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SEC's Recent Order Narrows the Path for "Utility Tokens"

January 7, 2018

The following summarizes the recent Order by the U.S. Securities and Exchange Commission requiring that a “utility token” issued in an Initial Coin Offering (ICO) carry an expectation of use, not an expectation of profits, in Order to not be considered a security under the Howey test for investment contracts.


On  December  11,  2017,  the US  Securities  and Exchange Commission (SEC)  issued  an Order (Order) instituting cease-and-desist  proceedings  pursuant  to  Section  8A  of  the  Securities  Act of  1933  with respect to  Munchee  Inc.  (Munchee).  


The SEC’s settlement with Munchee is an important milestone in the emerging area of “token law”, as it challenges assertions that a token is a ‘utility’ rather than a security simply based on its nomenclature.  Instead, the SEC considers the substance, rather than the form, in classifying a token.


The Order was based on traditional legal analysis of the Howey Test and determined that Munchee offered investors a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The Order evaluated six elements that are common to many ICOs in their determination whether an ICO is a securities offering:


(1) whether the tokens are immediately usable,

(2) the buyers' expectation that the tokens will rise in value,

(3) whether an expected rise in value will be derived from the efforts of others,

(4) whether there will be a secondary market for the tokens,

(5) how the ICO offering is advertised, and

(6) how the proceeds of the ICO are to be used.




Munchee,  a California-based company,  was  in the process  of  offering  digital tokens (designated as  “MUN”  tokens)  to investors  through  an  initial coin  offering (ICO).  In the Order, the SEC  determined that  the  ICO  was  an  offering of  securities  without  registration  or  an available  exemption, notwithstanding that  the  digital  tokens  offered and sold  in the  ICO were  intended to  have  a  utility  function.       


Munchee  created  a  visual  food review  and social  networking  smart  phone  application (app) for  users located in the US.  It  developed  a plan  to conduct  an  ICO  of  MUN  tokens  in October  and November  2017 in Order  to raise  approximately  US$15  million  in  capital  to fund  its  operations,  including the development of  blockchain-based  apps.  


Munchee  described the MUN tokens and the offering in its whitepaper.  The white paper described the creation  of  an “ecosystem,”  in  which  users  of  the app,  restaurants,  and Munchee’s  advertising business  would be connected  and  would  transact  using  MUN  tokens. App users  would be paid  in  MUN tokens  for  writing food reviews  and  could  use MUN tokens to  pay  for  “in-app”  purchases  and food  at participating  restaurants.  Restaurants participating in the  ecosystem  could  receive  MUN  tokens  by  selling food to app  users  and could  use MUN  tokens  to  purchase advertising  from  Munchee  and  to  pay  rewards to  app users  who reviewed  their  meals.  


However,  at  the time of  the offering,  the ecosystem  was  not functional  and none of  these goods  or  services  were  available for  purchase  with  MUN  tokens.   Munchee  stated  in  its White  Paper  that  it  would run  its  business  in  ways  that  would increase participation in the ecosystem,  which  would  lead to increased  value  of  MUN  tokens  —  users  would create additional quality  content  to  attract  more restaurants  onto the platform,  and,  with  more restaurants  participating  in the platform,  MUN  tokens  could be  more widely  used, increasing the  value  of  the  MUN  token.  Munchee also  stated in its  White  Paper  that  it  would  list MUN  tokens  for  trading on at  least  one US-based exchange  within 30 days  of  the  offering.  


Moreover,  Munchee also agreed  that  it  would  use its  reserves  in Order  to  provide liquidity to  the MUN  token market. Munchee’s  ICO  marketing  efforts  targeted a  broad  audience. According  to the  SEC  these efforts  included web postings  such as  “199%  GAINS  or  MUN token at  ICO  price!  Sign  up for  PRE-SALE NOW!”  as  well  as links  to  promotional  videos touting the possible  returns  investors  could make  on the tokens.  


The  SEC noted that  Munchee “did not  use the Munchee App  or  otherwise specifically  target current  users  of  the Munchee  App  to promote how  purchasing  MUN  tokens  might  let  them  qualify  for  higher  tiers  and bigger payments  on future  reviews.”       


On November  1,  2017,  the  second day  of  the ICO,  SEC  staff  contacted  Munchee,  which determined within  hours  it  would  shut  down  the ICO.  Munchee  had  not  delivered  any MUN  tokens  to  purchasers  and promptly  returned the  proceeds  that  it  had received. In applying the  Howey  test  to  the MUN  token  ICO,  the  SEC  determined  that  MUN  tokens were securities and cited  the following factors: •  Munchee  intended to  use the proceeds  from the ICO  to revise the app  and  build  an ecosystem  based on the MUN  tokens,  which  MUN token purchasers  reasonably  expected  would increase the  value of the MUN  tokens.  


Furthermore,  Munchee promised to facilitate a secondary  market  for  the MUN tokens  in advance of  creation of  the  ecosystem  in  which they  could  be used.  And  finally,  investors’ profit  expectations  were “primed”  by  Munchee’s  marketing,  which compared the MUN  tokens  to previous  ICOs  that  had  generated  profits  for  early  ICO  investors.  


Specifically,  Munchee “marketed to people  interested  in  those  assets  –  and those profits  – rather  than  to people  who,  for  example,  might have  wanted MUN  tokens  to buy  advertising or  increase their  ‘tier’ as  a reviewer  on the  Munchee App.”   •  Such profits  would be realized through the appreciation  in  value  of  MUN  tokens,  which  would require the “significant entrepreneurial  and managerial  efforts  of  others”  in the form  of  building the ecosystem, designing  the  revised app  and supporting  the secondary  market  for  the MUN  token.  


Due to Munchee’s  conduct  and  marketing approach during  the course  of  the ICO,  investors’ belief  that they  could rely  on  the significant  efforts  of  Munchee  to  drive increased  MUN token value  was reasonable. Because  MUN  tokens  were  securities,  and  Munchee offered and sold  these  securities  to  the  general public  without  filing  a  registration  statement  or through  a valid  exemption,  Munchee violated Sections  5(a) and (c)  of  the  Securities  Act.   


Tokens As Securities
The SEC’s definition of a security includes investment contracts, which it defines as (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.

In its cease-and-desist Order to Munchee, the SEC focused on those last two elements: a reasonable expectation of profits derived from the efforts of others.

Reasonable Expectation of Profits
The SEC identified two characteristics of MUN tokens that satisfied the reasonable-expectation-of-profits element. First, the value of the pre-functional MUN tokens bought during the ICO would naturally increase once the Munchee “ecosystem” on which they

could be used was implemented.

Second, in promoting MUN tokens in its white paper, through social-media accounts, and elsewhere online, Munchee emphasized the likelihood that the tokens would increase in value. It also promoted MUN tokens to investors in countries other than the United States, even though the Munchee app is only available in the U.S.

Derived from the Efforts of Others
Any increase in MUN tokens’ value between the ICO and the launch of the enhanced Munchee app would be the result of Munchee’s efforts. Specifically, Munchee would develop the enhanced app, increasing demand for MUN tokens and, accordingly, the tokens’ value.

In addition, Munchee had promised to support secondary markets on which MUN tokens could be sold, including by buying or selling MUN tokens to ensure a “liquid secondary market.” This, too, would tend to increase MUN tokens’ value.


As to each of the six elements common to many purported “utility token”” sales referenced above, following are the takeaways that the Munchee Order provides:


Immediately usable
The Order notes that "no one was able to buy any good or service with [the Munchee tokens] throughout the relevant period” (i.e. during the offering and before Munchee added the functionality to the app to buy meals with the tokens).

Even though the Munchee token was not immediately usable, the SEC cautioned against reasoning that if a token is immediately usable that is a strong factor for it not to be a security:

"Even if the Munchee 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 characterizing an ICO as involving a 'utility token' – but instead requires an assessment of 'the economic realities underlying a transaction.' All of the relevant facts and circumstances are considered in making that determination."

Takeaway: Even immediately usable tokens can be securities, depending on all the facts and circumstances of the ICO.

Buyers' expectations
The Order observes that Munchee's white paper emphasized that the "ecosystem" that it was to create allowing diners and restaurants to use the tokens in various ways would cause the tokens to rise in value.

It also stated that Munchee would run the company in a way to cause the tokens to rise in value such as "burning tokens" to restrict supply.

From these statements, the Order concludes: "Purchasers would reasonably believe they could profit by holding or trading [Munchee] tokens, whether or not they ever used the Munchee App or otherwise participated in the [Munchee] 'ecosystem,' based on [the white paper]."

Takeaway: Claims from promoters that tokens will appreciate in value are consistent with an investor's intent, not a customer's intent.


Efforts of others
The Order notes that Munchee's website, advertising and white paper reasoned that the tokens would rise in value because "Munchee and its agents could be relied on to provide the significant entrepreneurial and managerial efforts required to make [the Munchee] tokens a success."

Representations that management of an ICO issuer will upgrade the functionality of the platform or the tokens themselves in the future are common.

Takeaway: If the promise of future improvements by the ICO issuer are combined with the issuer's claims that token holders will profit by a related increase in value, that will satisfy the prong of the Howey test whether the investor reasonably expects to profit from the efforts of others.

Secondary market
The Order observes that Munchee's white paper stated "Munchee will ensure that [the Munchee] token is available on a number of exchanges in varying jurisdictions to ensure that this is an option for all token-holders."

Specifically, Munchee said that the "tokens would be available for trading on at least one U.S.-based exchange within 30 days of the conclusion of the" ICO, the SEC said. "Munchee highlighted that it would ensure [a] secondary trading market for [the] tokens would be available shortly after the completion of the offering and prior to the creation of the ecosystem."

In other words, token holders could profit from Munchee's efforts to establish and support a secondary market without ever using the tokens to buy a good or service.

Takeaway: If an ICO issuer is promising to maintain a secondary market, it is less likely that the token will be seen simply as a utility token. With a secondary market, a token holder can profit without ever using the token for the purpose it was made for.  This is especially the case if the secondary market will exist prior to the token being usable for its intended purpose.

Manner of advertising
The Order notes that Munchee had advertised and marketed the token offering broadly on its website and message boards, likening the Munchee tokens "to prior ICOs and digital assets that had created profits for investors."

Moreover, the SEC observed that to the extent Munchee had a focus of its marketing it was to people interested in digital assets and the profits earned by investing in such assets as opposed to members of the restaurant industry, promoting how the tokens "might let them advertise in the future," or otherwise use the tokens in their restaurants' businesses.

Takeaway: Marketing an ICO to the groups other than the members of the industry who would use the token in the ordinary course of their business, tends to show that the token is really an investment or a security rather than a true utility token.

Use of proceeds
The Order comments on how Munchee told token buyers the proceeds of their purchases would be used:

"The proceeds of the [Munchee] token offering were intended to be used by Munchee to build an 'ecosystem' that would create demand for [Munchee] tokens and make [the] tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using [the] tokens and was to recruit 'partners' such as restaurants willing to sell meals for [the] tokens."

Takeaway: Where the proceeds of the token offering are used to promote the general corporate purposes of the issuer, rather than being held in escrow or invested in a hedging transaction to help provide the good or service that the buyer can exchange a token for in the future, the ICO appears to be more of an investment rather than a deferred purchase of a good or service not implicating the securities laws.

Not surprisingly, all of these factors analyzed together led SEC to the conclusion that Munchee token was in fact a security.

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