United States: SEC's Latest On Icos: If It Walks Like A Duck And Quacks Like A Duck, It's A Security

Last Updated: January 23 2018
Article by Dror Futter

 If you are planning an ICO of a utility token in the near future, you probably want to think twice. In a powerful one-two punch on Monday, the SEC published a cease and desist order shutting down an ICO for the MUN utility token and a highly critical statement by SEC Chairman Jay Clayton entitled " Statement on Cryptocurrencies and Initial Coin Offerings". While utility tokens remain possible, the combined documents highlight the difficulty of avoiding being classified as a security.

The SEC Takes a Bite Out of Munchee

In October and November of this year, Munchee, Inc. launched the $15 million ICO of its MUN token. Funds raised by Munchee would be used to improve its existing app and recruit users to eventually buy advertisements, write reviews, sell food and conduct other transactions using MUN. The Munchee White Paper described how the MUN tokens would increase in value and highlighted the ability of MUN token holders to trade MUN tokens on the secondary market. The document even claims that Munchee had undertaken a Howey analysis (the Supreme Court case setting forth the criteria for what is a security) and that "as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws." Turns out the SEC sees it a bit differently.

The SEC determined that the MUN tokens were securities and contacted Munchee after the offering commenced. In response, Munchee stopped the offering and eventually returned about $60,000 in funds that had been raised. Applying Howey, the SEC found:

Among other characteristics of an "investment contract," a purchaser of MUN tokens would have had a reasonable expectation of obtaining a future profit based upon Munchee's efforts, including Munchee revising its app and creating the MUN "ecosystem" using the proceeds from the sale of MUN tokens.

Central to the SEC's determination were the following factors:

  • Munchee planned to create an ecosystem of users that would increase the value of the tokens.
  • Based on Munchee's marketing, token purchasers could reasonably believe they could profit by holding or trading the tokens,whether or not they used the tokens or participated in the MUN ecosystem. The SEC highlighted that Munchee's marketingdid not target existing users of its app and that the offering was promoted "in forums aimed at people interested in investingin Bitcoin and other digital assets."
  • Token purchasers had a reasonable belief that Munchee and its agents would expend significant efforts in developing the appand the MUN ecosystem. The SEC noted that this belief was reinforced by the White Paper that highlighted the credentials,abilities and management skills of its agents and employees.

The Muchee Order also noted: "Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security." This may be an indirect criticism of the SAFT instrument. SAFTs are convertible instruments that are sold as securities and convert into tokens when the service utilizing the token is ready. Advocates of SAFTs maintain that this delay in token issuance improves the Howey analysis of a utility token when contrasted with a token for a "to-be-developed" service. The SEC is making it clear that even when the service is up and running, tokens still run the risk of being deemed a security.

Call Chairman Clayton Skeptical

Actually, in his personal statement, published by the SEC, Chairman Clayton is more than skeptical; he is downright concerned. He warns "Main Street" Investors:

As with any other type of potential investment, if a promoter guarantees returns, if an opportunity sounds too good to be true, or if you are pressured to act quickly, please exercise extreme caution and be aware of the risk that your investment may be lost.

The Chairman's concerns extend beyond the issuers to the entire "industry" that has developed to support ICO issuances, calling out by name "Market Professionals" such as broker-dealers, investment advisers, exchanges, lawyers and accountants. The Chairman is critical of Market Professionals who have tried to highlight the utility functions of their tokens in arguing that they are not securities. In most cases, he believes they are attempting to "elevate form over substance."

Merely calling a token a "utility" token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. 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 in the original)

Other critical points of the Chairman's statement:

  • Main Street investors need to be aware that trading of the tokens may occur on systems and platforms outside the US and maybe outside the reach of the SEC to pursue bad actors or recover funds.
  • The Chairman is especially troubled by ICO promoters who emphasize the secondary market trading potential of the tokens. He believes: "Prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others." This he believes is the classic definition of a security and a security offering.
  • "Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of "scalping," "pump and dump" and other manipulations and frauds."
  • Operators of ICO token exchanges may be operating unregistered exchanges or broker-dealers that violate the Securities and Exchange Act of 1934.
  • Cryptocurrencies may still be securities and will be subject to the same analysis as other tokens. Although the CFTC has designated Bitcoin as a commodity, the Chairman clearly believes that at least some aspects of cryptocurrencies and some use cases may fall within the purview of the SEC.
  • Brokers, dealers and other market participants who accept payment in cryptocurrencies to facilitate securities transfers must pay special attention to AML and KYC requirements.


  • The SEC generally, and Chairman Clayton specifically, are very concerned about the booming ICO market and its potential impact on "Main Street" investors. At the same time they do not want to kill this market in the U.S. and are proceeding in a cautious, incremental fashion. They have brought enforcement actions against parties that have committed fraud, but in both the DAO case and the Munchee case the SEC did not take further action against the issuers.
  • The SEC continues to acknowledge that not all tokens are securities. However, both the Munchee Order and the Chairman's statement highlight that structuring a token that will qualify as a utility will be quite difficult and run counter to many common practices in current ICOs. As opposed to the DAO ruling, analysis of the Munchee Order provides a significant list of "don'ts" that issuers of utility tokens should avoid.
  • While the Munchee Order provides new guidance, significant uncertainty remains. The interests of both the SEC and the ICO community would be well served by the development of the criteria for a utility token "safe harbor." Tokens outside the safe harbor could still be utility tokens but would have to "pass" the Howey analysis.
  • Given Chairman Clayton's very specific focus on "Market Professionals," it would not be surprising to see SEC action against non-issuer participants in the ICO ecosystem. When the Chairman says these individuals "need to focus on their responsibilities," the warning should not be taken lightly.
  • The Munchee Order highlights a potential minefield for ICO issuers – statements made by promoters in promoting token sales. One can only imagine what the internal emails of many ICO issuers state about the goals of their offerings. To have any chance of qualifying as a utility, issuers will need to implement strict communications protocols.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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