The U.S. Supreme Court’s decision in SEC v. W.J. Howey Co. (328 U.S. 293 (1946)) is the seminal case that still forms the basis of the test used to determine whether a financial instrument or transaction should be deemed a security and, therefore, subject to securities regulation. Under Howey, “an investment contract for purposes of the Securities Act of 1933 (the “Securities Act”) means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party…”. The Howey test generally requires a security to include the following elements: (1) an investment of money (2) in a common enterprise (3) with an expectation of profits from the efforts of others. Four recent developments help establish, or challenge, when a digital asset should be deemed a security.
On February 14, 2019, U.S. District Judge Gonzalo P. Curiel of the Southern District of California entered a preliminary injunction against cryptocurrency company Blockvest LLC (“BLV”) and its founder, Reginald Ringgold, for making fraudulent offers of securities, in granting a motion for reconsideration of the court’s prior order in November 2018.
The case involves Blockvest’s allegedly false claim that their upcoming initial coin offering (“ICO”) was registered with the SEC. Ringgold claims that none of the alleged misrepresentations involved securities, and the money raised in pre-ICO sales came solely from test investors who were working on the functionality of Blockvest’s exchange and who did not have an expectation of profits. In a prior motion, Judge Curiel denied granting summary judgment to the SEC because he deemed that there were disputed facts about the nature of Blockvest’s tokens that needed to be resolved before determining whether the tokens were indeed securities. On reconsideration, however and after further review of the facts, the court determined that the tokens were indeed securities in granting the preliminary injunction.
The court ultimately found that the “contents of defendants’ website, the white paper and social media posts concerning the ICO of the BLV tokens to the public at large constitute an ‘offer’ of ‘securities’ under the Securities Act.” Blockvest’s marketing materials asked investors to pay for BLV tokens with digital or other currency, and any funds raised would be pooled together, which the court found to be a common enterprise. Lastly, the marketing materials stated that “the investors in Blockvest would be ‘passive’ investors and the BLV tokens would generate ‘passive income,’” which Judge Curiel found to meet all of the elements of the three-part Howey test. While Blockvest’s tokens were found to be securities, the court never looked at the actual character of the tokens; rather, the court relied on admissions and inferences from the defendants through its own whitepaper and marketing materials, coming to the conclusion that the token sponsors themselves deemed the token to have the characteristics of a security. In particular, Blockvest’s website claimed that there would be a profit-sharing formula with respect to the proceeds of the sale of the tokens—a significant distinction from many tokens that had been offered while claiming to not be securities.
Kik Interactive Wells notice
In a different case from late last year, the SEC sent a Wells notice to Kik Interactive Inc. and the Kin Ecosystem Foundation (collectively, “Kik”) alleging violations of Sections 5(a) and 5(c) of the Securities Act. In contrast to the findings in Blockvest, counsel for Kik submitted a Wells notice response on December 10, 2018, outlining in detail the argument that its tokens are not securities, albeit involving a significantly different fact pattern.
Kik argued that its token is a currency, which is explicitly excluded from the definition of a security in the Securities Exchange Act of 1934 (the “Exchange Act”) and, while not explicitly excluded from the definition under the Securities Act, is not included in the Securities Act definition. The token was marketed solely as a means of accessing digital products and services for platforms on Kik’s blockchain and not as an investment. Other companies besides Kik accept the token as a method of payment. In addition, the accredited participants in the pre-sale agreed to a Simple Agreement for Future Tokens (“SAFT”) where the tokens did not convert until there was a network launch and the tokens could be used as currency. When the token sale occurred, it wasn’t to raise capital but rather to create a broad community for use of the tokens. Kik asserted that it followed know-your-customer and anti-money-laundering protocols, lending credence to the argument that Kik believed this to be a currency and not a security.
Kik further argued that the elements of the Howey test were not satisfied and thus the token is not an investment contract. First, Kik argued that it had no ongoing obligation to maintain the platform after the sale and would be one of many participants in the ongoing maintenance of the token, which shows that the “efforts of others” prong under the Howey test had not been satisfied. Kik also argued that there was no “common enterprise” as the token holders have no ownership interest or claims to assets or profits, and a sale of property does not constitute a common enterprise. There was never any promise or offer to make a profit as the tokens were marketed for consumptive use. Last, Kik argued that if there was any expectation of profit, it was not based on the managerial efforts or marketing by Kik, but rather on standard market fluctuations, more like a currency or a commodity than a security.
The Wells notice also tackled the fact that the token sale occurred after the SEC had published the DAO Report. While the DAO Report found that tokens may be securities, Kik argued that the DAO tokens had very different characteristics that made them more similar to securities. For example, the DAO token holders had voting rights, funds were jointly contributed to invest in specific projects and token holders would have received dividends from the profits of those projects.
Kik further made an argument that, because it made good faith efforts to comply with applicable laws and that punishment would harm rather than help investors, it should not be punished even if the tokens were indeed securities, although the SEC has shown little sympathy to this type of argument in the past. It is unclear how the SEC will respond to the arguments made by Kik.
Speech by Commissioner Hester M. Peirce
In a recent speech at the University of Missouri School of Law, Commissioner Hester M. Peirce appeared to echo some of the sentiments from the Kik Wells notice response, indicating she believed that the SEC’s application of the Howey test may be overly broad when used for digital assets.
“Token offerings do not always map perfectly onto traditional securities offerings. For example, as a recent report from Coin Center noted, the decentralized nature of token offerings can mean that the capital raised through token sales may not be truly owned or controlled by a company. Functions traditionally completed by people designated as “issuers” or “promoters” under securities laws—which, importantly, bestow those roles with certain responsibilities and potential liabilities—may be performed by a number of unaffiliated people, or by no one at all,” stated Commissioner Peirce. While not binding on the Commission, she further stated that “[i]t is possible that some projects may simply not be able to work under the existing Howey framework and the applicable securities laws.” In particular, she expressed concern that many arguments that tokens are securities ignore the Howey requirement that the profit be derived solely, or at least primarily, from the efforts of others.
Recent settlement of self-reported ICO
On February 20, 2019, the SEC charged Gladius Network LLC (“Gladius”) with conducting an unregistered ICO. Gladius self-reported to the SEC in summer 2018, after the SEC warned in its DAO Report that ICOs can be securities offerings. Gladius had conducted its unregistered ICO in late 2017 and raised approximately $12.7 million from the sale of its digital assets.
The SEC chose not to impose a penalty against Gladius despite the charges, showing for certain the circumstances under which “amnesty” would be offered for ICO issuers. To avoid further punishment, Gladius self-reported to the SEC and then agreed to compensate investors and register the tokens as a class of securities. The compensation to investors was essentially in the form of a rescission offer, giving investors notice of potential claims and offering to pay the delta between the purchase and sale price (or market price as of the record date, if the tokens continue to be held by the purchaser) as damages. The SEC stated that it is using the Gladius case as an example to other companies to show “the benefits of self-reporting and taking proactive steps to remediate unregistered offerings.” Interestingly, Gladius essentially admitted that its ICO was an offering and sale of securities, even though it lacked many common characteristics with Howey-style investment contracts. Furthermore, the offer to register the tokens under the Exchange Act, rather than just under the Securities Act, might be an expansion of the definition of what constitutes an “equity security” for purposes of Section 12(g) of the Exchange Act. Section 12(g) of the Exchange Act generally only requires registration of equity securities that have too many holders; even if the tokens have the characteristics of securities, it is much less well-settled what constitutes an equity security versus other types of securities.
Unfortunately, self-reporting may not be an easy option for many issuers. Steps for remediation such as paying back initial investors are only possible if the issuer still has funds available that are sufficient to both complete the project and compensate its investors. This problem is likely to be exacerbated by issuers that accepted Bitcoin or other cryptocurrencies as consideration before their significant devaluation in early 2018.