The Initial Coin Offering (“ICO”) market exploded in 2017 with almost $4 billion of investments. Securities regulators in the United States have responded first with a series of public warnings and, more recently, by bringing enforcement actions against promoters of ICOs and other digital currency investments. We survey some of the recent regulatory developments in this rapidly evolving field.
SEC Guidance – DAO Report
As we first reported in our August 2017 client alert, the Securities and Exchange Commission (“SEC”) zeroed in on the ICO market when it issued its report of investigation concerning the DAO and its sale of DAO Tokens (the “DAO Report”). An ICO is a form of financing technique in which a company (typically one operating in the digital currency space) seeking to raise seed money makes a “token” available for sale, and the token gives the purchaser some future right in the business or other benefit.
The SEC applied its traditional Howey test to conclude that the DAO Tokens were investment contracts, and thus securities, for purposes of the federal securities laws. Importantly, the SEC concluded that the Howey test was met because the promoters’ efforts were essential to the enterprise and DAO Token holders’ control rights were limited. As securities, such tokens are subject to SEC oversight, which includes the requirement that every offering of securities either be registered with the SEC or find an appropriate exemption from registration.
We noted that although the SEC declined to bring any formal action against the promoters, the DAO Report drew a line in the sand for holders of similar tokens. The DAO Report placed the token market on official notice that U.S. federal securities laws apply to the offer and sale of tokens that qualify as securities, including securities issued as tokens on blockchains in ICOs in exchange for cryptocurrencies. Without a valid exemption from registration, both the issuer and those who participate in the unregistered offer and sale of digital securities may be deemed to be violating U.S. federal securities laws.
SEC Enforcement – Munchee
Since the summer of 2017, the SEC has brought several enforcement actions against promoters of ICOs. A number of these actions involved old-fashioned Ponzi schemes masquerading as token offerings. But at least one action has involved a token issuer where no allegations of fraud were made. On December 11, 2017, the SEC issued a cease-and-desist order against Munchee Inc. after finding that the company’s ICO involved unregistered offers and sales of securities in violation of Section 5 of the Securities Act of 1933.
Munchee sought to raise $15 million for its blockchain-based food review and social platform by selling to users digital tokens that could be used to buy and sell goods and services through an iPhone app. Munchee and others promoting the ICO told investors that the tokens could be expected to increase in value as the company implemented improvements to the app and said that the company would work to support a secondary market for the tokens. Drawing on the DAO Report, the SEC concluded that the tokens were securities, and Munchee was in violation of the federal securities laws by conducting unregistered offers and sales. After being contacted by the SEC, Munchee halted its ICO and refunded investors’ money before any tokens were delivered. Due to Munchee’s cooperation and its quick action to end the ICO and return funds, the SEC chose not to impose a penalty.