In a world’s first, U.S. District Judge Gonzalo Curiel (pictured) has ruled that an Initial Coin Offering (ICO) is not a security.
“In sum, the Court concludes that Plaintiff has not demonstrated a prima facie showing that there has been a previous violation of the federal securities laws,” the judge said.
The Securities and Exchanges Commission (SEC), which is charged with enforcing the Securities Act 1933, had claimed Blockvest made a sale or offering of an unregistered security in violation of the Act.
SEC therefore had asked for an injunction to freeze all the assets, which was denied because the judge found on a prima facie (on the face of it) that the offering was not a security.
SEC claimed – and the judge took them at their word – that Blockvest had fraudulently claimed they were approved by the SEC, CFTC and other agencies.
That is not true, the judge said, just as he said that the definition of a security did not “intend to provide a broad federal remedy for all fraud.”
Thus making fraud allegations and all the rest irrelevant to the question of whether this was a security or not. The answer to that question is based only on whether there is:
“A contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
Blockvest is described as an ERC20 token based upon the Ethereum blockchain. It aimed to build a Decentralized Blockchain Based Assets Exchange as well as a cryptocurrency index fund that autonomously tracks the top 30 cryptocurrencies. It would generate passive income through asset backed profit sharing smart contracts.
In other words a somewhat fairly typical ICO, but the details here are very particular because first of all Blockvest claimed there was no ICO as such, there was no sale to the public. SEC said it doesn’t matter whether there is a sale, an offer is sufficient to breach the law. The judge agreed.
The question thus turned on whether this is a utility token. In judge’s words: “They assert they have not sold any BLV tokens to the public but instead used the BLV tokens for purposes of testing during the development phase.
During this phase, 32 testers put a total of less than $10,000 of Bitcoin and Ethereum onto the Blockvest Exchange. The BLV tokens were only designed for testing the platform and no tokens were released to the 32 testing participants.”
Again, a fairly typical claim of utility, but the difference here might be that the defendant claimed – and the judge had to take him on his word because this was a short preliminary hearing on whether to freeze assets – that he knew all 32 individuals and that they were just using BLV for testing.
What the judge said has somewhat broad implications because it clarifies, as a matter of law, what is a security token and what is a utility token. The judge said, and we quote to some extent:
“The first “investment of money” prong of Howey “requires that the investor ‘commit his assets to the enterprise in such a manner as to subject himself to financial loss.’” SEC v. Rubera, 350 F.3d 1084, 1090 (9th Cir. 2003) (quoting Hector v. Wiens, 533 F.2d 429, 432 (9th Cir. 1976) (per curiam)).
In Rubera, the investors “turned over substantial amounts of money . . . with the hope that [the investment managers’ efforts] would yield financial gains.” Id.
“At the outset, we note that, while the subjective intent of the purchasers may have some bearing on the issue of whether they entered into investment contracts, we must focus our inquiry on what the purchasers were offered or promised.” Warfield v. Alaniz, 569 F.3d 1015, 1021 (9th Cir. 2009).
The focus on this “investment of money” prong is “what the purchasers were offered or promised.” Id. (courts frequently examine promotional material associated with the transaction); SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 352 – 53 (1943) (“The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”).
As explained in Hocking, before applying the Howey test, “we must determine what exactly [the defendant] offered to [the plaintiff].” Hocking v. Dubois, 885 F.2d 1449, 1457 (9th Cir. 1989) (concerning sale of real estate).
The Ninth Circuit in Hocking explained, “[c]haracterization of the inducement cannot be accomplished without a thorough examination of the representations made by the defendants as the basis of the sale. Promotional materials, merchandising approaches, oral assurances and contractual agreements were considered in testing the nature of the product in virtually every relevant investment contract case.” Id. (quoting Aldrich v. McCulloch Properties, Inc., 627 F.2d 1036, 1039-40 (10th Cir. 1980)).
The SEC argues that Blockvest’s website and whitepaper presented an offer of a unregistered security in violation of Sections 5 of the Securities Act; however, its argument presumes, without evidentiary support, that the 32 test investors reviewed the Blockvest website, the whitepaper and media posts when they clicked the “buy now” button on Blockvest’s website.
At his deposition, Ringgold explained that the Blockvest website was available to the public for pre-registration for the upcoming exchange. (Dkt. No. 27-18, Brown Decl., Ex. 17, Ringgold Depo. at 131:6-9.)
There were also testers working on the functionality of the exchange. (Id. at 131:10-14.) The “buy now” button on the website did not disclose that it was only for testors and management but once a person moved forward, he or she could not buy any coins because the platform was not “live.” (Id. at 131:15-20.)
But the “buy now” button was accepting crypto currency and 32 “internal” people who were sophisticated investors helped Defendants with managing the different functions needed to test the platform. (Id. at 132:4-14.)
Ringgold states he knows the identity of the 32 investors. (Id. at 132:15-20.) He indicated it was clear to the 32 testers that they were testing the platform.”
In other words, one of the most important aspect in determining whether an ICO is a security is in considering just what exactly the “investors” were told or promised.
Here, the defendant is claiming they were told this was just for testing, but that doesn’t deal with the offer aspect. The judge said the burden is on SEC to prove expectations of profit, stating:
“As to the second prong of Howey, Plaintiff has not demonstrated that the 32 test investors had an “expectation of profits.”
While Defendants claim that they had an expectation in Blockvest’s future business, no evidence is provided to support the test investors’ expectation of profits.
“By profits, the Court has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds.” Forman, 421 U.S. at 852.”
Plaintiff is SEC and the defendant is Blockvest. The judge is basically saying SEC has not shown that investors gave Blockvest money in the expectations of profits considering the very specific claimed circumstances.
In a prior hearing where only SEC was present, the same judge had granted them the injunction. In this hearing with the Defendant arguing his case, the judge has unfrozen the assets because it isn’t clear to him whether this is a security.
The matter will now go to trial where SEC and Blockvest are not quite taken on their word, but are examined, cross examined, in an adversarial setting.
So this isn’t a broad determination or even opinion on whether the general token model is or is not a security, as in whether the token itself provides utility and therefore is not a security.
What it does determine, however, is that the US judiciary is indeed independent and is willing to stand up to SEC rather than rubber stamp all their actions in what many perceive as an incredible overreach of the unelected executive.
That said, this is a first instance court where you face entry level judges. Some of them have no knowledge of the law any more than a university law student, while some of them are quite brilliant and do eventually go to higher courts, to the court of appeal, and even to the supreme court.
The judge in question is kind of famous, courting certain statements from Trump that most reasonable people would say lacked much taste, so he might be one of the “refined” judges.
Yet this case does not really show much at a principles level, except that the SEC did get it wrong, can get it wrong, and can be told that they are wrong in an adversarial court setting.
With 2019 now around the corner, there is a very big case and a more general case on whether the token model is a security. SEC has tainted that case too with fraud and the rest, but we shall trust the people and their judgment and their ability to differentiate between fraud – which is irrelevant to the matter in question – and the definition of a security.
We say the American people because it is not a judge that will decide, but a jury. If the jury says that, as a matter of fact, tokens are not a security, then that will force Congress to pass new, modern, laws which take into account the very distinct qualities of the digital age.
Because rules will be needed, but balanced rules made by a modern people rather than century old laws from a time when slavery was within living memory.
The option is not between ICOs as a security and ICOs with no laws. The option is between ICOs as a security and ICOs with their own regulatory framework which applies to them specifically in a fairly unique opportunity to update old laws which have caused many problems, such as the creation of monopolies and a maths like end result of the rich get richer because of how the Securities Act is designed.
On a world’s first preliminary decision on the matter, it does look like we have the judiciary on our side. That’s the power of that which is self-evidently good. Yet the decision that matters is in January. May the American people speak truth to the executive and to Congress.