S.” Earlier this year, it announced a plan to issue tokens in three stages: a private sale with a 50% bonus, followed by a “pre-sale” with a 20% bonus, and then a $100 million ICO to be launched on December 1, 2018.

In its original complaint filed on October 3, the Commission premised its fraud case on the notion that Blockvest’s token was a security without analyzing the facts under Howey, but rather by asserting that Blockvest itself conceded that its BLV token was a security by filing a Form D with the Commission and stating on its website that it was “Regulation A+ compliant and can offer [its] securities offering to Unaccredited Investors all over the globe” (emphasis added). See my last blog post regarding the Blockvest offering and its apparent offering exemption confusion.

In mid-October, U.S. District Judge Gonzalo Curiel, issued an ex parte (i.e., with only the Commission appearing before him) temporary restraining order in this case freezing Blockvest’s assets related to the ICO, based solely on the Commission’s version of the facts and largely because of multiple false claims made by Blockvest in its ICO promotional materials that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte.

As to the issue of whether Blockvest’s BLV token was a security, because the earlier TRO motion was made ex parte, the Court based its factual findings at that procedural stage entirely on what the Commission had asserted, namely that investors had invested more than $2.5 million in BLV tokens, which constituted 18% of the offering, and that the purchasers were interested primarily in the profit the BLVs were expected to generate given that Blockvest’s website promised that the BLVs would generate passive income.

But in Blockvest’s brief opposing the preliminary injunction motion and in a related written declaration by its founder Buddy Ringgold, the defendants offered a completely different factual narrative. They asserted that in fact no tokens were sold to the public and that Blockvest never received any money from their sale, and that Blockvest had only one investor (Rosegold Investment, in which Ringgold himself and friends and family were investors). Further, they asserted that BLV tokens were only used to test the platform by 32 “testers” who contributed less than $10,000 in the aggregate.  The BLV tokens were never released to the testers and the testers could not remove the tokens from the platform. Presumably, the testers could not resell them for profit.

The injunction rejection order states that “Ringgold recognizes that mistakes were made” but does not specify what those were. Presumably, it’s a reference to the various misrepresentations about regulatory endorsement. It may also refer to allowing eight of 17 investors in Rosegold (the investment vehicle) to write “Blockvest” and/or “coins” on their checks. It may also be a reference to Blockvest’s website temporarily featuring a credit card function with a “buy now” button. As to the SEC’s allegation that Blockvest had raised $2.5 million from investors, as Blockvest had boasted on social media, Blockvest explained it away as an “overly optimistic” statement and that in any event the funds were not intended to come from the public but rather from one investor, David Drake, and had fallen through anyway. Ringgold maintains the mistakes were made in the early stages of development when Blockvest’s chief compliance officer had not yet reviewed all the materials.

Unlike the TRO order, the injunction rejection order does invoke the Howey test, under which an instrument is deemed to be an investment contract and thus a security if it involves (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others. Judge Curiel addressed the first and third prongs of Howey, but not the second.  Under the first prong, “investment of money”, Judge Curiel examined not what the testers’ intent was in committing funds, but rather what Blockvest represented to the testers and what the testers relied on. Here, Judge Curiel found that the Commission and Blockvest provided “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”, and that consequently the court could not make a determination as to whether the test BLV tokens were “securities” under the first prong of Howey.  As to the second prong, “expectation of profits”, which Judge Curiel identified as either through capital appreciation or profit participation, he once again found that the Commission had not met its burden of proving expectation of profit.

So what are the key takeaways here? The competing factual narratives suggest this to be a narrow ruling. It must be kept in mind that this order comes without the benefit of full discovery; it’s basically “he said/she said”.  And without full discovery to address disputed issues of material facts, the court could not conclude that the Commission had met its burden in establishing that the BLV token offered to the 32 test investors was a security. Also, the Commission may have brought this case prematurely inasmuch as it was under the impression that the tokens had already been sold to the public; Blockvest in turn asserted facts indicating that no tokens had yet been issued (or offered) to the public and the tokens purchased by the testers were for testing purposes only and never released from the platform. It’s also unclear whether the Commission will pursue this case inasmuch as it has already secured Blockvest’s commitment to cease all efforts with respect to the ICO and to give the Commission 30 days’ notice of any resumption of efforts in this regard. Nevertheless, the order does serve as a reminder that the Commission, when seeking enforcement against an ICO in court, will have the burden of establishing that each of Howey’s prongs have been met, and suggests that future cases may be decided on the issuer’s actual marketing efforts and representations to purchasers and not on subjective perceptions of those purchasers’ expectations of profit.

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.