Katherine Cooper is an attorney advising financial institutions on legal and regulatory matters. Before opening her practice, she worked in senior roles at NYSE Euronext, Barclays and Citigroup Global Markets, as well as at the Commodity Futures Trading Commission's Enforcement Division.
This article is not meant to provide legal advice.
The Securities and Exchange Commission's Munchee order has given the token market plenty to munch on.
In fact, the order offers the most significant insight into the SEC's views of how to analyze ICOs under the securities laws since its July 25 report regarding The DAO offering.
To recap: On December 11, the regulator issued an administrative order accepting an offer of settlement from Munchee Inc. The startup had launched an initial coin offering to raise $15 million to improve its Munchee App by building an ecosystem of users who were to write restaurant reviews, provide advertising opportunities to restaurants and allow token holders to use the tokens to buy meals and drinks.
On the second day that its tokens were available for sale, Munchee stopped the offering after being contacted by SEC staff, and refunded the funds paid by buyers who had bought tokens.
Notwithstanding Munchee's assertion that it "had done a 'Howey analysis' and that 'as currently designed the sale of [the Munchee] utility tokens does not pose a significant risk of implicating federal securities laws,'" the SEC disagreed.
Recall that in its DAO report, the SEC for the first time analyzed a token offering under the Howey test to determine whether the token offering was a securities offering. Under the Howey test, a product is an "investment contract" and therefore a security if it involves (1) the investment of money (2) in a common enterprise with (3) a reasonable expectation of profits which (4) are to be derived from the entrepreneurial or managerial efforts of others.
But the SEC's Munchee order provides significant additional insight into how SEC staffers think about six common elements of many ICOs in their determination whether an ICO is a securities offering under the Howey test: (1) whether the tokens are immediately usable, (2) the buyers' expectation whether 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.
Below is a menu of takeaways from the SEC's comments on these six common elements. ICO issuers who wish to avoid being found to be issuing securities may want to avoid combinations of the following dishes, and in particular, the same combination of the dishes that Munchee was serving.
The order notes that "no one was able to buy any good or service with [the Munchee tokens] throughout the relevant period." Presumably, the relevant period is during the offering and before Munchee added the functionality to the app to buy meals with the tokens.
Many lawyers advising ICO issuers have thought that if the token is not usable as soon as it was sold, this was a very strong factor weighing in favor the token being found to be a security, and if a token was immediately usable that it would be a strong factor weighing against it being a security.
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:
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: The not-uncommon claims from ICO promoters that their tokens will appreciate in value are consistent with an investor's intent, not a user's intent. For example, back in the day, people bought travelers' checks not because they thought they would go up in value, but because they wanted to use them as a safe way to transport monetary value.
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 general public, or to groups focused on digital asset investments, rather 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:
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.
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