United States: Recent ICO Enforcement Trends

One week after filing a fraud suit against the organizer of the PlexCoin token sale (discussed below), the SEC issued an enforcement order in connection with a token offering by Munchee and a public statement that shed some additional light on the SEC's approach to ICO issuances. The PlexCoin fraud suit and the Munchee enforcement action were initiated by the SEC's recently created cyber unit and reinforce the SEC's ongoing interest in policing ICOs and token sales involving U.S. investors.

As the SEC discussed in the DAO report, tokens, coins or other digital assets issued on a blockchain may be securities under the federal securities laws, and if they are securities, issuers and others who offer or sell them in the United States must register the offering and sale with the SEC or qualify for an exemption from registration. On Dec. 11, 2017, the SEC made this determination with respect to MUN tokens sold by Munchee, a California business that created an app that allows users to post photographs and reviews of meals they eat in restaurants. In addition, it appears that state regulators are starting to follow the SEC's lead. For instance, on Jan. 17, 2018, the state of Massachusetts brought an action against a company based outside Boston that offered a token to residents of Massachusetts, the proceeds of which would be invested in cryptocurrencies and residential real estate. The Securities Division of the state of Massachusetts (the MA Securities Division) considered this "a textbook example of a conventional security, required to be registered or exempt from registration in the Commonwealth." To our knowledge, this marks the first enforcement action brought by a state regulator in the context of an ICO.

I. Cyber Scams: The PlexCoin Case

The SEC filed charges in federal court against PlexCorps and its owner for selling PlexCoin, a token the SEC determined was a security. The offering materials related to the ICO promised investors a thirteenfold profit in less than a month. This claim, as well as others made in connection with the ICO, were fraudulent, and the SEC alleged that the ICO constituted a "full-fledged cyber scam." Robert Cohen, the chief of the cyber unit, said the SEC "acted quickly to protect retail investors from this initial coin offering's false promises," noting that it is "exactly the kind of misconduct the unit will be pursuing."

II. SEC Halts Munchee's Token

 1. The Application of the Howey Test

Under Section 2(a)(1) of the U.S. Securities Act of 1933, a security includes "an investment contract."[1] The term "investment contract," as interpreted by the U.S. courts, has been defined as 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.[2]

The SEC order in the Munchee action claimed that the token purchasers had a reasonable expectation of profits from their investment in the Munchee enterprise. The investors handed over their capital to Munchee so that Munchee, through its entrepreneurial and managerial efforts, would create the "ecosystem" that would increase the value of MUN (through both an increased demand for MUN tokens by users and Munchee's specific efforts to cause appreciation in value, such as by burning MUN tokens) and support a secondary trading market for the MUN token. In the order, the SEC briefly delved into the concept of a "utility token" and indicated that "even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling [sic] – such as characterizing an ICO as involving a 'utility token' – but instead required an assessment of the 'economic realities underlying a transaction.'"[3]

In addition, the SEC was not impressed by the fact that Munchee had conducted the Howey analysis itself, reaching the self-serving conclusion that the sale of its tokens did not pose a significant risk of implicating the federal securities laws.

2. Cooperation Credit

On a positive note, the SEC did not impose a civil penalty, in light of Munchee's cooperation with the SEC's staff and prompt implementation of remedial actions. "In deciding not to impose a penalty, the SEC recognized that the company stopped the ICO quickly, immediately returned the proceeds before issuing tokens and cooperated with the investigation," said Stephanie Avakian, co-director of the SEC's Enforcement Division.

III. State Regulators Move to Regulate ICOs: The Caviar Case

The MA Securities Division alleged in its complaint that Caviar, a company located outside of Boston, was engaging in an ICO as a way to finance the creation of a hedge fund and offer freely transferable shares to investors in the form of tokens. The MA Securities Division sought to enjoin Caviar from offering and selling unregistered and nonexempt securities in violation of applicable state law. In determining whether the tokens were securities, the MA Securities Division followed the same approach as the SEC and analyzed the factors in Howey. The complaint also noted that the procedures to prevent the sale of Caviar tokens to U.S. investors were inadequate. In fact, an investigator employed by the MA Securities Division applied to participate in the Caviar ICO and was approved to participate in the ICO within 29 minutes of his submission of paperwork even though there were clear inconsistencies in his paperwork that should have raised red flags and that identified him as a U.S. person. 

Early on in its complaint, the MA Securities Division made its general unease with ICOs very clear, saying, "[d]espite the speculative nature, potential for fraud, and risk of loss associated with cryptocurrencies, they have captured the public imagination. Fueled by the frenzied interest surrounding Bitcoin and the other cryptocurrencies, ICOs have become an increasingly popular mechanism for entities and individuals seeking to raise capital quickly." 

Going forward, we expect the SEC and state regulators will continue to closely scrutinize ICOs. SEC Chairman Jay Clayton indicated in a recent speech that "by and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities ..." As a result, issuers engaging in ICOs need to carefully assess whether they are engaging in an offer and sale of securities. In the Munchee situation, for instance, the tokens appear to have been marketed, at least to some degree, as a proxy for the success of the Munchee business, and the token purchasers therefore would have had a reasonable expectation of profit on the purchase of the tokens through the efforts of Munchee. Had the MUN ecosystem and technology been fully developed prior to the time of the ICO, perhaps the ICO could have been effectuated in a manner that was not a securities offering by focusing on the utilitarian aspects of the MUN token in the sales process. In conclusion, it is essential for entities considering a token offering to discuss the structuring of their ICO with counsel in order to ensure compliance with the existing guidance provided by the different regulators. 


[1] See 15 U.S.C. § 77b.

[2] See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975).

[3] Forman, 421 U.S. at 849.

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