(Article from Securities Law Alert, February/March 2019)
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On February 14, 2019, the Southern District of California held that digital tokens sold in an initial coin offering (“ICO”) constitute securities under the test set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). SEC v. Blockvest, 2019 WL 625163 (S.D. Cal. 2019) (Curiel, J.) (Blockvest II).
An ICO is a “fundraising event” in which an entity offers investors unique digital tokens or assets in exchange for virtual currency or other consideration. Each digital token “may entitle its holders to certain rights related to a venture underlying the ICO, such as rights to profits,” and “may also be listed on online trading platforms.” Issuers typically promote ICOs through social media and other online methods, and also “usually release a ‘Whitepaper’ describing the project and the terms of the ICO.”
In Blockvest, the SEC brought suit against a company that offered digital tokens through an allegedly fraudulent ICO, as well as the company’s chairman, under Section 10(b) of the Securities Exchange Act of 1934 and Sections 17(a)(1), (2) and (3) of the Securities Act of 1933, among other claims. The SEC moved for a preliminary injunction to halt the ICO and freeze the assets of the company and its chairman. The Southern District of California initially found that it could not determine whether the digital tokens at issue constituted securities and denied the SEC’s motion for a preliminary injunction, but granted the SEC’s request to freeze assets and protect investors from the potential dissipation of the company’s and CEO’s assets. SEC v. Blockvest, 2018 WL 6181408 (S.D. Cal. Nov. 27, 2018) (Curiel, J.).
On reconsideration, the court held that the digital tokens offered in the ICO at issue satisfied “Howey’s three-part test” for determining whether an investment opportunity is a “security.” Howey “requires (1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” The Blockvest II court explained that “[a]n investment of money can take the form of goods and services . . . or exchange of value.” The court found that “[d]efendants’ website and their Whitepaper’s invitation to potential investors to provide digital currency in return for [digital] tokens satisfies” the first prong of the Howey test. The court held that Howey’s second prong was met because defendants “claimed that the funds raised [through the ICO] will be pooled and there would be a profit sharing formula.” Finally, the court determined that Howey’s third prong was satisfied because, “as described on the website and Whitepaper, the investors in [the ICO] would be ‘passive’ investors and the [digital] tokens would generate ‘passive income.’” The court concluded that “the promotion of the ICO of the [company’s] token was a ‘security’” under the Howey test.
The Blockvest II court granted the SEC’s motion for a preliminary injunction with respect to the ICO even though defendants contended that the digital tokens were designed merely for the purposes of testing the company’s platform, and no actual sales of the tokens had taken place. The court found defendants could nevertheless face securities fraud liability because defendants’ promotion of the ICO constituted an “offer” of unregistered “securities” for purposes of Section 17(a). The court stated that “Section 17(a) is intended to cover any fraudulent scheme in an offer or sale of securities, whether in the course of an initial distribution or in the course of ordinary market trading.” The court explained that “[u]nder securities law and caselaw, the definition of ‘offer’ is broad and there is no requirement that performance must be possible or that the issuer must be able to legally bind a purchaser.”