The rise of cryptocurrencies and initial coin offerings (ICOs) undoubtedly shows that we live in interesting times that regularly present us with new and innovative products, markets, and opportunities. When the words “new” and “innovative” come to mind, the federal government is usually not part of the conversation. But the US Securities and Exchange Commission (SEC) under Chairman Jay Clayton appears more than willing to challenge that stereotype and to use the SEC’s regulatory and enforcement authority to take on the complex legal and other issues arising from innovative ICOs and other cryptocurrency products. Throughout these efforts, the SEC’s message has been clear and consistent: it will apply established federal securities laws principles and use its regulatory authority over ICOs and other cryptocurrency products expansively when appropriate, and it expects “gatekeepers” to aid in that effort.
Recent SEC Enforcement Actions: Munchee and Plexcorps
Two SEC enforcement actions over the last few weeks represent just the latest attempt by the SEC to get its message across. Most recently, it announced on December 11 a settled enforcement action that halted an ICO by Munchee Inc., a California business that created an iPhone app for reviewing restaurant meals. In a remarkably quick action for the SEC, it brought the case just weeks after Munchee commenced its ICO. The SEC charged Munchee with violating Sections 5(a) and 5(c) of the Securities Act of 1933 (the Securities Act) by conducting an unregistered offering of securities, and is notable because the SEC did not allege that Munchee made any misrepresentations in connection with the offering. Bringing such a standalone unregistered offering case is unusual for the SEC and represents its intention to bring these cases quickly, even in the absence of fraud.
The Munchee case follows an emergency action that the SEC filed on December 1 against Plexcorps for conducting an allegedly fraudulent ICO that started in August 2017. In Plexcorps, the SEC alleged that the issuer made false representations about expected profits that investors would realize from the ICO. The SEC’s action was the first by its Cyber Unit, which was created in September 2017 to focus, in part, on distributed ledger technology and ICOs.
In both the Munchee and Plexcorps cases, the SEC followed through on the analysis in its July 2017 Section 21(a) report of investigation on cryptocurrency offerings, on which we previously reported. The July 2017 report was itself notable, as the SEC had not issued a Section 21(a) report in more than three years and had only issued seven such reports in the previous 10 years. In the July 2017 report, the SEC cautioned that ICOs may be considered offerings of securities that bring them within the jurisdiction of the federal securities laws. It further detailed the analysis that it intended to conduct under the seminal Howey test in considering whether a coin offering was a security. Under that test, the SEC viewed an ICO in which token purchasers make a contribution of value (which need not take the form of cash), with a reasonable expectation of profits (even if the profits came from the funding of projects consisting of services or the creation of goods for use by investors) that is derived from the managerial efforts of others, as a security.
In Munchee, for example, the issuer represented that the tokens it sold in the offering would be part of an “ecosystem” alongside other tokens issued to app users who wrote food reviews or to customers who might receive tokens from restaurants they frequented. These tokens could then be used to, among other things, purchase food from participating restaurants, with the expectation that the tokens would increase in value as participation in the “ecosystem” increased. Based on these and other facts, the SEC deemed the tokens securities, even if they had “a practical use at the time of the offering.”
The SEC’s aggressive actions on ICOs—represented by the July 2017 Section 21(a) report and the standalone Section 5 case against Munchee—served as a mere backdrop to Mr. Clayton’s public “Statement on Cryptocurrencies and Initial Coin Offerings” issued on the same day as the Munchee case. Although the statement expressed Mr. Clayton’s views and not necessarily those of the SEC itself, it is sure to shape the SEC’s enforcement efforts and deserves close attention. Not only does Mr. Clayton’s statement reiterate the Howey analysis in the Section 21(a) report, but it is also a warning shot at so-called “gatekeepers”—broker-dealers, investment advisers, exchanges, lawyers, and accountants—with a message that Mr. Clayton expects them to protect investors as well.
Most notably, the SEC chairman took aim at those who have sought to minimize the reach of the federal securities laws, including market professionals who “have attempted to highlight utility characteristics of their proposed initial coin offerings” to avoid regulation. In his view, these attempts elevate form over substance, and he cautioned that “merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” He also addressed the broader question of the applicability of the federal securities laws to cryptocurrencies themselves, saying that whether the assertion that cryptocurrencies are not securities “proves correct with respect to any digital asset that is labeled as a cryptocurrency will depend on the characteristics and use of that particular asset.” He urged securities industry professionals, including lawyers and accountants, to focus their responsibilities on ensuring compliance with the federal securities laws. Moreover, to the extent that entities subject to anti-money laundering rules accept payment in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions, those entities must ensure that they satisfy their anti-money laundering and know-your-customer obligations.
By placing an emphasis on gatekeepers, Mr. Clayton appears to be utilizing an effective strategy for the SEC, particularly when the main actors are, as is often the case with ICOs, overseas, difficult to identify, or otherwise elusive. By focusing on the responsibilities of those who might interact with investors directly and who are brought within the SEC’s jurisdiction more easily—broker-dealers, investment advisers, clearing houses, exchanges, lawyers—Mr. Clayton is seeking to enhance the SEC’s oversight of ICOs and potentially other manifestations of cryptocurrencies.
When we reported on the SEC’s Section 21(a) report in July, we viewed it as, in substance, a shot across the bow for those active in the ICO and cryptocurrency space. Mr. Clayton’s strong statement and the two recent enforcement actions, however, show that the SEC has moved from warning into active enforcement mode, and we expect further regulatory actions ahead. The SEC’s creation of the specialized Cyber Unit, the issuance of a Section 21(a) report, and the filing of a standalone Section 5 case, are all signs of an activist regulatory approach. Most certainly, the Munchee matter is not the last we have heard from the SEC and its Cyber Unit on ICOs or cryptocurrencies, with the most likely potential targets ahead being registered or unregistered exchanges on which cryptocurrencies trade, registered or unregistered brokers who facilitate transactions in cryptocurrencies on the secondary market, and even lawyers the SEC views as aiding and abetting or causing unregistered securities offerings. Market participants need to exercise caution in this new territory, as do their lawyers and other advisers.
 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).