Munchee Settlement Puts the Utility Token Argument to the Test
Coin Center’s analysis of the recent SEC enforcement action against an ICO found to be in violation of securities law.
The SEC’s settlement with Munchee is an important milestone in the young history of token law, because it begins to challenge the naive version of the utility token argument and shows us how the SEC is drawing a clearer line between useful digital commodities and speculative investment tokens.
Previous SEC actions can be summarized as follows:
21(a) Investigative Report on the DAO:
- Some token sales fit our definition of securities issuance.
- The applicable test is the howey test for an “investment contract.”
- Authors of smart contract code and special functionary participants within smart contracts may be sufficiently important to the realization of expected profits that they are promoters or issuers.
- The DAO was sold as a profit-making investment.
- Secondary markets trading DAO and DAO-like tokens must be registered alternative trading systems or national securities exchanges or else they are also in violation of Federal securities laws.
Zaslavskiy Enforcement Action (Diamond and Real Estate backed coins)
- It is securities fraud to sell tokens that are advertised as being asset-backed, if— in reality—there are no assets.
Statement on Celebrity Endorsements
- Celebrities or others who advertise token sales but do not make necessary compensation disclosures are violating anti-touting provisions, and may also be unregistered promoters.
One thing not discussed in any of those actions is whether the usefulness or commercial purpose of a particular token saves it from being classified as a security. The so-called utility token argument.
The DAO token was nakedly an investment deal; it was essentially a partnership interest in a decentralized venture capital fund. But not everything looks like the DAO.
Other tokens and coins, like bitcoin and ether, have real and active usage for non-investment purposes: as fuel for decentralized computation or currency for peer-to-peer electronic money transmission.
Simultaneously, new tokens are being developed and sold that entitle the bearer to some service provided by a decentralized network (sometimes before and sometimes after that network has been developed): Filecoins/Storj/Siacoins are or will allow one to access cloud storage; Basic Attention Tokens will give you an ad-free Internet browsing experience.
And still other tokens are being marketed and sold as profitable investments yet promotional materials repeatedly tout that they are “utility tokens” that will purportedly have some usefulness someday (even though that usefulness is speculative and often poorly explained).
These distinctions matter for securities law because sales of useful items are generally not regulated as securities issuance even if some part of the motivation behind the purchaser’s decision is investment. That case law includes real estate sales, golf club memberships, precious metals deals, and more.
The inference made in the utility token argument is that similar interpretations of securities laws would govern sales of tokens that are useful. This is a perfectly reasonable argument, but the question that remains is when is a token useful-enough and sold in a context dissimilar-enough from a typical investment contract that it is saved from being classified as a security?
The Munchee settlement begins to give us some answers to that question.
Utility? Substance over form
The clearest takeaway is that mere claims of “utility!” in a white paper or other marketing materials will not suffice. In short, the SEC is from Missouri, and that means “show me” the economic realities. As the settlement reads:
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.”
Utility? Now over later
It’s also clear that the SEC doesn’t appreciate “utility in the long run.” Munchees may have one day offered you the ability to monetize good restaurant reviews, or book a table at Tavern on the Green, but on the day of the sale they offered you the ability to do… bupkis (except maybe… just maybe you will get rich if they do become useful in the future). According to the SEC:
While Munchee told potential purchasers that they would be able to use MUN tokens to buy goods or services in the future after Munchee created an “ecosystem,” no one was able to buy any good or service with MUN throughout the relevant period.
So timing may matter. Does that mean the SAFT is the best way to sell a token that has a future promised functionality? I can’t be sure, but it seems like a reasonable approach to a complicated problem.
Utility? But also some other promises
I think this one matters maybe more than anything else. Bitcoin gives you what? A bitcoin and the ability to make valid transactions on the bitcoin blockchain. Ether gives you what? Ether and the ability to run a decentralized app on the ethereum virtual machine. The utility is bound up inextricably and totally in the token and does not depend on the continued efforts or promises of the person who sold it to you.
If you are selling something that will only work based on your efforts to “build an ecosystem,” and obtain formal agreements with restaurants or other legal entities, then you are selling a promise to deliver value. Here’s the SEC:
Munchee said in the MUN White Paper that the value of MUN tokens would depend on the company’s ability to change the Munchee App and create a valuable “ecosystem” that would inspire users to create new reviews, inspire restaurants to obtain MUN tokens to reward diners and pay Munchee for advertising, and inspire users to obtain MUN tokens to buy meals and to attain higher status within the Munchee App. Munchee said that it and its agents would undertake that work during 2018 and 2019.
This is exactly what we said about Paycoin back in 2015. Its creators weren’t promising a cryptocurrency, they were promising iminent Amazon integration and all the negotiating chutzpah that would be needed to get it.
Also, (unless you admit you are selling a security) you can’t go around promising that people will buy your tokens back if you end up with buyer’s remorse. Paycoin did that too with a minimum $20 price floor. Munchee didn’t offer such guarantee but, as per the SEC, the marketing materials,
highlighted that it would ensure a secondary trading market for MUN tokens would be available shortly after the completion of the offering and prior to the creation of the ecosystem.
Making these sorts of additional promises beyond delivery of an (otherwise) non-security is exactly what can turn a sale of a product into a securities issuance. There’s a great case on point here called Gary Plastic.
In that case Merrill Lynch was selling bank-issued certificates of deposit (CDs) to customers. CDs are not securities, but the additional promises made by Merrill Lynch made the sales securities issuance. Merrill Lynch also promised to create a secondary trading market for CDs, and offered to buy them back from customers who wanted to close their CD before the maturation term (typically you are locked into a CD for a set number of years, e.g. a 5-year High Yield CD). They also offered to watch out for defaults of the issuing banks and collect FDIC insurance for those defunct CDs. All in all, as the court held,
Plaintiff's decision to invest is obviously made in reliance upon the efforts, knowledge and skill of Merrill Lynch.
So, just like a token with real consumptive utility, a CD is not a security, but promises to take additional steps to make the investment more profitable for the buyer may make the sale securities issuance.
Utility? But guilt by marketing association
Finally, the SEC spent a lot of time characterizing how (and where) Munchee advertised the sale.
[Munchee] offered to provide MUN tokens to people who published promotional videos, articles or blog posts in forums such as BitcoinTalk.org or otherwise helped Munchee promote the MUN token offering. …
Nor did Munchee advertise the offering of MUN tokens in restaurant industry media to reach restaurant owners and promote how MUN tokens might let them advertise in the future.
If you market it as a profitable investment (and don’t even advertise to people who might use the darn thing) it’s going to be difficult to argue that the primary purpose of the sale is anything other than capital formation with the promise of profits.
Utility? What does it all mean?
We appreciate the SECs analysis. Since 2015, it has been our priority to help securities regulators draw a reasonable line between tokens embedded within active and useful technological projects, and those that are merely sold as pump and dump scams or thinly-veiled equity crowdfunding. The SEC has started to further chisel out that dividing line, and we will continue to do our best work to ensure that the line doesn’t extend unreasonably into the realm of truly useful and decentralized networks and their cryptocurrencies and tokens.
We have nothing against equity crowdfunding, but think that it should either be done in compliance with existing law or else we should work together to change those laws (for everyone, not just the token-folks).