Securities Token Or Not? A Case Study – Part II

This is the second part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. Although the first and easy answer is that if a digital asset is being issued today, it is most assuredly a security upon issuance that needs to comply with the federal securities laws, the answer is not always that straightforward for digital assets that have been in the marketplace for a period of time, such as Bitcoin and Ether, or for new digital assets that are carefully being constructed to fall outside the purview of a securitized token.

In the first part of this series, we examined the Oldie Token and, under the fact pattern presented, was able to determine that the Oldie Token was not a security. Part 1 can be read HERE. In this part we will examine the Functional Token, which has not yet been issued. In our fictional fact pattern, Freight Blockchain, Inc. has created what they believe to be a true utility token, the Functional Token that would not need to comply with the federal securities laws. Based on the analysis below, I concluded that Functional Token does indeed need to comply with the federal securities laws.

Sources Applicable to an Analysis of all Digital Assets

In determining whether a digital asset is a security and/or needs to comply with the U.S. federal securities laws in its issuance and distribution, at least the following sources should be reviewed and considered by securities counsel. This is not a comprehensive list as facts and circumstances, and the evolving state of the U.S. and international laws, must also be considered, but it covers the basics.

1. The Securities Act;
2. The Exchange Act;
3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”);
4. Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”);
5. Report of Investigation Pursuant to Section 21(a) of the Exchange Act: The DAO (July 25, 2017)(the “DAO Report”);
6. In the Matter of Munchee Inc. (“Munchee Order”);
7. Statement on Cryptocurrencies and Initial Coin Offerings (SEC Chairman Jay Clayton) (December 11, 2017) (“SEC Cryptocurrency Statement”);
8. Speech by William Hinman, the Director of the SEC Division of Corporation Finance at Yahoo Finance’s All Markets Summit on June 14, 2018;
9. SEC v. PlexCorps et al., Civil Action No. 17-cv-07007 (E.D. N.Y., filed December 1, 2017) (“PlexCorp Litigation”);
10. In the Matter of Tomahawk Exploration LLC et al. (“Tomahawk Matter”);
11. The Bitcoin White Paper;
12. The Ethereum White Paper;
13. The MUN Coin White Paper;
14. The PlexCoin White Paper; and
15. The White Paper and all relevant documents associated with the particular Digital Asset.

Like the first, this blog and case study is limited to an analysis of the U.S. federal securities laws and does not include any state or international securities laws nor the applicability of any regulations promulgated under or enforced by any other U.S. regulators such as the CFTC, FinCEN or the IRS.

The Functional Token

Facts

Freight Blockchain, Inc. is a software company focused in the logistics and transportation business. They have built a blockchain software application whereby the defragmented small trucking company can have access to the freight and transport needs of customers such as warehouses, stockrooms and shipping and receiving stations, without the use of a freight agent or broker. In addition to allowing for direct communication between trucking companies and potential customers, the Freight Blockchain allows for pre-screened qualified businesses in the logistics industry to advertise their goods and services on its platform. Freight Blockchain’s revenue model is based on transaction fees for the use of the Freight Blockchain.

Freight Blockchain’s idea was well received in the trucking industry and, as a result, they were able to raise funds in traditional debt and equity offerings and through venture capital investors. The Freight Blockchain is fully built out and operational, though as with any application, it is expected that it will need consistent development modifications and improvements as it gains users.

Partially as a result of the marketing angle and to attract users, and partially to encourage developers and the crowd to collaborate on maintenance and improvements to the Freight Blockchain, the company has decided to issue a Functional Token. Freight Blockchain created 10 million Functional Tokens for release with an upper limit of 15 million tokens. The management team of Freight Blockchain each received 100,000 Functional Tokens for deferred compensation, and the company removed the deferred compensation liability from its financial statements.

Freight Blockchain sold the Functional Token to users of the Freight Blockchain in its initial release at $2.00 per token with the Functional Tokens to be used as currency on the Freight Blockchain. Freight Blockchain accounted for the sales as advance transaction fees and purchasers were given a transaction fee credit for the purchase. Freight Blockchain sold 5 million Functional Tokens in its initial launch, all to individuals or entities that they thought to be customers or prospective customers of the Freight Blockchain based on a check-the-box response from purchasers.  Freight Blockchain did not separately advertise the Functional Token, but rather included the offer to prepay transaction fees via the purchase of a Functional Token in its regular Freight Blockchain ads and on its website.

Transaction fees equate to 6% of the transaction value and could vary widely depending on the customer and whether a haul is local or long-range. However, Freight Blockchain did not include either a minimum or maximum on the ability to purchase the Functional Token. A review of purchase records show that the minimum purchase was $500 and the maximum was $50,000. Although it is possible that a large customer could pay $50,000 in transaction fees in a year, it does not appear that the particular purchaser would do so and thus in hindsight, it is likely that person purchased for speculative value.

Users of the Freight Blockchain can opt to be paid in Bitcoin, Ethereum, Functional Token or fiat currency.  Transaction fees are paid to Freight Blockchain in the same currency that the users complete their transaction with.  Following the initial release Freight Blockchain launched the Functional Token open source code on Github and began trading on several cryptocurrency exchanges. Tokens can be earned by miners and are issued as compensation for website maintenance, code updates and other contributions to the Freight Blockchain. The Functional Token works as Proof-of-Stake. Freight Blockchain did not and does not market the Functional Token as an investment opportunity.

All changes to the Freight Blockchain platform must be approved by the Freight Blockchain management team, who maintains ultimate control over the software. No Foundation has been formed.

Functional Token holders do not have rights generally associated with security holders.  In particular, Functional Token holders (i) have no ownership rights in Freight Blockchain; (ii) have no right to share in profits and/or losses of Freight Blockchain; (iii) claims in bankruptcy or similar proceedings with a status of an equity holder; (iv) right to convert or exchange the Functional Token for a security token or other security; or (v) right to purchase a security token.

Legal Analysis

As I’ve written about many times, the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the re-sale of a security by an existing security holder must either be registered or exempt from registration.

Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

The registration requirements, or necessity to utilize an exemption, only apply to securities and accordingly, if Functional Token is not a security, it could be issued or resold on a cryptocurrency exchange without compliance with the federal securities laws.

The Securities Act defines the term “security” broadly to include “investment contracts.” Several tests have been used by the SEC and the courts to determine whether an offering involves an investment contract and thus a security, with the most commonly used test being the “Howey test.”  The SEC relied on the Howey test in its DAO Report in determining that certain offerings of tokens may be deemed securities. Another common test is the “Reves Test,” which I will discuss further in this analysis.

As set forth below, I conclude that the Functional Token is a security requiring compliance with the federal securities laws. However, my conclusion is weighed by the lack of legal clarity on tokens in general and my belief that when in doubt, it is a security. Furthermore, I find an analysis of a token with the features of the Functional Token to be more difficult than a decentralized token such as the Oldie Token from Part 1 of this series.

The Howey Test

The US Supreme Court case of SEC v Howey, 328 U.S. 293 (1946) established the test for whether an arrangement involves an investment contract.  An investment contract is a type of security.  In Howey, the Supreme Court noted that the term “investment contract” has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” The Howey test can be expressed as three independent elements.  All three elements must be met in order for a token or cryptocurrency to be a security, including (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits predominantly from the efforts of others. For more on the Howey test, see HERE.

(i) Investment of Money. Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of investment, Functional Token distributed to developers for mining or other services to the Functional Token project may satisfy this part of the test, but it is also possible that a court might view the individual efforts of the miners or developers differently and conclude that no investment of money has occurred. Furthermore, it is possible that the courts would interpret the initial sale of the Functional Token, even though it was characterized as advance payment for transaction fees, as an investment of money. As part of this analysis, I consider the fact that it is unlikely that a customer would advance any fees associated with the use of the Freight Blockchain but for the potential for receiving value from such advancement in excess of the amount expended.

(ii) Common Enterprise. Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (a) horizontal; (b) narrow vertical; and (c) broad vertical.

1. Under the horizontal test, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor equal a prorated portion of the total profits of the pool; see, e.g., Curran v. Merrill Lynch, 622 F.2nd 216 (6th Cir. 1980). Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may not be deemed to exist. For example, a court has found that a discretionary trading account was not an investment contract because there was no pooling of funds.

Under the horizontal test, the Functional Token may be considered a common enterprise — notwithstanding the absence of a pooling of funds — where the reward for work, through mining or the contribution of other services, correlates to the reward received by the miners, developers or other members of the Functional Token platform receiving Functional Token. However, since Freight Blockchain retains control over the platform and there is no sharing of profits or pooling of funds, it is also likely that there is not a common enterprise under the horizontal test.

1. Under the narrow vertical test, the key is whether the profits of an investor are tied to the promoter. For example, a court has found that the imposition of profit limitations on investors through requiring a promoter to receive an excess return rate tied to the investors return, satisfied this test. This test generally relates to income earned by a promoter from profits derived from participants.
2. Under the broad vertical test, the critical fact is whether the success of the investor depends on the promoter’s expertise. If there is such a reliance, then a common enterprise is deemed to exist.

In this case, I believe a common enterprise exists in applying the vertical test.  Although miners depend on their own efforts to receive Functional Tokens, the ultimate secondary trading value of the Functional Token is inextricably tied to the success of the Freight Blockchain. Moreover, management of Freight Blockchain has maintained control over the platform and it is their expertise that will drive the success of the enterprise as a whole. If the Freight Blockchain does not gain customers and users, it is unlikely that the Functional Token will have any value to miners or those receiving the Functional Token in exchange for services.  Furthermore, I don’t believe a reasonable argument could be made that the initial purchasers of the Functional Token were purchasing for the purpose of pre-paying transaction fees, but rather were purchasing with the hope of an increased value on secondary markets, which would depend on the success of the Freight Blockchain under the control of its management.

An alternative test, sometimes called the “risk capital test,” focuses on whether the holder of an investment may be deemed passive, and in being passive, relying on the efforts of others.  This test has four parts: (i) are any funds raised for use by a venture or enterprise; (ii) who is the target investor (i.e., is it the public generally, or a group comprised only of those with specialized interest or expertise in the area relating to the investment); (iii) how much influence do investors have on the success of the enterprise; and (iv) is the investor’s investment substantially at risk?  Under the risk capital test, I believe the Functional Token would be a security.  If Freight Blockchain is not successful, then the Functional Tokens will have no value either on a secondary market or to be used against future transaction fees.

(iii) Expectation of Profit from the Efforts of Others.  Under this element of the test, profit refers to the type of return or income an investor seeks on their investment.   This could refer to any type of return or income earned from being the owner of a Functional Token, but for purpose of the Howey test and a securities law analysis would only include profits earned passively from the efforts of others.  In other words, it is the essentially passive nature of the return, utilizing the efforts of others, that results in an “investment contract” and determination of the existence of a security, rather than a simple contract which in itself would not be a security.

As discussed above, the success of the Freight Blockchain and therefore value of the Functional Token depends on the efforts of the Freight Blockchain management and as such, I believe that this part of the Howey test is satisfied.

As with the Oldie Token, the appreciation in the value of the Functional Token after issuance, due to secondary trading, should not affect the analysis of whether a Functional Token is an investment contract and thus a security.  Other rights that are not investment contracts or securities, such as loyalty points, airline points, licenses and franchise rights, can increase in value over time due to the secondary market for those assets.

Reves and the Family Resemblance Test

An analysis of Reves and the “family resemblance test” as formulated by the Supreme Court in Reves v. Ernst & Young, is only appropriate when determining whether a loan is a security under the Securities Laws.  Reves focused on the term “note” rather than the term “investment contract” as such terms are included in the definition of a security under the Securities Laws.  For more on the Reves test, see HERE.

The Functional Token as sold as pre-paid transaction fees and recorded as same on the books and records of the company. Each purchaser received a credit on their account. Accordingly, the funds received from the Functional Token sales are a liability on the books of Freight Blockchain and each purchaser is a creditor. In the event that Freight Blockchain were to fail, the purchasers of the Functional Token with remaining transaction fee credits would be creditors of the company entitled to a distribution of assets, if any.

The first part of an analysis as to whether the Functional Tokens could be a debt security would be to consider the time in which repayment is likely. The Exchange Act and SEC specifically exclude notes with a term of less than nine months, the proceeds of which are used for a current transaction, from the definition of a “security.”  The transaction fee credit associated with Functional Tokens does not have an expiration date and based on the amounts purchased, although some will be used up in nine months, many will take much longer.

A Reves analysis involves four tests: (i) the motivation of the seller and buyer; (ii) the plan of distribution of the instrument; (iii) the reasonable expectations of the investment public; and (iv) the presence of an alternative regulatory regime.

(i) Motivation of the seller and buyer. The first factor is described as the motivation that prompts “a reasonable seller and buyer to enter into” the transaction.  If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, the courts can determine that indeed a security has been sold.  Furthermore, Reves specifically states that if the purpose is, for example, to “facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash flow difficulties, or to advance some other commercial or consumer purpose,” it is unlikely to be deemed a security.

Although the Freight Blockchain management was attempting to motivate users and build the commercial enterprise of the Freight Blockchain by issuing the Functional Token, I think it would be difficult to establish that the motivation of the purchaser was to pre-pay transaction fees.  Transaction fees do not fluctuate and therefore there would be no motivation to pre-pay this expense.  However, the immediate secondary trading of the Functional Token created a motivation to expend risk capital with the hope of a return on such investment.  Moreover, the Freight Blockchain transaction fees could be paid in fiat currency, and thus it would not be necessary to purchase the Functional Token to conduct business on the platform.

(ii) Plan of distribution.  The second factor determines whether the instrument is being distributed for investment or speculation.  If the debt instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.  Although the Functional Blockchain was not marketed as an investment, advertisements related to the Freight Blockchain and the availability of the Functional Token were widely disseminated.  Moreover, a Telegram group quickly formed regarding the Functional Token, which appeared to increase sales dramatically.

(iii) Reasonable expectation of investing public.  An instrument will be deemed a security where the reasonable expectation of the investing public is that the securities laws (and accompanying anti-fraud provisions) apply to the investment.  Although the investing public did not believe they were purchasing a security, as described herein, it is likely that the purchase of the Functional Token was motivated by a potential return on investment as opposed to purely commercial uses.

(iv) The presence of alternative regulatory regime.  The fourth factor is a determination whether another regulatory scheme “significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary.”  A “utility token” or cryptocurrency remains largely unregulated in the U.S. unless such token is found to be a security under the federal securities laws, or a commodity subject to the Commodity Exchange Act.  The lack of alternative regulatory regime supports the need for protection under the federal securities laws in the issuance and sale of the Functional Token.

Speech by William Hinman

On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he expressed his views on when a cryptocurrency would most assuredly be a security, and laid out some factors to consider in completing an analysis under the securities laws.  An important factor in determining that a token is not, or no longer, a security is the decentralization of the underlying platform.  If a platform is decentralized, purchasers of the token would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the result of which would increase the value of the token.

When the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.  It is this information asymmetry that I find is key to the analysis of the Functional Token, and why using both Howey’s based-on-the-efforts-of-others test and Reves’ motivation test, the Functional Token is a security.

The Freight Blockchain management team is uniquely positioned to know whether the Freight Blockchain platform is meeting its milestones, successful, and profitable, all of which are necessary for the Functional Token to have value.  To the extent that initial purchasers hold credits for future transaction fees, those credits become worthless if the Freight Blockchain fails.  Furthermore, it is likely that the trading value of the Functional Token is inextricably tied into the success of the Freight Blockchain.  Without meaningful disclosures, such as can be found in a registration statements or proper private placement offering document, the only information that purchasers receive is found on the Freight Blockchain website, press releases and on social media such as the Telegram group.

Moreover, a review of the social media sites, such as Telegram, clearly indicates that some are promoting the Freight Blockchain for the purpose of increasing the value of the Functional Token, presumably because they hold tokens and hope to sell at a profit.  The Functional Token was sold to anyone who sought to purchase which would include those that may not understand the risks associated with the investment, and even those that did, were not provided with any meaningful information on which to assess such risks.

Hinman provided some guidance in determining whether a particular sale involves the sale of a security.  The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment.  Questions to consider include:

1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
4. Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Other than that the Freight Blockchain was built and operational at the time of the issuance of the Functional Token, the answer to all of these questions supports the conclusion that the Functional Token is a security.

License/Contract Right Considerations

Providing access to the open-source Functional Token blockchain can be analogized to the grant of a license.  Because software licenses are typically governed by contract law, one possible analysis would be to focus on the rights associated with the license that are granted by the licensor to the licensee. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights.  Thus, the licensee would receive all of these rights, or a portion of these rights depending on what the licensor grants.

In the context of a license of the Functional Token blockchain, if any, Freight Blockchain would act as the licensor of the system, which includes the right to use the Functional Token platform and earn fees for accepted developments, but which does not include most other proprietary rights, including the right to assign or sublicense the Functional Token blockchain or transfer any rights.  There are no voting rights inherent in the Functional Token or provided other members of the Functional Token community.  Of the bundle of rights, the only right is to use the Functional Token blockchain, with the hope that innovations will be rewarded.  This limitation could be used to argue that the right is more analogous to a limited contract right rather than a security.

The DAO Report

The SEC has advised that tokens may be securities in certain circumstances, generally when involving raising capital for the issuer or seller of the tokens.  On July 25, 2017, the SEC issued the DAO Report detailing its investigation into whether the DAO (an unincorporated “decentralized autonomous organization”), Slock.iotUG (“Slock.it”), its co-founders, and intermediaries violated the federal securities laws.  Utilizing the Howey test, the SEC determined that the tokens issued by the DAO are securities under the Securities Laws and advised that those who would use distributed ledger or blockchain-enabled means for capital raising must take appropriate steps to comply with the Securities Laws (e.g., register the offering or qualify for an exemption from registration).

The DAO Report emphasized that whether a particular investment transaction involves the offer or sale of security is not dependent on the terminology used, but rather on the facts and circumstances, including the economic realities of the transaction. For more on the DAO Report, see HERE.

As detailed in the DAO Report, the concept of the DAO was memorialized in a white paper (the “DAO White Paper”) authored by the Chief Technology Officer of Slock.it.  In the DAO White Paper Slock.it proposed an entity (a DAO entity) that would use smart contracts to attempt to solve governance issues it describes as inherent in traditional corporations. Slock.it organized a DAO as a crowdfunding contract to raise funds to grow a company in the crypto space. The DAO was a for-profit entity where participants would send ETH to the DAO to purchase DAO tokens, which would permit the participant to vote and entitle the participant to “rewards.” The White Paper described this as similar to “buying shares in a company and getting . . . dividends.”  The DAO was to be “decentralized” in that it would allow for voting by investors holding DAO tokens.  All funds raised were to be held at an Ethereum blockchain “address” associated with the DAO, and the DAO token holders were to vote on contract proposals, including proposals to the DAO to fund projects. Based on the vote of the DAO token holders, the DAO would use any “rewards” from the projects it funded to either fund new projects or distribute them to the DAO token holders. The DAO was intended to be “autonomous” in that project proposals were in the form of smart contracts that exist on the Ethereum blockchain and the votes were administered by the code of the DAO.

In applying the Howey test, the SEC found that the DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it, its co-founders, and the DAO’s curators to manage the DAO and generate profits.

The Freight Blockchain project is an actual for-profit corporation under the control of a standard board of directors and officers.   Under this analysis the Freight Blockchain management acted as promoters of the Functional Token, and continue to be motivated to increase its value, as each received Functional Tokens as compensation. Moreover, although the Functional Token can be used as currency on the Freight Blockchain, its real value is in the secondary trading market, which depends on the success of the underlying platform. Applying the Howey test and principles in the DAO Report, it is difficult to argue that the Functional Token is not a security.

The Munchee Order

On December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc. (“Munchee”) to stop Munchee’s ICO and require it to return to investors the funds it collected through the sale of its MUN token. The SEC found that Munchee’s token sale constituted an offering of securities in violation of the Securities Laws.

In applying the Howey test to the offering of the MUN token, the SEC gave little weight to the fact that Munchee characterized the MUN token as a “utility” token because of their functional use in connection with the business model of Munchee.  Instead, the SEC focused on the manner in which the offering of the MUN token was marketed.  In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as the result of Munchee’s future efforts. The SEC noted that Munchee made statements in its White Paper, on blogs, podcast and Facebook posts that suggested that investors would profit from purchasing MUN tokens.  In addition, Munchee endorsed statements made by other commentators that highlighted the opportunity for profit through the purchase of MUN tokens, including, for example, by linking their public post on their Facebook page about the offering (“199% GAINS on MUN token at ICO price!”) to a YouTube video in which the person featured claimed that if investors got in early enough on ICOs, they would make a profit.  Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.

In the Munchee Order, the SEC noted that in its White Paper, Munchee said that they would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens. The SEC viewed such statements as priming “purchasers’ reasonable expectations of profit” and that “[p]urchasers would reasonably believe that they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUM ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials.”

In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s states, the SEC concluded that those profits would be based primarily on the future efforts of Munchee.  In the Munchee Order, the SEC said:

The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of the MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.

The SEC focused on the ongoing efforts by Munchee after the token sale. However, in most cases token issuers intend to use at least a portion of the proceeds from the sale to further develop the token ecosystem. In the Functional Token context, the work done by developers, miners and other contributors to the Functional Token project is rewarded with Functional Tokens.

The Freight Blockchain management team believed that because the Freight Blockchain was built and operational at the time of issuance of the Functional Token, and because they did not tout the potential increase in value, it would not be a security. However, I believe that, because the Functional Token immediately began to trade in a secondary market, despite how it was marketed, its purchase would logically be to realize an increase in value and because the Functional Token is not a requirement to use the Freight Blockchain, it is a security.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a Bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC’s and NASAA’s statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to Ether and Bitcoin and guidance on cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook and FINRA regulatory Notice 18-20 related to member firms’ digital asset activities, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
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Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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