Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

Munchee Inc., a California-based company selling digital tokens to investors to raise capital for its blockchain-based food review service halted its initial coin offering (ICO) after being contacted by the SEC. Munchee Inc. agreed to an order in which the SEC found that its conduct constituted unregistered securities offers and sales.  The announcement of the settlement was followed by a statement of SEC Chair Jay Clayton, where he gave his views on certain aspects of ICOs.

Munchee Inc. Order

According to the order:

  • Munchee offered and sold MUN tokens in a general solicitation that included potential investors in the United States. Investors paid Ether or Bitcoin to purchase their MUN tokens. Such investment is the type of contribution of value that can create an investment contract.
  • MUN token purchasers had a reasonable expectation of profits from their investment in the Munchee enterprise. The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise a Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens. In addition, Munchee 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. Like many other instruments, the MUN token did not promise investors any dividend or other periodic payment. Rather, as indicated by Munchee and as would have reasonably been understood by investors, investors could expect to profit from the appreciation of value of MUN tokens resulting from Munchee’s efforts.
  • Investors’ profits were to be derived from the significant entrepreneurial and managerial efforts of others – specifically Munchee and its agents – who were to revise the Munchee App, create the “ecosystem” that would increase the value of MUN (through both an increased demand for MUN tokens by users and Munchee’s specific efforts to cause appreciation in value, such as by burning MUN tokens), and support secondary markets. 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.
  • Investors’ expectations were primed by Munchee’s marketing of the MUN token offering. To market the MUN token offering, Munchee and its agents created the Munchee Website and a MUN White Paper and then posted on message boards, social media and other outlets. They described how Munchee would revise the Munchee App and how the new “ecosystem” would create demand for MUN tokens. They likened MUN to prior ICOs and digital assets that had created profits for investors, and they specifically 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. Because of the conduct and marketing materials of Munchee and its agents, investors would have had a reasonable belief that Munchee and its agents could be relied on to provide the significant entrepreneurial and managerial efforts required to make MUN tokens a success.
  • 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 characterizing an ICO as involving a “utility token” – but instead requires an assessment of “the economic realities underlying a transaction.”
  • Munchee offered and sold securities to the general public, including potential investors in the United States, and actually sold securities to about 40 investors. No registration statements were filed or in effect for the MUN token offers and sales and no exemptions from registration were available.
  • On November 1, 2017, Munchee stopped selling MUN tokens hours after being contacted by SEC staff. Munchee had not delivered any tokens to purchasers, and the company promptly returned to purchasers the proceeds that it had received.
  • Munchee and the investors entered into a contract of sale for MUN in which investors were irrevocably bound. Munchee unilaterally terminated the contracts of sale, returning the money to investors. Any offer by Munchee to buy the investors’ securities would have required registration of the transaction or an exemption from registration.
  • Munchee did not admit or deny the findings in the SEC order.

Statement of SEC Chair Jay Clayton

In his statement, SEC Chair Clayton offered warnings to Main Street investors contemplating participating in ICOs. Much of the statement was directed at professionals involved in ICOs.  According to Chair Clayton (emphasis in original):

  • Certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. 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. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.
  • I also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of “scalping,” “pump and dump” and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.
  • By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws. Generally speaking, these laws provide that investors deserve to know what they are investing in and the relevant risks involved.
  • I have asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws.