Would you give me some money if I promised you 200% returns? In Munchee’s case, 40 people gladly parted with their (now-very valuable) Ethereum.
199% GAINS on MUN Token at ICO price! Sign up for PRE-SALE NOW!
The music stops…
On 11 December 2017, the SEC instituted cease-and-desist proceedings against Munchee Inc., a company that was seeking to raise funds through the issuance of digital tokens (“MUN”) in a token sale. MUN was intended to be used as payment currency in the Munchee App, a platform for restaurant review and advertising.
The SEC informed Munchee that its token sale violated the US Securities Act because MUN constitutes a security. For the uninitiated, under US securities laws, any offer of securities must be registered with the SEC or qualify for an exemption from registration. In the case of Munchee, no registration statements were filed and no exemptions from registration were available.
Yet another failed token sale, but at least this was not because Munchee was a scam. Munchee’s business model is not particularly interesting (read: don’t bother finding out). What is more interesting though, is the SEC’s analysis of the Howey Test and the facts it used to support the finding. This warning shot by the SEC should be heard loud and clear by all potential issuers who intend to offer for sale utility tokens in the US.
The Howey Test (see below) looks complicated but we will attempt to break it down in the context of Munchee. Factor 1 (investment of money) is easy enough. Factors 3, 4 and 5 are not as straightforward. Sounds challenging? Keep reading. All will be clear in about…2 minutes.
In the Supreme Court case of SEC v. Howey (1946), the Supreme Court set out the test for determining whether an instrument is an “investment contract” within the definition of security under the US Securities Act and Exchange Act. Under the Howey Test, a contract is an investment contract (and hence a security) if it satisfies 4 factors:
- It is an investment of money.
- The investment of money is in a common enterprise.
- There is an expectation of profits from the investment.
- Expectation of profit comes solely from the efforts of others (such as a promoter or third party).
Profits, profits, profits!
Let’s look at how the SEC concluded that MUN tokens were investment contracts. The culprit behind Munchee’s demise was the overzealous marketing of the MUN token that created an expectation of profit. Not only did Munchee liken MUN to prior ICOs that created profit for investors, it also focused its selling efforts on potential investors who were interested in profits, rather than on people who might want MUN for use in the Munchee App.
Munchee told potential investors a variety of things: (a) Munchee would use funds to build an ecosystem that would create demand for the MUN Tokens and make MUN more valuable, (b) Muchee would run the business in a way that would cause MUN to appreciate, and (c) Munchee would support secondary trading markets. Although the MUN token did not promise any dividend or other periodic payment to its holders, investors would naturally expect the value of MUN to appreciate resulting from Munchee and its agent’s entrepreneurial and managerial efforts to deliver on its marketing promises.
The SEC noted that:
“Investors had little choice but to rely on Munchee and its expertise. At the time of the offering and sale of MUN tokens, no other person could make changes to the Munchee App or was working to create an “ecosystem” to create demand for MUN tokens.”
Would it make a difference if the “ecosystem” was established at the time of offering? Apparently not. The SEC added:
“Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling – such as characterising an ICO as involving a “utility token”- but instead requires an assessment of the “economic realities underlying a transaction”.”
Fortunately, Munchee was able to return all the contributions it received. I’m sure Munchee’s investors were not too disappointed because they received 200% returns anyway – the 200 EtherEthereum (the No.2 largest cryptocurrency by market capitalisation) the investors contributed in November 2017 has doubled in value recently!
Utility tokens facing a slow death?
Clearly, issuers have to tone down their marketing pitch to investors. Such restraint should be extended to all marketing channels, such as YouTube, Slack, Facebook etc. Munchee’s demise touches on one of the biggest difficulties in the increasingly crowded ICO market – how do I sell my digital token? More often than not, issuers want to issue a utility token so that it falls outside securities regulations. But how can an issuer sell its utility token to Main Street investors without trumpeting possible profits?
In a public statement dated 11 December 2017, SEC Chairman Jay Clayton noted:
“Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities.” (emphasis original)
Indeed, this is a rather sombre statement. Based on the recent flurry of public releases by the SEC on utility tokens, I wonder if the SEC is actually deriving utility1 from clamping down on these so-called “utility tokens”. It may be time for aspiring issuers of utility tokens and their professional advisers to accept the hard truth: if you play with fire, you (will most likely) get burned.
1Utility is "that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness...or...to prevent the happening of mischief, pain, evil, or unhappiness” (Introduction to the Principles of Morals and Legislation, 1789, Jeremy Bentham)