The United States Securities and Exchange Commission (SEC) recently entered into a settled cease-and-desist order with a California-based company (Company) in which the Company agreed to halt its initial coin offering (ICO). The SEC found that the Company's conduct constituted unregistered offers and sales of securities. The action is significant because it highlights the SEC's continued scrutiny of ICOs, as well as the SEC's recent guidance that ICOs may involve the offer and sale of securities. Moreover, the SEC's real-time enforcement activity further demonstrates its heightened focus on ICOs.
Background on the Offering
On or about October 1, 2017, the Company announced, through various social media outlets, that it would be launching an ICO and selling its tokens to the general public. In addition, the Company released a "white paper" that detailed how the proceeds of the ICO were to be used.1 The Company told investors that they could use the tokens to buy goods and services after the Company had created an "ecosystem." In this "ecosystem," the Company would pay app users in tokens for writing food reviews and sell "both advertising to restaurants and 'in-app' purchases to app users" in exchange for tokens.2 Furthermore, the Company would negotiate with restaurant owners to reward app users—who review their food—with tokens. The ICO essentially created an independent payment system with restaurants that would increase the value of the tokens. In the cease-and-desist order, the SEC notes that the investors reasonably believed that the anticipated "ecosystem" was an opportunity to make a profit.3 Their belief was affirmed by the Company's public statements on social media outlets, including a posting on Facebook that stated, "199% GAINS on [] token at ICO price!"4 The Company even stated that the tokens would be traded on secondary markets "in varying jurisdictions."5
On or about October 31, 2017, the Company began selling the tokens, and by the time the cease-and-desist order was issued, the Company had raised about $60,000 in token purchases from 40 investors.
The SEC's Real-Time Enforcement
In its press release, the SEC Co-Director of Enforcement stated that the SEC continues to scrutinize the market for improper offerings without the required registrations or exemptions. In this matter, the SEC staff contacted the Company one day after it began selling tokens, and hours later the Company stopped selling tokens. The SEC's action follows its guidance issued last summer, which stated that ICOs may be securities.6
The SEC applied the Howey test to the facts of this ICO.7 The SEC determined that the tokens were securities, and thus violated the Securities Act, because the investors had a reasonable expectation that the Company's managerial and marketing efforts would result in the value of the tokens appreciating, resulting in a profit.8 Furthermore, the SEC made clear that the practical use of the token had no bearing on determining whether such token is a security, but instead "require[d] an assessment of 'the economic realities underlying a transaction.'"9
Interestingly, the SEC also pointed out that investors "had little choice but to rely on [the Company] and its expertise," and the Company "specifically marketed to people interested in those assets…rather than people who…might have wanted [] tokens to buy advertising or increase their 'tier' as a reviewer."10
Takeaways
Of particular note is the SEC's proactive approach in contacting the Company prior to completion of its ICO. The SEC specifically cited the Company's swift response and cooperation in its decision not to impose a penalty.
This Order further highlights the SEC's scrutiny of the uncharted and complex waters of the cryptocurrency market. Technology companies, startups, other market participants, and the attorneys who represent them should carefully assess recent regulatory guidance with respect to ICOs and consider whether such offerings require registration. Any company considering the launch of an ICO is on notice that the SEC is watching.
[1] A "white paper" is an official report that is released to explain the plans or ideas underlying a proposal or venture.
[2] Order Instituting Cease-And-Desist Proceedings, Securities Act of 1933 Release No. 10445, ¶ 11 (December 11, 2017) (the "Order").
[3] Id. ¶ 14.
[4] Id.
[5] Id. ¶ 13.
[6] Report of Investigation Pursuant To Section 21(a) Of The Securities Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017) (the "DAO Report").
[7] SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
[8] Order ¶ 36.
[9] Id. ¶ 35.
[10] Id. ¶ 33 and 34.