Initial Coin Offerings After the SEC’s Munchee Order

Photographer: Chris Ratcliffe/Bloomberg

Munchee and its Repercussions in the ICO World

Gary Ross of Ross & Shulga PLLC, New York, examines the implications of the Securities and Exchange Commission’s cease-and-desist order to Munchee, Inc. during its Initial Coin Offering.

On December 11, 2017, the Securities and Exchange Commission (the SEC) issued a cease-and-desist order (the Order) to Munchee, Inc. (Munchee) during its Initial Coin Offering (ICO). Until the Order, the SEC had only interceded in ICOs when either clearly fraudulent activity was occurring or, in the case of the DAO, to signal to the world that digital tokens can be securities. The Order sent two new messages to the cryptocurrency world: (1) that the SEC has moved on from simply punishing the most blatant bad actors and will be regulating ICOs more closely, and (2) the world of utility tokens is much smaller than previously believed. These two messages, along with other lessons learned from Munchee discussed below, will change how ICOs are carried out.

Munchee Followed Many Mainstream Market Practices

Munchee represents a warning shot to other companies in the cryptocurrency-sphere that wish to hold their own ICOs. Munchee made a few missteps that likely invited the SEC’s scrutiny – no doubt without the knowledge of its lawyers. But for the most part, Munchee’s proposed token platform, or “ecosystem”, and the promotion of its ICO are not so different from what has been used in many other ICOs.

Munchee, a California company, sought to create a token ecosystem centered around a U.S. smart phone application it launched in early 2017 that linked restaurants, restaurant-goers, and reviewers. To create this proposed ecosystem, Munchee would generate and sell tokens (MUN tokens) to the public. Munchee stated that it hoped to raise $15 million to get its business off the ground, and that the proposed token ecosystem would be online and functional within a year or two.

Munchee promoted the MUN token offering (the MUN ICO) on its website, Facebook and Twitter, and also on cryptocurrency-specific websites such as BitcoinTalk, where many people discuss and promote individual ICOs. Munchee targeted its marketing efforts towards the cryptocurrency community instead of the restaurant-going community, and did not direct any particular selling efforts to the current users of its application. Though Munchee’s application was operational, the app did not accept MUN tokens and there was no good or service that could be purchased with MUN tokens at the time of the MUN ICO.

Munchee made its white paper (the MUN White Paper) publicly available, and like all other companies conducting ICOs, it promoted the experience and expertise of its founders and other team members. As is typical when a platform has yet to be built, Munchee conveyed in its white paper how its platform would actually work and how the company’s team had the skills and abilities to bring such an effort online. Munchee also instituted a “bounty” program, by which third parties who raised awareness of the MUN ICO by creating promotional videos, articles or blog posts, as well as through translation services, were awarded tokens. Again, all of this is common practice for ICOs.

Munchee intended for its tokens to trade on a secondary market. Though legal counsel will typically remove any references in a white paper to secondary trading, the MUN White Paper was hardly unique in openly discussing that the company would work to ensure the MUN tokens traded on secondary markets. Furthermore, Munchee stated that it would buy and sell MUN tokens using its retained holdings in order to ensure there was sufficient market liquidity. Munchee also planned to “burn” leftover tokens, which would serve to boost the value of the remaining tokens.

The Munchee team was aware of the Howey test and stated in the MUN White Paper that it had conducted a “Howey analysis” and found the MUN tokens were not securities, though it did not describe the specific reasoning it used.

Some of Munchee’s Actions Overstepped Typical Market Practices

In some ways, Munchee did veer from market norms in its quest to woo token purchasers; primarily in making several public statements, or endorsing other people’s public statements, that touted the token offering as an opportunity to profit.

Legal counsel will typically advise founders and officers of a company conducting an ICO against going on television or a public forum and stating that the value of the company’s utility token will rise. Munchee, if it received such advice, did not heed it, since one of the founders went on a podcast and discussed the specific factors, such as the creation of quality content on the ecosystem, that were going to make the value of the MUN tokens rise.

Another one of Munchee’s founders also appeared on a cryptocurrency podcast to promote the MUN token offering, where she emphasized the financial value of cryptocurrency, and spoke of the financial gains she had made from Ether and other cryptocurrencies. While it is not uncommon for founders of a company conducting an ICO to do the equivalent of an IPO road show, care should have been taken not to convey any expectation of profits to the potential MUN token-buying community.

Most egregiously, Munchee posted the following message on Facebook: “199% GAINS on MUN token at ICO price! Sign up for PRE-SALE NOW!”, linking to a video in which a person (apparently unaffiliated with the company) said “Pretty much, if you get into it early enough, you’ll probably most likely get a return on it.” The person went on to speculate that a $1,000 investment could create a $94,000 return. It’s easy to imagine a person viewing such a video and forwarding it to the SEC.

Understandably, the SEC took notice of these oversteps and included them in its rebuke.

SEC’s Reaction

The SEC concluded that Munchee’s purported utility tokens were investment contracts under the Howey test. The Order does not go through each prong of the Howey test the way the SEC did in its investigative report on the DAO tokens. Instead, the SEC went right to the third and fourth prongs, declaring that token purchasers had a reasonable expectation of obtaining a future profit from the efforts of Munchee and others.

The SEC emphasized that the Howey test was flexible rather than static, and could be adapted to meet “the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” In short, the SEC endorsed a “substance over form” analysis.

The SEC found that MUN token purchasers reasonably expected the company to expend efforts to develop the ecosystem, which would cause the value of the MUN tokens to rise. The SEC specifically cited a video in which an ICO reviewer stated that MUN token holders who were looking to “flip it” would need to wait until the MUN token could be used on the app or until the platform becomes active. However, unlike with the video and podcasts referred to previously, it is not apparent the company did anything to endorse or promote this video.

Though in December members of the SEC stated that just because a token trades on a secondary exchange does not automatically mean the token is a security, it is clear in the Order that the secondary trading aspect was an important factor to the SEC’s determination, as it is mentioned several times.

While typical, the SEC also took issue with the target of Munchee’s marketing efforts, noting that they reached far beyond the potential user-base who would use MUN tokens as a regular part of the ecosystem. In particular, the marketing efforts and promotional materials seemed to heavily target purchasers who would buy MUN tokens as an investment rather than for their utility. The SEC found these activities to be problematic, and decided that they primed purchaser’s expectation of profit in an investment sense.

What Does This Mean Going Forward?

The Order is expected to put an end to several of the common practices described above. It is likely many of the following practices will be affected:
• Functional platform is not a determining factor. Perhaps most importantly, the SEC sent a clear signal that it is not in agreement with the concept that tokens used for a functional platform will necessarily be utility tokens. It explicitly stated that, “[e]ven if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.” This had been a common belief among the securities bar. • Secondary trading. Companies promoting ICOs of purported utility tokens are going to be much more circumspect about secondary trading. White papers will be scrubbed clean of any references to secondary trading, and founders and officers will be warned not to mention in any taped event of any efforts by the company to list its tokens on secondary markets. • Target marketing. Companies conducting ICOs will need to target some if not most of their marketing efforts towards communities which are anticipated to actually use the eventual platform. For example, if a company is building a platform to assist homeschooled children in Japan learn Latin, the company should expend energies marketing the tokens to Japanese parents, instead of only to the cryptocurrency community in the U.S. • References to token value and profiting. Founders and others affiliated with a company conducting an ICO will be more careful when referring to the possibility of profiting off of a utility token, likely avoiding the topic altogether. White papers will also need to be careful when describing the value of the tokens. • Third party statements. The SEC, in finding that token purchasers were dependent upon the company for expected profits, cited a video that Munchee had nothing to do with. Thus, companies will – or at least should – start trying to clamp down on influential third parties who go on record as suggesting an offering of the company’s utility tokens as a means to a profit. • Bounties. The SEC had a dim view of the “bounty” practice, so that will probably end as well, though the “airdrop” tactic of giving away tokens to boost interest may not be affected. • Legal opinions. The practice of giving legal opinions based on overly precise readings of Howey will likely end. Most lawyers who do not already do so will condition their opinions on there being no secondary market trading for the token in question.
With Bitcoin having gone up over 1500 percent in 2017 as of this writing, cryptocurrencies and ICOs are not going away. However, until the SEC provides a road map as to how a token can definitively be considered a utility token, the industry and the securities bar will need to reexamine the utility token/securities token divide. Careful attorneys will likely reserve utility token determinations for those tokens that function as credits for a service or a good on a platform, with either no possibility of extracting value from the platform on account of the token, or with a token whose price does not change. Anything else may be inviting an unwelcome phone call from 100 F Street.

Gary is a partner at Ross & Shulga PLLC in New York. Gary focuses his practice on securities law, venture capital and private equity, corporate governance, and general corporate matters. Gary represents a bevy of companies in the blockchain/cryptocurrency space, as well as angel investors and investment funds. Gary can be reached at