The U.S. Securities and Exchange Commission (SEC) convinced a federal district court to reconsider whether a digital token sale consistutes a security offering, providing guidance on the application of securities law to cryptocurrency.
Though the U.S. District Court for the Southern District of California originally refused to enjoin a company’s cryptocurrency exchange because its tokens could not be considered “securities,” the SEC’s motion for reconsideration succesfully shifted the court’s focus from what or to whom the company offered its token, to how the company made its offer. The reversal marks the first of its kind in the cryptocurrency context and provides insight into how the SEC is likely to frame its enforcement efforts going forward.
SEC Fails to Establish Sale to Test Investors Violated Law
In SEC v. Blockvest, LLC, the SEC filed suit in the U.S. District Court for the Southern District of California to enjoin defendant Blockvest from offering and selling unregistered securities in the form of digital tokens. Prior to its Initial Coin Offering (ICO), Blockvest sold its tokens to 32 test investors, representing its platform as the “first licensed and regulated tokenized crypto currency exchange and index fund.” To promote the upcoming ICO, Blockvest published materials claiming its tokens would generate passive income and realize double-digit returns. According to the SEC’s complaint, the materials falsely stated that the SEC registered and approved the ICO, and further claimed a sham regulatory agency, the “Blockchain Exchange Commission,” licensed and regulated its tokens.
Blockvest argued the sale of its test tokens did not violate securities law because the tokens were not securities. It offered supporting testimony from the test investors who claimed they did not intend to purchase securities by participating in the pre-sale. Instead, they argued, they purchased the tokens merely to test the digital platform. In rebuttal, the SEC presented checks with “coins” or “Blockvest” written on the memo line to evidence intent to invest in the company.
The court held that the memo lines, in and of themselves, were insufficient to demonstrate the extent to which the test investors may have relied upon promotional materials, information, ecomonic inducements, or oral presentations before purchasing the Blockvest tokens. With “starkly different” facts as to the 32 investors in this regard, the court concluded it was unable to determine whether the tokens were “securities” under the 3-part test from SEC v. WJ Howey Co.
Under Howey, a security exists when one invests money in a common enterprise with a reasonable expectation of profit derived from another’s efforts. The test focuses on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold on a secondary market. The Blockvest court found disputed facts existed and denied injunctive relief.
Court Reverses after Finding Company Made an “Offer” to Sell Securities
The SEC moved the court to reconsider. Through briefing, the SEC explained that the district court improperly required it to prove actual purchase or sale to establish the tokens were securities. According to the SEC, the court undermined the purpose of the Securities Act, which protects against fraudulent sales and offers to sell. Rather than focusing on the sale, the SEC argued, the court should consider more generally whether the company made an offer through its promotional materials.
Taking the SEC’s cue, the court examined whether the company’s promotional materials amounted to an “offer” as defined under securities law. The court observed that an offer does not require a “manifestation of intent to be bound,” and “there is no requirement that performance must be possible or that the issuer must be able to legally bind a purchaser.” Blockvest’s materials urged investors to purchase tokens through a “Buy Now” button and claimed the funds would be pooled together to generate passive income. When viewed together, the court held, these materials amounted to an offer even though the test investors did not rely upon them to purchase tokens. The court granted the motion for reconsideration and granted the injunction based on a likelihood Blockvest would violate the law in the future.
Security Definition Unchanged, Offering Definition Refined
The court’s reconsideration of its decision is “a perfect example of how the system is supposed to work,” observes Vincent P. (Trace) Schmeltz III, cochair of the Cryptocurrency and Blockchain Subcommittee of the ABA Section of Litigation’s Securities Litigation Committee. “The government used the reconsideration process appropriately and shifted focus from the “what” to the “how,” adds Schmeltz. Going forward, the SEC “will likely change their playbook to focus on the fraud,” he opines.
“This is a very significant decision as this is the first time that a federal court has held that an ICO constitutes an offering of a security such that the federal securities laws apply,” adds Lynda J. Grant, New York, NY, cochair of the Cryptocurrency and Blockchain Subcommittee of the Section of Litigation’s Securities Litigation Committee. “Up to this point, there has been a real question as to whether ICOs constitute securities offerings, and under what circumstances the tokens could be considered a security,” Grant explains. Although Blockvest is based in part on facts specific to this offering, she advises, “the underlying premise, that the ICO constitutes an offering of securities, is generally applicable in other contexts depending upon the nature of the token at issue and the terms of the ICO.”
Even so, Section leaders agree that Blockvest does not change the definition of security. In that regard, “most practitioners in the securities space have been comfortable with the application of the Howey test since the day cryptocurrencies came out,” suggests Schmeltz. But the decision reaffirms “the definition of security will not change even when a token has a dual purpose,” explains Schmeltz.
“In other words, he says, “a token may only unlock a door initially, but if by buying the token you will be in line to profit as the company grows, then one of the purposes is a security.” Therefore, he advises, companies that “have an exchange and plan to make a market in the U.S., regardless of what [they] call the cryptocurrency, need to be properly registered under the securities laws.”
Kristen L. Burge is an associate editor for Litigation News.
Hashtags: #cryptocurrency, #ICO, #SEC, #securitieslaw
- Bill Hinman, “Statement on Framework for ‘Investment Contract’ Analysis of Digital Assets,” U.S. Securities and Exchange Commission (Apr. 3, 2019).
- Martha L. Kohlstrand, “Cryptocurrency Covered Under Securities Laws, Federal Court Rules,” Litigation News (Jan. 4, 2019).
- Daniel S. Wittenberg, “Blockchain: Technology Rockin’ the Legal Industry,” Litigation News (Sept. 11, 2018).
Copyright © 2019, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).