Monday, February 12, 2018

Overview of the SEC Regulation of Virtual Currency: Do Utility Tokens Still Exist?

In this post, I would like to analyze the trend in the regulation (including guidance) by the Securities and Exchange Commission (the "SEC") of the virtual currencies offerings, often referred to as ICOs (initial coin offerings) or TGEs (token generation events).  Please note that all opinions expressed herein are my own.

The first major SEC pronouncement regarding digital assets was the investigative report issued by the SEC on July 25, 2017 "concluding DAO Tokens, a digital asset, were securities."  I am sure that by now you know the details of this report.  There are, however, two thing I would like to note.  First, the SEC determined not to pursue an enforcement action in this matter, and instead issued an investigative report.  Second, the general impression from the report was that some, but not all, of the offered tokens out there were "securities" under the US federal laws, and that all depended on the "facts and circumstances" of that particular set of tokens.  The DAO report described what a "security" token could look like.  However, it left undefined the boundaries around the "utility" token.  In my opinion, this resulted in much speculation and agonizing in the legal profession regarding the precise divide between the "security" and "utility" tokens, something that now (in retrospect) seems like an unnecessary task.   Some legal practitioners adopted a conservative attitude trying to fit the tokens of their clients within the tests provided by the 1946 SEC v. W. J. Howey Co. case, while others tried to redefine the functionalities of the tokens to fit them within the "utility" realm.

Regardless of the interpretations, several things became clear to the legal practitioners and the ICO world: (i) traditional tests used to determine what are securities applied regardless of whether the issuing entity was a traditional company or a decentralized autonomous organization and whether the securities were purchased with fiat or virtual currency; (ii) the DAO token holders could immediately re-sell their tokens on secondary platforms; (iii) the DAO token holders held certain voting rights, although they were essentially meaningless given the power of the DAO Curators; and (iv) the DAO token holders expected to earn profits by investing into promising projects.  Knowing these features, applying the Howey test became an important exercise in determining whether any particular tokens were "securities" under the US laws.

The next step came two months later, at the very end of September 2017, when the SEC filed charges against Maksim Zaslavsky and the two ICOs supposedly backed by investments into real estate and diamonds.  According to the SEC complaint, investors into REcoin Group Foundation and DRC World (aka Diamond Reserve Club) expected sizable returns from the companies' operations but in fact neither company had any operations.  In addition to charges for fraud, the SEC's charges included selling unregistered securities.  The numerous fraudulent representations made by the principal raised the investors' expectations to make a profit from their investments.  There was a clear and predominant fraudulent component to those ICOs.

Then, on December 4th, the recently created SEC Cyber Unit filed an emergency asset freeze to stop the ICO fraud allegedly perpetrated by Dominic Lacroix and his company PlexCorps.  Mr. Lacroix marketed and sold PlaxCoins claiming that these investments would "yield a 1,354 percent profit in less than 29 days."  Once again, even though the defendants were charged with violating the anti-fraud provisions as well as the registration provisions, the focus of the SEC seemed to be on the ICO scams.

Until December 11th, 2017, the "utility" vs "security" debate had remained largely the same: lots of speculation and uncertainty.  Then, on December 11th, came the SEC order against Munchee, Inc., a California-based company that was conducting an ICO of its tokens that had a definite utility component.  The one thing that was different about this ICO was that it did not involve fraud.  The main focus of the SEC cease-and-desist order was on the ubiquitous question of whether or not those tokens were "securities."  This order put many legal practitioners on guard by refining the previous guidance issued in the DAO report on the nature of the tokens.

Munchee was raising funds to improve their restaurant review app, hoping to create an ecosystem where users would receive tokens for writing food reviews and would then buy and sell goods and services using the tokens.  Throughout the offering, the company emphasized that investors could expect an increase in value of the tokens, and that it would take steps to create and support a secondary market in the tokens even before the ecosystem was built.

The SEC determined that MUN tokens were "investment contracts" under the Howey test because the investors had a reasonable expectation of obtaining future profit based tokens' appreciation in value due to the Munchee team's efforts to revise the app and create the ecosystem.  The SEC also noted that "even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security."  This meant that even tokens with utility aspects could be deemed to be "securities" under the US laws.

On January 30th, 2018, the SEC halted another fraudulent ICO that aimed to get investors to fund "the world's first decentralized bank" called AriseBank.  According to the SEC complaint, AriseBank lied to the public by saying that it purchased an FDIC-insured bank that offered its customers FDIC-insured accounts and the ability to get a VISA credit card linked to cryptocurrencies.  In addition to the 10b-5 claims, the SEC claimed violation of Section 5(a) (failure to register securities).

So, we come to the February 6th testimony by Jay Clayton, the Chairman of the SEC before the Senate's Committee on Banking, Housing, and Urban Affairs.  This speech confirms what most experienced legal practitioners suspected from the beginning, - that most ICOs are offers and sales of securities.  Mr. Clayton stated: "When investors are offered and sold securities - which to date ICOs have largely been - they are entitled to the benefits of state and federal securities laws and sellers and other market participants must follow these laws."  Mr. Clayton also stated that "... simply calling something a currency" or a currency-based product does not mean that it is not a security."  Further, "[m]erely calling a token a "utility" token or structuring it to provide some utility does not prevent the token from being a security."

Mr. Clayton also mentioned the need for increased federal regulation of cryptocurrency trading platforms and cautioned that platforms that effect or facilitate transactions in virtual currencies may be operating as unregistered broker-dealers in violation of the Securities Exchange Act of 1934.

In conclusion, the last six or so months have shaped the US policy towards regulation of initial coin offerings.  Through the pronouncements, guidance, enforcement actions, and cease-and-desist orders, the SEC has shown readiness to combat fraud and to regulate most, if not all, ICOs as "securities."  Going forward, any client wanting to structure their token offering directed at US investors as "utility token" offering outside of the realm of the US securities laws, would be ill advised to do so.     

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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