Not So Fast: District Court Balks at SEC’s Blanket Characterization of Tokens as Securities

By: George Calhoun

An issue of major importance to cryptocurrency and digital token markets has been whether tokens were all to be considered securities under U.S. law. The SEC’s frequent admonishments that it would consider ICOs to be securities offerings has caused a dramatic slowdown in the U.S. ICO market. In one of the first cases to test the SEC’s broad definition, the United States District Court for the Southern District of California refused the SEC’s invitation to characterize a company’s tokens as securities – holding that factual disputes prevented that characterization and thus denying the SEC’s requested injunction.

The SEC brought an action against Blockvest LLC and sought an injunction freezing the company’s assets and barring it from proceeding with a planned ICO and any other securities sales. Blockvest defended the motion based solely on its contention that it had not sold any securities.[1] In a November 27, 2018 ruling, U.S. District Judge Gonzalo P. Curiel held that the SEC had not demonstrated that the tokens offered by Blockvest LLC to 32 purported “test investors” ahead of a proposed $100 million ICO were subject to securities laws. The SEC and “defendants provide starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test [tokens],” Judge Curiel said. “Therefore, because there are disputed issues of fact, the court cannot make a determination whether the test [tokens] were ‘securities.’” Although Judge Curiel denied the SEC’s request for a preliminary injunction, the defendant company voluntarily agreed not to move forward with its proposed ICO at this time.

The decision is important because it begins to put contours on how the Howey test will be applied to cryptographic tokens. The court focused primarily on the first Howey prong: investment of money, which it stated required it to consider “what the purchasers were offered or promised.” In doing so, it considered whether purchasers of the tokens had an expectation of profit and the promotional materials they had relied upon, if any. For companies that may believe that their token is a “utility token” that does not qualify as a security, the court’s focus emphasizes the importance of a tightly focused and disciplined marketing strategy that avoids any implication that the purchaser may profit from the purchase in any way.

The court also considered the second Howey prong expectation of profit. The court focused narrowly upon profits as either capital appreciation or a participation in earnings. Because it found that the SEC – without full discovery – had not proven an interest in profits, it concluded that the SEC had not demonstrated an expectation of profits.

Although the ruling is a preliminary ruling on a motion for an injunction, it offers a window of possibility that the SEC’s broad reading of the Howey test might not live up to judicial scrutiny. If courts require proof of an actual interest in profits, ICOs that offer utility tokens with no profit expectation may once again have a path forward that does not include entanglement with U.S. securities laws. There is still much to shake out, and this ruling could change after factual development, but rulings like this one suggest that – despite the SEC’s recent efforts – the “utility token” may just be “mostly dead.” And as we all know, “there’s a big difference between mostly dead and all dead … mostly dead is slightly alive.”