By Gary J. Ross
Gary is a partner at Ross & Shulga PLLC in New York. Gary focuses his practice on securities law, venture capital and private equity, corporate governance, and general corporate matters. Gary represents a bevy of companies in the blockchain/cryptocurrency space, as well as angel investors and investment funds. Gary can be reached at Gary@RSglobal.law.
On December 11, 2017, the Securities and Exchange Commission (the SEC) issued a cease-and-desist order (the Order) to Munchee, Inc. (Munchee) during its Initial Coin Offering (ICO). Until the Order, the SEC had only interceded in ICOs when either clearly fraudulent activity was occurring or, in the case of the DAO, to signal to the world that digital tokens can be securities. The Order sent two new messages to the cryptocurrency world: (1) that the SEC has moved on from simply punishing the most blatant bad actors and will be regulating ICOs more closely, and (2) the world of utility tokens is much smaller than previously believed. These two messages, along with other lessons learned from Munchee discussed below, will change how ICOs are carried out.
Munchee represents a warning shot to other companies in the cryptocurrency-sphere that wish to hold their own ICOs. Munchee made a few missteps that likely invited the SEC’s scrutiny - no doubt without the knowledge of its lawyers. But for the most part, Munchee’s proposed token platform, or “ecosystem”, and the promotion of its ICO are not so different from what has been used in many other ICOs.
Munchee, a California company, sought to create a token ecosystem centered around a U.S. smart phone application it launched in early 2017 that linked restaurants, restaurant-goers, and reviewers. To create this proposed ecosystem, Munchee would generate and sell tokens (MUN tokens) to the public. Munchee stated that it hoped to raise $15 million to get its business off the ground, and that the proposed token ecosystem would be online and functional within a year or two.
Munchee promoted the MUN token offering (the MUN ICO) on its website, Facebook and Twitter, and also on cryptocurrency-specific websites such as BitcoinTalk, where many people discuss and promote individual ICOs. Munchee targeted its marketing efforts towards the cryptocurrency community instead of the restaurant-going community, and did not direct any particular selling efforts to the current users of its application. Though Munchee’s application was operational, the app did not accept MUN tokens and there was no good or service that could be purchased with MUN tokens at the time of the MUN ICO.
Munchee made its white paper (the MUN White Paper) publicly available, and like all other companies conducting ICOs, it promoted the experience and expertise of its founders and other team members. As is typical when a platform has yet to be built, Munchee conveyed in its white paper how its platform would actually work and how the company’s team had the skills and abilities to bring such an effort online. Munchee also instituted a “bounty” program, by which third parties who raised awareness of the MUN ICO by creating promotional videos, articles or blog posts, as well as through translation services, were awarded tokens. Again, all of this is common practice for ICOs.
Munchee intended for its tokens to trade on a secondary market. Though legal counsel will typically remove any references in a white paper to secondary trading, the MUN White Paper was hardly unique in openly discussing that the company would work to ensure the MUN tokens traded on secondary markets. Furthermore, Munchee stated that it would buy and sell MUN tokens using its retained holdings in order to ensure there was sufficient market liquidity. Munchee also planned to “burn” leftover tokens, which would serve to boost the value of the remaining tokens.
The Munchee team was aware of the Howey test and stated in the MUN White Paper that it had conducted a “Howey analysis” and found the MUN tokens were not securities, though it did not describe the specific reasoning it used.
In some ways, Munchee did veer from market norms in its quest to woo token purchasers; primarily in making several public statements, or endorsing other people’s public statements, that touted the token offering as an opportunity to profit.
Legal counsel will typically advise founders and officers of a company conducting an ICO against going on television or a public forum and stating that the value of the company’s utility token will rise. Munchee, if it received such advice, did not heed it, since one of the founders went on a podcast and discussed the specific factors, such as the creation of quality content on the ecosystem, that were going to make the value of the MUN tokens rise.
Another one of Munchee’s founders also appeared on a cryptocurrency podcast to promote the MUN token offering, where she emphasized the financial value of cryptocurrency, and spoke of the financial gains she had made from Ether and other cryptocurrencies. While it is not uncommon for founders of a company conducting an ICO to do the equivalent of an IPO road show, care should have been taken not to convey any expectation of profits to the potential MUN token-buying community.
Most egregiously, Munchee posted the following message on Facebook: “199% GAINS on MUN token at ICO price! Sign up for PRE-SALE NOW!”, linking to a video in which a person (apparently unaffiliated with the company) said “Pretty much, if you get into it early enough, you’ll probably most likely get a return on it.” The person went on to speculate that a $1,000 investment could create a $94,000 return. It’s easy to imagine a person viewing such a video and forwarding it to the SEC.
Understandably, the SEC took notice of these oversteps and included them in its rebuke.
The SEC concluded that Munchee’s purported utility tokens were investment contracts under the Howey test. The Order does not go through each prong of the Howey test the way the SEC did in its investigative report on the DAO tokens. Instead, the SEC went right to the third and fourth prongs, declaring that token purchasers had a reasonable expectation of obtaining a future profit from the efforts of Munchee and others.
The SEC emphasized that the Howey test was flexible rather than static, and could be adapted to meet “the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” In short, the SEC endorsed a “substance over form” analysis.
The SEC found that MUN token purchasers reasonably expected the company to expend efforts to develop the ecosystem, which would cause the value of the MUN tokens to rise. The SEC specifically cited a video in which an ICO reviewer stated that MUN token holders who were looking to “flip it” would need to wait until the MUN token could be used on the app or until the platform becomes active. However, unlike with the video and podcasts referred to previously, it is not apparent the company did anything to endorse or promote this video.
Though in December members of the SEC stated that just because a token trades on a secondary exchange does not automatically mean the token is a security, it is clear in the Order that the secondary trading aspect was an important factor to the SEC’s determination, as it is mentioned several times.
While typical, the SEC also took issue with the target of Munchee’s marketing efforts, noting that they reached far beyond the potential user-base who would use MUN tokens as a regular part of the ecosystem. In particular, the marketing efforts and promotional materials seemed to heavily target purchasers who would buy MUN tokens as an investment rather than for their utility. The SEC found these activities to be problematic, and decided that they primed purchaser’s expectation of profit in an investment sense.
The Order is expected to put an end to several of the common practices described above. It is likely many of the following practices will be affected:
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