On December 11, 2017, the United States Securities and Exchange Commission (the "SEC") issued a cease-and-desist order (the "Order") that halted the Initial Coin Offering, or "ICO", of Munchee, Inc., a California business that created an iPhone application for people to review restaurant meals. According to the Order, Munchee engaged in an ICO of its digital tokens ("MUN" or "MUN tokens") to raise capital so that it could improve its existing iPhone app and recruit users to eventually buy advertisements, write reviews, sell food and conduct other transactions using MUN.
Munchee started selling MUN tokens under the ICO on or about October 31, 2017, and it stopped selling MUN tokens on November 1, 2017 after being contacted by the staff of the SEC.
In the Order, the SEC concluded that the MUN tokens were "investment contracts," and thus "securities," after applying the Supreme Court case analysis of SEC v. W.J. Howey Co. (i.e., the "Howey Test"). As a result, the offer and sale of MUN tokens by Munchee to potential investors in the United States without having a registration statement filed or in effect with the SEC or qualifying for exemption from registration with the SEC constituted a violation of federal securities laws.
In its analysis, which focused significantly on the fact that the ICO was being conducted prior to the establishment by Munchee of the "ecosystem" that would drive the value for the MUN tokens (with the proceeds of the ICO being used to undertake such work), the SEC noted that:
"MUN purchasers had a reasonable expectation of profits from their investment in the Munchee enterprise. The proceeds of the Munchee token offering were intended to be used by Munchee to build an 'ecosystem' that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise the Munchee app so that people could buy and sell services using MUN tokens and was to recruit 'partners' such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of MUN tokens created by the revised Munchee App and by Munchee's ability to create an 'ecosystem'.... In addition, Munchee highlighted it would ensure a secondary trading market for MUN tokens would be available shortly after the completion of the offering and prior to the creation of the ecosystem."
Further, although "the MUN token did not promise investors any dividend or other periodic payment. . . . as would have reasonably been understood by investors, investors could expect to profit from the appreciation of value of MUN tokens resulting from Munchee's efforts."
In response to arguments that the MUN tokens were "utility tokens" and thus not securities, the Order went on to state,
"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 labeling – such as characterizing an ICO as involving a 'utility token' – but instead requires an assessment of 'the economic realities underlying a transaction.'"
This action serves as yet another reminder of the SEC's willingness to aggressively target violations in the ICO space, and to focus on the economic realities of a token regardless of the labels applied by the issuer. Those seeking to conduct an ICO should be very careful – and should seek the advice of experienced securities counsel – when structuring their tokens.
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