By: Michael W. Zarlenga*
On December 11, 2017, the Securities and Exchange Commission (SEC) made public three important documents related to ICOs and cryptocurrency ecosystems. The first was the public release of an order instituting a cease-and-desist proceeding against Munchees, Inc., a restaurant review iPhone application. Munchees, Inc. engaged in an ICO of MUN, coins which closely resembled utility tokens. However, using the U.S. Supreme Court’s analysis in SEC v. W.J. Howey Co., the SEC classified the MUN as investment contracts. As the SEC discussed in The DAO Report, tokens, coins, or other digital assets issued on a Blockchain may be securities under Federal law. If they are securities, issuers and others who offer or sell them in the United States must register the offering and sale with the SEC or qualify for an exemption from registration. Quoting two other U.S. Supreme Court Cases, United Housing Found., Inc. v. Forman and Tcherepnin v. Knight, the SEC noted that “In analyzing whether something is a security, form should be disregarded for substance, and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto. In other words, calling something a Utility Token does not make it so in the eyes of the SEC or the Federal securities laws.
The second issuance by the SEC was a longer statement on cryptocurrencies and ICOs. It was a statement from SEC Chairman Jay Clayton. Chairman Clayton stated: “A key question for all ICO market participants: ‘Is the coin or token a security?’ As securities law practitioners know well, the answer depends on the facts.” Chairman Clayton went on to provide an example of the difference:
For example, a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come. It is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens. Prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.”
As with the Muchees, Inc. cease-and-desist order, the example points out that the fact that if a token is going to increase in value based on the future efforts of others, it is most likely a security. This position should not be surprising given the SEC’s position that a SAFT (Simple Agreement for Future Tokens) is an investment contract and therefore, a security.
The final public release by the SEC is a transcript of a speech last week by Dalia Blass, the Director of the SEC’s Division of Investment Management. While Ms. Blass spent very little of her speech on cryptocurrencies, Ms. Blass did note the following:
We also continue to think about new innovations in asset management. For example, we have seen several filings for registered funds that would hold cryptocurrency. As with any new product, there are questions to ask. For example, would retail investors have sufficient information to consider these products and to understand the risks? . . . When thinking about cryptocurrencies and other blockchain offerings as fund assets, are differences in their features important? How would these funds fit into the existing regulatory scheme? What regulatory structure or structures apply to the market for the underlying instrument? We will be discussing these questions with you as we work through these filings.
Is this a foreshadowing that the SEC is looking to regulate the secondary markets for utility tokens or coins?
As with other Federal and state agencies, the SEC is very interested in the topics of cryptocurrencies and other Blockchain assets. The future regulatory landscape is anything but clear. Bergstrom Attorneys continues to monitor developments and advise clients in the cryptocurrency and distributed ledger network arena. Let us know if we can help you.
* Michael W. Zarlenga is Of Counsel to Bergstrom Attorneys, PLLC. Mr. Zarlenga has extensive securities law experience, including both public and private placements of securities totaling in excess of $2 billion. In addition, Mr. Zarlenga has advised clients ranging in size from start-up companies to Fortune 500 in such diversely regulated fields as biotech, hi-tech, financial services, and insurance.