The following summarizes the recent Order by the U.S. Securities and Exchange Commission requiring that a “utility token” issued in an Initial Coin Offering (ICO) carry an expectation of use, not an expectation of profits, in Order to not be considered a security under the Howey test for investment contracts.
On December 11, 2017, the US Securities and Exchange Commission (SEC) issued an Order (Order) instituting cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 with respect to Munchee Inc. (Munchee).
The SEC’s settlement with Munchee is an important milestone in the emerging area of “token law”, as it challenges assertions that a token is a ‘utility’ rather than a security simply based on its nomenclature. Instead, the SEC considers the substance, rather than the form, in classifying a token.
The Order was based on traditional legal analysis of the Howey Test and determined that Munchee offered investors a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The Order evaluated six elements that are common to many ICOs in their determination whether an ICO is a securities offering:
(1) whether the tokens are immediately usable,
(2) the buyers' expectation that the tokens will rise in value,
(3) whether an expected rise in value will be derived from the efforts of others,
(4) whether there will be a secondary market for the tokens,
(5) how the ICO offering is advertised, and
(6) how the proceeds of the ICO are to be used.
Munchee, a California-based company, was in the process of offering digital tokens (designated as “MUN” tokens) to investors through an initial coin offering (ICO). In the Order, the SEC determined that the ICO was an offering of securities without registration or an available exemption, notwithstanding that the digital tokens offered and sold in the ICO were intended to have a utility function.
Munchee created a visual food review and social networking smart phone application (app) for users located in the US. It developed a plan to conduct an ICO of MUN tokens in October and November 2017 in Order to raise approximately US$15 million in capital to fund its operations, including the development of blockchain-based apps.
Munchee described the MUN tokens and the offering in its whitepaper. The white paper described the creation of an “ecosystem,” in which users of the app, restaurants, and Munchee’s advertising business would be connected and would transact using MUN tokens. App users would be paid in MUN tokens for writing food reviews and could use MUN tokens to pay for “in-app” purchases and food at participating restaurants. Restaurants participating in the ecosystem could receive MUN tokens by selling food to app users and could use MUN tokens to purchase advertising from Munchee and to pay rewards to app users who reviewed their meals.
However, at the time of the offering, the ecosystem was not functional and none of these goods or services were available for purchase with MUN tokens. Munchee stated in its White Paper that it would run its business in ways that would increase participation in the ecosystem, which would lead to increased value of MUN tokens — users would create additional quality content to attract more restaurants onto the platform, and, with more restaurants participating in the platform, MUN tokens could be more widely used, increasing the value of the MUN token. Munchee also stated in its White Paper that it would list MUN tokens for trading on at least one US-based exchange within 30 days of the offering.
Moreover, Munchee also agreed that it would use its reserves in Order to provide liquidity to the MUN token market. Munchee’s ICO marketing efforts targeted a broad audience. According to the SEC these efforts included web postings such as “199% GAINS or MUN token at ICO price! Sign up for PRE-SALE NOW!” as well as links to promotional videos touting the possible returns investors could make on the tokens.
The SEC noted that Munchee “did not use the Munchee App or otherwise specifically target current users of the Munchee App to promote how purchasing MUN tokens might let them qualify for higher tiers and bigger payments on future reviews.”
On November 1, 2017, the second day of the ICO, SEC staff contacted Munchee, which determined within hours it would shut down the ICO. Munchee had not delivered any MUN tokens to purchasers and promptly returned the proceeds that it had received. In applying the Howey test to the MUN token ICO, the SEC determined that MUN tokens were securities and cited the following factors: • Munchee intended to use the proceeds from the ICO to revise the app and build an ecosystem based on the MUN tokens, which MUN token purchasers reasonably expected would increase the value of the MUN tokens.
Furthermore, Munchee promised to facilitate a secondary market for the MUN tokens in advance of creation of the ecosystem in which they could be used. And finally, investors’ profit expectations were “primed” by Munchee’s marketing, which compared the MUN tokens to previous ICOs that had generated profits for early ICO investors.
Specifically, Munchee “marketed to people interested in those assets – and those profits – rather than to people who, for example, might have wanted MUN tokens to buy advertising or increase their ‘tier’ as a reviewer on the Munchee App.” • Such profits would be realized through the appreciation in value of MUN tokens, which would require the “significant entrepreneurial and managerial efforts of others” in the form of building the ecosystem, designing the revised app and supporting the secondary market for the MUN token.
Due to Munchee’s conduct and marketing approach during the course of the ICO, investors’ belief that they could rely on the significant efforts of Munchee to drive increased MUN token value was reasonable. Because MUN tokens were securities, and Munchee offered and sold these securities to the general public without filing a registration statement or through a valid exemption, Munchee violated Sections 5(a) and (c) of the Securities Act.
Tokens As Securities
The SEC’s definition of a security includes investment contracts, which it defines as (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.
In its cease-and-desist Order to Munchee, the SEC focused on those last two elements: a reasonable expectation of profits derived from the efforts of others.
Reasonable Expectation of Profits
The SEC identified two characteristics of MUN tokens that satisfied the reasonable-expectation-of-profits element. First, the value of the pre-functional MUN tokens bought during the ICO would naturally increase once the Munchee “ecosystem” on which they
could be used was implemented.
Second, in promoting MUN tokens in its white paper, through social-media accounts, and elsewhere online, Munchee emphasized the likelihood that the tokens would increase in value. It also promoted MUN tokens to investors in countries other than the United States, even though the Munchee app is only available in the U.S.
Derived from the Efforts of Others
Any increase in MUN tokens’ value between the ICO and the launch of the enhanced Munchee app would be the result of Munchee’s efforts. Specifically, Munchee would develop the enhanced app, increasing demand for MUN tokens and, accordingly, the tokens’ value.
In addition, Munchee had promised to support secondary markets on which MUN tokens could be sold, including by buying or selling MUN tokens to ensure a “liquid secondary market.” This, too, would tend to increase MUN tokens’ value.
As to each of the six elements common to many purported “utility token”” sales referenced above, following are the takeaways that the Munchee Order provides:
The Order notes that "no one was able to buy any good or service with [the Munchee tokens] throughout the relevant period” (i.e. during the offering and before Munchee added the functionality to the app to buy meals with the tokens).
Even though the Munchee token was not immediately usable, the SEC cautioned against reasoning that if a token is immediately usable that is a strong factor for it not to be a security:
"Even if the Munchee 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 – such as characterizing an ICO as involving a 'utility token' – but instead requires an assessment of 'the economic realities underlying a transaction.' All of the relevant facts and circumstances are considered in making that determination."
Takeaway: Even immediately usable tokens can be securities, depending on all the facts and circumstances of the ICO.
The Order observes that Munchee's white paper emphasized that the "ecosystem" that it was to create allowing diners and restaurants to use the tokens in various ways would cause the tokens to rise in value.
It also stated that Munchee would run the company in a way to cause the tokens to rise in value such as "burning tokens" to restrict supply.
From these statements, the Order concludes: "Purchasers would reasonably believe they could profit by holding or trading [Munchee] tokens, whether or not they ever used the Munchee App or otherwise participated in the [Munchee] 'ecosystem,' based on [the white paper]."
Takeaway: Claims from promoters that tokens will appreciate in value are consistent with an investor's intent, not a customer's intent.
Efforts of others
The Order notes that Munchee's website, advertising and white paper reasoned that the tokens would rise in value because "Munchee and its agents could be relied on to provide the significant entrepreneurial and managerial efforts required to make [the Munchee] tokens a success."
Representations that management of an ICO issuer will upgrade the functionality of the platform or the tokens themselves in the future are common.
Takeaway: If the promise of future improvements by the ICO issuer are combined with the issuer's claims that token holders will profit by a related increase in value, that will satisfy the prong of the Howey test whether the investor reasonably expects to profit from the efforts of others.
The Order observes that Munchee's white paper stated "Munchee will ensure that [the Munchee] token is available on a number of exchanges in varying jurisdictions to ensure that this is an option for all token-holders."
Specifically, Munchee said that the "tokens would be available for trading on at least one U.S.-based exchange within 30 days of the conclusion of the" ICO, the SEC said. "Munchee highlighted that it would ensure [a] secondary trading market for [the] tokens would be available shortly after the completion of the offering and prior to the creation of the ecosystem."
In other words, token holders could profit from Munchee's efforts to establish and support a secondary market without ever using the tokens to buy a good or service.
Takeaway: If an ICO issuer is promising to maintain a secondary market, it is less likely that the token will be seen simply as a utility token. With a secondary market, a token holder can profit without ever using the token for the purpose it was made for. This is especially the case if the secondary market will exist prior to the token being usable for its intended purpose.
Manner of advertising
The Order notes that Munchee had advertised and marketed the token offering broadly on its website and message boards, likening the Munchee tokens "to prior ICOs and digital assets that had created profits for investors."
Moreover, the SEC observed that to the extent Munchee had a focus of its marketing it was to people interested in digital assets and the profits earned by investing in such assets as opposed to members of the restaurant industry, promoting how the tokens "might let them advertise in the future," or otherwise use the tokens in their restaurants' businesses.
Takeaway: Marketing an ICO to the groups other than the members of the industry who would use the token in the ordinary course of their business, tends to show that the token is really an investment or a security rather than a true utility token.
Use of proceeds
The Order comments on how Munchee told token buyers the proceeds of their purchases would be used:
"The proceeds of the [Munchee] token offering were intended to be used by Munchee to build an 'ecosystem' that would create demand for [Munchee] tokens and make [the] tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using [the] tokens and was to recruit 'partners' such as restaurants willing to sell meals for [the] tokens."
Takeaway: Where the proceeds of the token offering are used to promote the general corporate purposes of the issuer, rather than being held in escrow or invested in a hedging transaction to help provide the good or service that the buyer can exchange a token for in the future, the ICO appears to be more of an investment rather than a deferred purchase of a good or service not implicating the securities laws.
Not surprisingly, all of these factors analyzed together led SEC to the conclusion that Munchee token was in fact a security.