Regulator finds that sellers of blockchain-based digital coins cannot dodge securities law by calling the coins “utility tokens.”
It is still possible to carry out an initial coin offering in compliance with the Securities Act by relying on the Act’s Rule 506(c) or Regulation A provisions.
There are important differences that will make one or the other of those provisions more suitable for a particular offering.
In a December 11, 2017 Administrative Proceeding, In the matter of Munchee Inc. (the Order), the U.S. Securities and Exchange Commission (SEC) shut down an ICO (initial coin offering). In doing so, it dealt a serious blow to a somewhat strained distinction relied on in many ICOs this year between “utility tokens” and “security tokens.” The Order underscores the need to develop approaches for ICOs that are compliant with the Securities Act of 1933 (the Securities Act) and highlights the risks of engaging in non-compliant ICOs.
The Munchee ICO Launch
Munchee Inc. (Munchee) is a California business that created an iPhone application to allow users to post photographs and reviews of restaurant meals. Munchee intended to sell blockchain-based digital tokens or coins (MUNs) in order to raise about $15 million to improve its application. The MUNs would be integrated into the application and used for a variety of transactions, including buying advertisements, writing reviews and selling food. After an initial marketing period, Munchee launched its ICO on October 31, 2017, but on the next day, the SEC staff called and, within hours, Munchee shut down the ICO.
A Typical ICO Path Ends in a Bad Place
As described in the Order, the steps Munchee took to launch its ICO were typical of many prior ICOs. First, on October 1, Munchee announced that it would be launching a public ICO of 500 million MUNs. Concurrently, it posted a “white paper,” which described the MUNs, the offering process, the use of proceeds, statements as to how the MUNs would increase in value and the trading market for the MUNs. Munchee then posted information about the ICO and the MUNs on its main webpage, a blog, Facebook, Twitter, BitcoinTalk and various message boards.
The distribution method was also typical. MUNs could be purchased through various websites in the U.S. and worldwide. The offering included a pre-sale in which early purchasers could buy MUNs at discounts to the offering price. Munchee planned to hold back 55 percent of the MUNS to support its business, including by paying rewards in its application with MUNs, paying its employees and advisors with MUNs and facilitating advertising transactions with MUNs. Munchee also described a two-year timeline to develop a smart contract on the Ethereum blockchain platform, which would automatically integrate “in-app” use of the MUNs and set up virtual wallets for end-users of the MUNs.
Finally, Munchee took typical steps to develop a liquid secondary market for the MUNs. The white paper stated that MUNs would be available for trading on at least one U.S.-based crypto-currency exchange within 30 days of the conclusion of the offering. It also stated that Munchee would buy or sell MUNs, as required, to ensure liquidity.
On November 1, after being contacted by the SEC staff, Munchee unilaterally terminated its ICO and the contracts of sale it had entered into with investors, and returned their funds. The SEC decided to pursue the matter. Applying the Howey test, the SEC found that the MUNs were securities and that Munchee had violated the Securities Act by selling MUNs to the public without complying with the registration requirements. In light of the prompt remedial action taken by Munchee, the SEC elected not to impose a civil penalty. Instead, it imposed a cease and desist order on any future violations of Sections 5(a) and (c) of the Securities Act by Munchee.
Wait, What? Weren’t They “Utility Tokens”?
According to the Order, Munchee’s white paper referred to the SEC’s earlier DAO Report and stated that Munchee had done a “Howey analysis.” The white paper stated that “as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.” (Emphasis added). Munchee concluded that because the tokens would be used in the iPhone application that it was developing, they were “utility tokens” and not “securities.”
The SEC disagreed. The Order states, “Determining whether a transaction involves a security does not turn on labelling—such as characterizing an ICO as involving a ‘utility token’—but instead requires an assessment of ‘the economic realities underlying a transaction’” (citing Forman, 421 U.S. at 849). The SEC acknowledged that the tokens were intended to be used in the Munchee application and to buy goods or services in the future. However, it focused on how Munchee created an expectation in its ICO that the value of the MUNs would rise due to the efforts of the company in developing its application (and managing its “ecosystem”) and how investors could expect to realize a profit by selling MUNs through a liquid secondary market. These features, of course, align with the core elements of the Howey test—namely “the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
The Myth of the Magic Frog
The Order strikes at the heart of the distinction—of which much has been made—between a “utility token” and a “security token.” Some ICO sponsors, like Munchee, have taken the view that a token is a utility token from inception and therefore outside of the scope of the Securities Act. Others have taken a “magic frog” approach, believing that a token can begin life as a security token (i.e., a magic frog) but at the point that the application and ecosystem go “live,” the token will be transformed into a utility token (i.e., the magic frog becomes a prince) and any securities law restrictions will no longer apply. The Order clearly rejects both of these approaches. So long as investors have the opportunity to trade in the tokens with an expectation that the value of the token will increase due to the efforts of the issuer, there is a high likelihood that the token will be—and will remain—a security (i.e., a plain old frog) in the eyes of the SEC.
Compliant Paths Forward
The concept of the “utility token” as a means of avoiding compliance with the Securities Act in ICO offerings has therefore been properly and decisively rejected by the SEC, but that does not mean that an ICO cannot be conducted without the full regulatory burden of a public offering registered under the Securities Act. Rule 506(c) of Regulation D and Regulation A+ under the Securities Act are particularly well-suited for ICOs. Both offer the ability to engage in broad public solicitation of investors, but there are important differences that will make one or the other more suitable for a particular offering.
The Advantages of Rule 506 and Regulation A+
The most notable advantages to offerings under the SEC’s Rule 506 are that, in an offering limited to “accredited investors” (as defined in Regulation D), there are: no substantive review at either the Federal or state level; no required disclosure filings; no limit on the amount that can be raised; and, in an offering under Rule 506(c), no limit on public advertising or general solicitation.
Further, disappointed investors in a Rule 506 offering cannot sue, under the federal securities laws, for negligent misrepresentation (that is, lack of due care or due diligence). As a result of a 1995 Supreme Court decision, Gustafson v. Alloyd (513 U.S. 561 (1995)) which held that the liability provisions of Section 12(a)(2) of the Securities Act do not extend to a private sale, investors in Rule 506 offerings may assert federal claims only under section 10(b) of the Exchange Act and Rule 10b-5, which require that the investor prove actual intent to defraud, or reckless indifference to the truth of the representations made in the offering. The practical effect of Gustafson has been to make it much harder for lawsuits to be maintained by investors in Rule 506 offerings.
The most notable disadvantages of Rule 506 are (1) that offerings generally must be limited to “accredited investors,” and (2) that securities sold in a Rule 506 offering are “restricted,” which means that there are substantial barriers to the establishment of a trading market that could offer liquidity for the securities. These disadvantages are both addressed in offerings under Regulation A+, but at a substantial cost.
Regulation A was recently expanded to allow an issuer to offer and sell up to $50 million of securities over a 12-month period in a public offering, without registration under the Securities Act, leading the amended rule to be called “Regulation A+.”
The most notable advantages of Regulation A+ are (1) that the issuer can “test the waters” with potential investors for interest in an offering both before and after filing an offering statement with the SEC; (2) that the offering can be made by public advertising or general solicitation; (3) that the offering need not be limited to “accredited investors”; and (4) that the securities sold in a Regulation A+ offering will not be considered “restricted securities” under the Securities Act and will not be subject to transfer restrictions. The lack of transfer restrictions creates an opportunity for establishment of trading markets in Regulation A+ securities, offering liquidity to investors that is not available in Rule 506 offerings.
In contrast to the lack of substantive review in Rule 506 offerings, however, the offering documents in a Regulation A+ offering must be filed with, reviewed by and “qualified” by the SEC. In addition, issuers in a Regulation A+ offering may be required to provide ongoing public reporting to the SEC, which is not required of issuers in Rule 506 offerings. “Tier 1” offerings under Regulation A+ (those raising up to $20 million) also are subject to substantive review by the states. “Tier 2” offerings under Regulation A+ (those raising $20-50 million), however, are not subject to substantive review in the states. Overall, Rule 506 offers a clear advantage in its lack of substantive review of offering materials at either the Federal or state level, and in the lack of any requirement for ongoing public reporting. This lack of review or ongoing reporting should also mean that there is a significant cost advantage to proceeding under Rule 506.
In contrast to Rule 506, sellers of Regulation A+ securities also will have the risk of liability under Section 12(a)(2) of the Securities Act for offers or sales that include a materially misleading statement or omission. As noted above, this liability risk is not present in offerings made under Rule 506. As a consequence, Regulation D offerings will continue to have a significant advantage over Regulation A+ offerings in terms of risk of liability. See Can Regulation A+ Succeed Where Regulation A Failed?
Rule 506 or Regulation A+?
Because Rule 506 and Regulation A+ both have advantages and disadvantages, there is no one answer that will be right for all offerings, but each offers a way to conduct an ICO offering in compliance with the Federal securities laws. The decision which one to use should be made only after careful consideration with securities counsel.