Dec 14, 2017
On Monday, the U.S. Securities and Exchange Commission (“SEC”) Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings (“ICOs”) or token sales concurrently with disclosure of an enforcement action against Munchee Inc., halting Munchee’s sale of tokens following the SEC’s finding that its sale of tokens constituted the unregistered offer and sale of securities. This CKR Client Alert will provide a brief overview of Chairman Clayton’s statement followed by a review of the Munchee action.
Chairman Clayton addressed his and the SEC’s view regarding the developing cryptocurrency and token sale market, setting forth consideration for those he considers “Main Street” investors and “Market Professionals”.
Consistent with previous SEC guidance, Clayton noted that he “believe[s] that initial coin offerings – whether they represent offerings of securities or not – can be effective ways for entrepreneurs and others to raise funding, including for innovative projects.” However, as to the Main Street investors, Clayton indicated the SEC’s concern is protecting investors, noting that there are “greater opportunities for fraud and manipulation” in the cryptocurrency and token sale markets as regulators determine how existing rules and regulations apply to tokens and token sales.
Clayton cautioned investors to (1) be aware that, to date, no initial coin offerings have been registered with the SEC; (2) make sure to ask questions and demand clear answers of the token issuers prior to investing in cyptocurrency-related products; (3) recognize that the cryptocurrency markets are international in nature and that rules and regulations outside those of the United States will likely apply to such investments; and (4) as the investment is likely international in nature, funds invested may very well end up overseas without the investor’s knowledge, thus amplifying the risk of making such investment beyond the reach and ability of the SEC and other U.S. regulators to pursue bad actors in the event of fraud or other malfeasance.
To help provide answers to those questions, Clayton recommended that token issuers prepare answers to the following questions (“SEC Sample Questions”), among others, in their offering documents and marketing materials:
As to Market Professionals, Clayton stated that merely changing the form of the recording of a corporate interest from a central ledger to a blockchain entry on a distributed ledger does not change the fundamental nature of such corporate interest. He encouraged Market Professionals to review the SEC’s actions halting prior token sales and advised professionals to closely consider the nature of what is a security when advising clients involved in token sales. He cautioned that securities laws, and the application thereof, must always be considered prior to embarking on such an offering. Simply by calling something a “utility token,” “currency” or “currency-based product” does not in and of itself remove the sale of such item from U.S. securities rules and regulations. Thus, he stated that “[b]efore launching a cryptocurrency…its promotors must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under U.S. securities laws.”
Munchee Inc., a California-based company, launched its restaurant review app in the second quarter of 2017. Around October 1, 2017, it announced its sale of MUN tokens (which would be incorporated into the app) in an effort to raise funds for the app’s improvement.
Munchee commenced sales of the MUN tokens on October 31, 2017, and stopped selling them by November 1, 2017, after Munchee had received a cease and desist order from the SEC. According to the SEC, the MUN tokens constitute “investment contracts” and, as such, Munchie’s offer and sale of the MUN tokens constitutes the unregistered sale of securities in violation of the U.S. Securities Act of 1933, as amended (the “Securities Act”).
The SEC, using a “facts and circumstances” analysis, determined that the MUN tokens were “investment contracts” under the four-pronged Howey Test and, thus, constitute securities under Section 2(a)(1) of the Securities Act. As a reminder to our readers, under the Howey Test, the purchase of a token is an investment contract, and therefore a security, if the answer to all of the below questions is “yes”:
In the MUN token sale, Munchee had stated that it intended to create an “ecosystem,” where “increased participation…would purportedly lead to the increased value of MUN tokens.” Following the DAO Report, Munchie stated in the MUN White Paper that, after conducting a Howey Test, “the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.” The SEC found otherwise.
According to the Howey Test, 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. As the court had determined in Howey, this definition is a “flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of money of the other on the promise of profits.”
The “promise of profits” used in the SEC’s analysis supports the finding that the MUN tokens are “investment contracts.” Indeed, the SEC determined that the MUN token purchasers had “a reasonable expectation of obtaining a future profit” from their investment in Munchee’s enterprise. Munchee’s “‘ecosystem’ that would create demand for MUN tokens and make tokens more valuable,” its promise of “a secondary trading market for MUN tokens” and, other statements and marketing actions indicated that “investors could expect to profit from the appreciation of value of MUN tokens resulting from [Munchee’s] efforts.” As the order states, “[i]nvestors had little choice but to rely on [Munchee’s management] and its expertise,” providing that these future profits would be derived solely by the “entrepreneurial or managerial efforts of others.”
Additionally, the order touches on the issue of the utility of the tokens. It is commonly supported that there is a distinction between “security tokens” and “utility tokens” and that only the first should consider securities laws during their token sales. However, this does not seem to be SEC’s perspective. According to the order, “[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 [since] [d]etermining whether a transaction involves a security does not turn on labeling – such as characterizing a token sale as involving a ‘utility token’- but instead requires an assessment of ‘the economic realities underlying a transaction.’”
The SEC found that Munchee had violated Sections 5(a) and (c) of the Securities Act by offering and selling securities without registration and without qualifying for an exemption from registration. In anticipation of the cease-and-desist proceedings by the SEC, Munchee submitted an Offer for Settlement to the SEC, which included Munchee’s return of all proceeds from the MUN token offering. Following the SEC’s consent to the Offer for Settlement, the SEC stated that it would not impose additional penalties against Munchee due to Munchee’s actions in immediately halting the token sale, returning all proceeds to the MUN token purchasers and otherwise cooperating with the SEC in its investigation of the MUN token sale.
As stated by SEC Chairman Jay Clayton, despite attempts to avoid classifying a token or cryptocurrency as securities, “Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” The Wall Street Journal reported his earlier comments at the Institute of Securities Regulation on November 8, 2017 that he has “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” Ultimately, the SEC has made it clear that it will be difficult to argue in any token sale that the token purchasers do not have any reasonable expectation to profit from the appreciation of value of the tokens resulting from the efforts of the token issuer or others.
CKR Law suggests that, until additional rules are put in place regarding tokens and token sales, all token sales should be treated as securities offerings and either be registered with the SEC or sold in compliance with an applicable exemption from registration.
Additionally, if tokens are sold pursuant to an exemption from registration for which there is currently no mandated form of disclosure, it is considered best practices that the token issuer provide prospective token purchasers with a disclosure document using plain language, which is transparent and in no way misleading, describing the token issuer’s business overview including its history and competition, its executive management, directors and their compensation structure, the token issuer’s future business plans, the summarized terms of any token purchase agreement, the token allocation, risk factors, and the use of proceeds of the token sale. Token issuers are strongly advised to include, at a minimum, specific responses to the SEC Sample Questions in this disclosure document.
CKR Law will continue to monitor developments surrounding the interaction of cryptocurrencies, token sales and securities law. Our Blockchain Task Force is in dialogue with the SEC and other regulators to seek additional guidance and we will follow up with future CKR Client Alerts. Should you have any questions or desire further insight, feel free to contact our lawyers, including the Chair of our Blockchain Technology & Digital Currency group, Alexandra Levin Kramer (firstname.lastname@example.org) and Corporate and Securities Partner Megan J. Penick (email@example.com) at 212-259-7300.
DISCLAIMER: This article is not intended to provide legal advice, and no legal or business decision should be made based on its contents.
 Link to Sample Questions for Investors Considering Cryptocurrency or ICO Investment Opportunity (contained as part of Chairman Clayton’s statement, dated December 11, 2017): https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11#_ftn6.
 SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), as further developed in United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) and SEC v. Edwards, 540 U.S. 389, 393 (2004)
 SEC v. Shavers, No. 4:13-CV-416, 2014 WL 4652121, at *1 (E.D. Tex. Sept. 18, 2014).
 Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 574 (10th Cir. 1991).
 SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973).
 https://www.sec.gov/litigation/admin/2017/33-10445.pdf, at 4.
 See also, https://www.ckrlaw.com/our-voices/2017/08/08/sec-investigates-the-dao-on-its-initial-coin-offering-on-blockchain/
 Supra note 1, at 3-4.
 Howey., 328 U.S. at 299.
 Supra note 1, at 8-9.
 Id. at 9.