Zachary O. Fallon (Principal and Co-Founder of Ketsal Consulting, LLC and Blakemore, Fallon, Garcia, Rosini, and Russo, PLLC)
The U.S. Securities and Exchange Commission’s December 2017 action against Munchee, Inc. (“Munchee”) illustrates how liability under the securities laws can inform arguments supporting the mutability of securities, specifically investment contracts. In particular, Munchee demonstrates how the distinction between investment contracts and digital assets is important from a regulatory standpoint for purposes of determining both the time at which securities law liability attaches to a violative securities offering and the scope of the obligations associated with the securities sold in that offering.
Liability under Section 12(a) of the Securities Act of 1933 (the “Securities Act”) attaches at the time of a violative investment contract sale, and not at the time of digital asset delivery. The scope of investment contractual obligations is similarly determinable at the time of sale. Yet, the outcome of the Commission’s recent actions against CarrierEQ Inc. (“AirFox”) and Paragon Coin Inc. (“Paragon”) risks obscuring the existence of investment contract scope (and mutability) in favor of a novel market-wide path to remediation in initial coin offerings (ICOs) that violate the securities laws.
The Commission would do well to more clearly and consistently distinguish between investment contracts and their digital asset constituent parts. It should not refer to digital assets as securities because doing so risks blurring the distinction between them and the investment contracts of which they are a constituent part. Digital assets are code that may evidence anything, including an investment contract, but they are not investment contracts themselves. An investment contract, like any contract, can, among other things, be fulfilled, amended, breached, or terminated, or expire by its terms.
In December 2017, the Commission settled claims against Munchee for offering and selling investment contracts, involving digital assets, in a non-fraudulent ICO that violated Securities Act registration requirements. The Commission did not impose a penalty or any ongoing undertakings on the company, as it did for similar misconduct a year later in the AirFox and Paragon matters, likely because, upon being contacted by Commission Staff, Munchee immediately stopped selling the digital assets, never actually delivered any of them, and promptly returned to investors the proceeds it had received.
Nevertheless, Munchee and its ICO investors had already entered into contracts of sale for, among other things, the digital assets at issue (the “investment contracts”) — ones in which the investors were irrevocably bound — hence the violation. According to the Commission, Munchee thereafter unilaterally terminated these investment contracts and returned the money to investors. Importantly, however, as the Commission noted in a footnote to the order, “any offer by Munchee to buy the investors’ securities would have required registration of the transaction or an exemption from registration.” This is a shorthand restatement of the fundamental securities law precept that any offer or sale of a security must either be registered under the Securities Act or offered and sold pursuant to an exemption from registration, including an offer to retract an outstanding security.
At first blush, there doesn’t appear to be anything incongruous with the Commission’s treatment of Munchee’s remedial actions and its technical statement about the need to conduct a rescission offering in compliance with Securities Act registration requirements. Munchee simply unilaterally cancelled the contract of sale before delivering the digital assets, which seems a reasonable and straightforward outcome under typical contract law principles. Upon closer inspection, however, this treatment does not necessarily withstand technical scrutiny under the securities laws.
Munchee violated the securities laws by offering and selling investment contracts — not digital assets — without registration or an exemption from registration. Technically, there is no regulatory distinction between a requirement to offer to buy back investment contracts in compliance with the securities laws and the unilateral cancellation of an investment contract by a company and its return of any proceeds received for the sale of those contracts. In Munchee, the remedial requirement for the violation of Securities Act Section 5 arose at the time of the violative sale, not at the time at which the digital asset would have otherwise been delivered.
In context, statements in the Commission’s order, including its footnote, suggest that, while Munchee violated the securities laws at the time of sale, its unilateral cancellation of the investment contract after sale did not require compliance with the fundamental securities law precept. They further suggest that the result would have been different if Munchee had delivered the digital assets. In other words, the Commission’s order seems to conflate the investment contracts with their digital asset constituent part, inasmuch as it focuses on digital asset delivery — as opposed to investment contract sale — as the event that triggers securities laws remedial effects.
The Commission’s order notwithstanding, Munchee’s unilateral cancellation of the investment contracts (and the related return of money) did not technically relieve it of Section 12 liability under the Securities Act, even if there would not have been much or any remuneration for an investor to recover in a potential action brought under that section. This is because unilateral cancellation of an investment contract does not comply with the fundamental securities law precept and is therefore not a remedial path to compliance in a violative securities offering. Munchee’s transactions should have been unwound or amended as part of a registered offering or pursuant to an exemption from registration.
Nevertheless, the Commission was right to be more generous to Munchee than it technically needed to be; the terms of the settlement make sense in context and under the circumstances, including, among other things, Munchee’s cooperation with the Commission’s investigation and a lack of indicia of fraud or harm (in fact) to investors. Additionally, at this time, the Commission was in the midst of a delicate market-wide balancing act in line with its mandate. And Munchee is an early example of the Commission’s effort to signal compliance obligations to crypto market participants without simultaneously hampering the development of a burgeoning technological sector. Unfortunately, it took market participants another year (and the issuance of the AirFox and Paragon matters) to more fully appreciate what the Commission had been saying for some time.
The Commission’s Munchee order highlights a fact readily understood in other contexts (see, e.g., the Commission’s 2005 Securities Offering Reform release); the time at which a Section 5 violation occurs not only informs the timing of a potential rescission offering requirement, but also the scope of the obligations associated with that security. It is this latter point that is illustrative of the distinction between investment contracts and digital assets and informs investment contract mutability.
Securities Act Section 12(a) Liability
Under Securities Act Section 12(a), purchasers of an issuer’s securities have a statutory basis for rescission or recovery of damages against a seller who offered or sold securities in violation of Section 5, or by means of materially deficient disclosure in a prospectus and oral communication. In Munchee, one point in time at which Section 5 was violated was the time of sale of the investment contracts and not at any later time at which the digital assets would have been delivered.
The remedial effects of the securities laws become available at the moment of a securities law violation. Section 12(a)(1) liability attaches at the time that Section 5 is violated. And, as the Commission noted in Securities Offering Reform, one point in time that Section 12(a)(2) liability applies is at the time of contractual commitment (i.e., sale), which occurs when the parties obligate themselves to perform what they have agreed to perform even if formal performance occurs later. When Section 5 is violated in an unregistered, non-exempt sale of investment contracts, Section 12 attaches to those violations at the time of the sale, and not later. It follows that any associated investment contract obligations are similarly determinable as of that time.
The Commission’s position in Munchee, however, suggests the contrary. It suggests that, while the securities law violation occurred at the time of sale, the event that would have triggered the securities laws’ remedial effects would have been the time of digital asset delivery. Its footnote further suggests that the digital asset was itself the security, the delivery of which would have thereafter required compliance with the fundamental securities law precept in order to be unwound. I do not believe that either is technically true. Nevertheless, the Commission positions in the AirFox and Paragon matters discussed below further support this suggestion.
Investment Contracts and Digital Assets
An investment contract is a contract, transaction, or scheme in which a person invests money in a common enterprise and is led to expect profits solely from the efforts of others. It provides investors with rights under the federal securities laws that are independent of their contractual rights under state law. Like any security, an investment contract is the bundle of intangible rights and obligations that a seller agrees to in exchange for the receipt of investment dollars, evidence of which is immaterial to its existence. It is not an orange grove land contract, oil lease, piece of paper, or line of code. It is a securities law contract of discernible mutual obligations.
It’s no secret under the securities laws that digital assets themselves are not necessarily securities. As the SEC’s Director of the Division of Corporation Finance stated in a speech on digital assets and securities in the summer of 2018, “The digital asset itself is simply code. But the way it is sold — as part of an investment; to non-users; by promoters to develop the enterprise — can be, and, in that context, most often is, a security — because it evidences an investment contract.”
It is settled that Munchee involved the sale of investment contracts in transactions that violated the securities laws. Yet, the digital assets at issue in Munchee were not themselves securities. They were sold as part of the investment contracts formed with investors at the time in which the investors became irrevocably bound to purchase them (i.e., the time of sale). Any eventual transfer of the assets would have been purely incidental. As the Director of Corporation Finance suggests, if delivered, the digital assets in Munchee could have done little more than evidence the pre-existing investment contracts of which they were a constituent part. They would not have been or somehow become the investment contracts.
An investment contract is not a tangible thing. It is not a thing to be delivered, but rather a thing to be delivered on. As with any contract, at the time of formation, the seller of an investment contract agrees to fulfill various ongoing obligations of which digital asset delivery is only one. In other words, investment contracts exist independent of any associated digital assets.
Munchee’s potential liability under the securities laws further highlights this distinction. Had Munchee delivered its digital asset, that delivery would not have provided investors with any additional basis for a Section 12 claim against the company. In this regard, Section 12 liability answers the question, “Liability for what?” Section 12 is a useful metric against which to consider not only the time at which a violation occurs, but also the security sold and the scope of any associated obligations.
The potential conflation of investment contracts and digital assets is important because it goes to the heart of the mutability of securities. If the digital asset is itself a security, then it is hard to envision it ever not being a security. But, when the digital asset is viewed as only a constituent part of an investment contract in the same way that orange grove land contracts or oil leases themselves only represented a portion of the investment contracts in seminal Supreme Court decisions, the result is different.
Like any contract, analysis of an investment contract should focus on the terms and obligations agreed to by the parties at the time of sale. As the Second Circuit explained in its Radiation Dynamics decision, cited by the Commission in Securities Offering Reform, the time of contractual commitment in a securities offering “is a simple and direct way of designating the point at which, in the classical contractual sense, there was a meeting of the minds of the parties; it marks the point at which the parties obligated themselves to perform what they had agreed to perform….” We must look to the parties’ meeting of minds at that time in order to determine the corresponding obligations.
Parties to an investment contract can seemingly agree to terms in an ICO but later realize — perhaps under judicial or regulatory scrutiny — that the terms of the agreement were broader than originally anticipated. This potential for post hoc scrutiny is fundamental to any contract analysis but is of particular importance under the securities laws, as it relates to the Commission’s mandate and the statutory protections provided to investors in private rights of action. It is one of the many checks that has helped keep U.S. capital markets in balance since the 1930s.
The SAFT Project
The SAFT Project attempted to deal with the issue of investment contracts by suggesting that a security issued by a company to fund the development of a digital asset ceased to exist upon delivery of the digital asset. This was largely based on the idea that the seller’s investment contractual obligations to the investor were fulfilled at the time of delivery when the security was purportedly terminated. As a thought leadership piece, it certainly moved the needle and, to be fair, included many of the concepts discussed herein. Yet, the views posited in the SAFT Project are susceptible to the same suggestion as the Commission’s recent orders: that securities law outcomes depend on digital asset delivery. I do not believe that this is technically true.
Many of those who used SAFTs to raise capital (often without the advice of counsel) failed to appreciate the extent of their ongoing obligations under the securities laws, particularly when they separately made marketing, liquidity, and appreciation in value promises to investors that went beyond the four corners of the SAFT agreement. As noted above, investment contractual obligations exist independent of any of their digital asset constituent parts, including delivery of those assets. As such, a SAFT issuer’s obligations and any associated securities laws liabilities may continue post-delivery — as part of the same or a separate investment contract, particularly where the SAFT interests convert into digital assets before the underlying network or digital asset has any functional utility.
Unlike traditional contracts, investment contracts will not fail for vagueness. Instead, they are likely to be scrutinized in the future and, in the absence of clarity, to be considered to include obligations that can appear to exist ad infinitum. Yet, investment contracts sold in SAFT offerings are not immutable. Rather, when considered in connection with the issuer’s actions, their terms were perhaps unnecessarily vague or broad, and, as a result, of a potentially indeterminable duration. Since good fences make good neighbors, the market would do well to more clearly define and document the seller’s investment contractual obligations before making offers or sales to potential investors.
Once the terms of an investment contract have been fulfilled, however, it ceases to exist and is no longer a security. This is true of all securities. Preferred stock only continues to be a security for so long as the intangible rights associated with it remain outstanding. Once it is, e.g., converted into common stock, the preferred stock and the obligations associated with it cease to exist. Liabilities may linger, but the security vaporizes upon conversion. In this regard, an investment contract is no different than preferred stock. It is a security only for so long as the obligations associated with it remain outstanding, and not a moment longer.
AirFox and Paragon
The Airfox and Paragon orders seem to confirm the suspicions aroused in Munchee that the Commission does not distinguish between investment contracts and their digital asset constituent part.
As in Munchee, AirFox and Paragon conducted ICOs in the latter half of 2017 after the Commission’s issuance of the DAO Report. Each of these companies violated Securities Act Section 5 at the time of sale in their respective offerings and were subject to liability under Section 12 at the time. Unlike Munchee, however, AirFox and Paragon actually completed their ICOs and delivered the digital assets to investors.
As noted above, the Munchee order suggested that delivery might have made a difference — that, had Munchee delivered its digital assets, the Commission would have required compliance with the fundamental securities law precept as an element of the companies’ remedial undertakings. And, consistent with this suggestion, AirFox and Paragon’s undertakings did in fact differ from Munchee’s. AirFox and Paragon were ordered to pay a civil penalty, and to undertake to compensate harmed investors who purchased digital assets in their offerings through an informal claims process, involving, among other things, linking the public to a claim form informing all purchasers of their potential claims under Securities Act Section 12. Additionally, the companies were required to “register under Section 12(g) of the Securities Exchange Act of 1934 [(the “Exchange Act”)] … [their respective digital assets] as a class of securities.”
The Commission released the AirFox and Paragon settlement orders the same day as several SEC Divisions released a joint statement on the treatment of digital assets under the securities laws (“Joint SEC Division Statement”). Among other things, the Divisions noted that the registration undertakings included in AirFox and Paragon are “designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the [Securities Act] prior to the offer and sale [ — and not delivery — ] of tokens in their respective ICOs.” Additionally, the Divisions stated that “[t]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”
Consistent with Securities Offering Reform and its unstated position in Munchee, the Commission acknowledged in AirFox and Paragon that Section 12 liability attached at the time of sale. Unlike Munchee, however, the Commission clearly dated its imposed remedial effort requirements in AirFox and Paragon from the dates of sale, not delivery. Notably, in Paragon, the claim form process required the company to inform all persons who purchased digital assets from the company on or before October 15, 2017 of their potential claims under Section 12, which was the last date of sale in the offering, and not from October 22, 2017, which was the date of delivery. It follows that the investment contracts at issue in Paragon were entered into, and that the obligations associated with them were determinable, as of October 15th, not October 22nd. This reinforces the idea that the investment contracts at issue in AirFox and Paragon were segregable from their digital assets. It is therefore interesting that the Joint SEC Division Statement refers to AirFox and Paragon as involving “illegal unregistered offering[s] of digital asset securities[,]” rather than illegal unregistered offerings of investment contracts. There is no such thing under the law as a digital asset security.
While the Commission generally has the authority to enter into orders on its own terms, the AirFox and Paragon settlements are still curious. Like Munchee, the remedial steps required to be undertaken in AirFox and Paragon do not comport with Securities Act registration requirements or with any exemption from registration. Unlike Munchee, however, they seem to closely track the informal process outlined by the Commission in Section IV.A.2.c. of Securities Offering Reform by which parties can terminate an old contract and create or reform a new one.
As investment contracts, reformation by AirFox and Paragon of the previously non-compliant contracts of sale in a manner that is consistent with Securities Offering Reform guidance would presumably allow the companies to terminate the initial, deficient contract, including any rights to damages with respect to material defects in the information provided at the time that such contracts were entered into, and the entrance into a new, compliant investment contract. This process seemingly satisfies the Securities Act offering violations in each of AirFox and Paragon. What then was the purpose of Exchange Act Section 12(g) registration?
Section 12(g) was enacted by Congress in the 1960s to ensure that investors in over-the-counter securities about which there was little information, but which had a significant shareholder base, were provided with ongoing information about their investment. The section meets this aim by requiring companies yearly to determine whether holders of a class of the company’s equity securities exceed a statutorily-specified number and whether their assets exceed $10 million. If so, they must register that class of security under the Exchange Act in the following fiscal year.
The Commission’s requirement in AirFox and Paragon that the companies register their respective digital assets as securities pursuant to Section 12(g) of the Exchange Act is somewhat puzzling. The Joint SEC Division Statement suggests that the Section 12(g) settlement component was “designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the [Securities Act] prior to the offer and sale of tokens in their respective ICOs.” This makes practical sense, of course, but that is usually the job of the Securities Act, not the Exchange Act. In reality, the registration requirement more likely stems from a policy determination by the Commission that the securities laws remedial requirements would be better served under the Exchange Act in light of:
· The newly reformed investment contracts and their associated obligations (consistent with Securities Offering Reform guidance described briefly above);
· The sheer number of investors involved in each offering, which was over 2,500 in AirFox and over 8,000 in Paragon; and
· The fact that the violative offerings took place in 2017 but were settled in late 2018.
An Exchange Act remedial solution in AirFox and Paragon makes a certain amount of sense when you consider the number of investors in each offering against the requirements of, and policy behind the enactment, of Section 12(g) — at first blush, anyway. Why bother, for example, having Paragon register a rescission offer pursuant to the Securities Act, when its huge shareholder base likely would have triggered registration under Section 12(g) of the Exchange Act at the end of 2017 anyway, and, if otherwise compliant, the company would have already been an Exchange Act reporting company at the time of settlement in 2018? When you consider this, in addition to the informal Securities Offering Reform contract reformation process outlined above, methinks Milton H. Cohen would be proud.
It is unusual, however, for the Commission to rely on Section 12(g) to compel AirFox and Paragon to register their digital assets as a class of security for at least two reasons:
First, by its terms, Section 12(g) only compels, or applies to, the registration of equity securities, and investment contracts typically are not considered equity securities. For instance, while Exchange Act Section 3(a)(11) grants the Commission fairly broad authority to define equity securities, the Commission did not include investment contracts within its Exchange Act Rule 3a11–1 definition of “equity securities.”
Investment contracts, however, may be created with any number of features, including equity-like features, such as profit sharing. In this regard, one may argue that the profit-sharing aspect of some investment contracts, including potentially those in AirFox and Paragon, is sufficient for these purposes to characterize investment contracts as equity securities. The Commission’s orders, however, are conspicuously silent on this point and merely note the requirement to register the digital assets “as a class of securities[,]” not as equity securities.
Separately, while Section 12(g) compels the registration of equity securities under its specified terms, it does not necessarily prevent the registration of other types of securities voluntarily registered by the issuer or otherwise registered at the compulsion of a regulatory authority. Given potential contract reformation pursuant to Securities Offering Reform, the sheer number of investment contract purchasers in each respective ICO, and the potential equity-like characteristics of the investment contracts, the Commission’s ability to regulatorily, if not statutorily, compel registration pursuant to Section 12(g) as part of a settlement order may — for policy reasons — have been determinative of the remedial process chosen.
Second, as discussed above in the context of Munchee, the securities that sold in each of AirFox and Paragon were investment contracts, not digital assets. The digital assets were only a constituent part of the investment contracts. At best, they evidenced the investment contracts, but did not supplant or become them. And, while it may be convenient to refer to the digital assets as securities when speaking colloquially, one expects Commission orders — and the remedial actions they require — to be more precise.
A remedial model that requires registration of digital assets as securities under either the Securities Act or Exchange Act risks obscuring the mutability of investment contracts generally. In its orders of late, the Commission has stated that an investment contract is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” I do not know of any asset, digital or otherwise, that can satisfy that definition. Under similar facts of a hypothetical violative common stock offering, I do not believe that the Commission would require a company to register a digital asset that evidences that common stock. It would simply require the company to register the common stock itself.
The Commission’s order in Munchee illustrates that the time at which Section 12 liability attaches to a violative investment contract sale informs the timing of a potential rescission offering requirement and the scope of the associated investment contractual obligations. In this regard, Munchee helps to highlight the distinction between investment contracts and digital assets, which, in turn, betrays the mutability of securities.
When you consider AirFox and Paragon against Munchee, the SEC seems to have taken the greatest umbrage not with the violative sale of investment contracts, but rather the delivery of their digital asset constituent part. This is further emphasized by the Joint SEC Division Statement’s reference to the offerings as “illegal unregistered offering[s] of digital asset securities[,]” and not illegal unregistered offerings of investment contracts. Despite the Director of the Division of Corporation Finance’s characterization of digital assets as code that can evidence an investment contract, these orders and statements suggest that the Commission and its Divisions collectively view the digital assets as the securities themselves.
The distinction between investment contracts and digital assets, however, is important because implicit in the Commission’s treatment of the digital asset as a security is the risk that it will always be considered a security. It will always “simply [be] code” that is a security, and its status as such will not change. The Commission’s model settlement requirement outlined in AirFox and Paragon to register the digital assets as securities under the Exchange Act exacerbates that risk.
The Commission would do well to better distinguish between investment contracts and digital assets, and, in so doing, to acknowledge that it is the offer and sale of investment contracts — and not code — that requires compliance with the fundamental securities law precept and/or the model settlement requirements. In so doing, the Commission will provide a path to compliance that is not only technically correct, but also involves ongoing obligations of a more determinable scope and duration.
In the Matter of Munchee Inc., Securities Act Release №10445 (Dec. 11, 2017), available at https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
In the Matter of CarrierEQ, Inc., d/b/a AirFox, Securities Act Release №10575 (Nov. 16, 2018), available at https://www.sec.gov/litigation/admin/2018/33-10575.pdf.
In the Matter of Paragon Coin, Inc., Securities Act Release №10574 (Nov. 16, 2018), available at https://www.sec.gov/litigation/admin/2018/33-10574.pdf.
Securities Offering Reform, Securities Act Release №8591 (July 19, 2005), available at https://www.sec.gov/rules/final/33-8591.pdf.
Radiation Dynamics, Inc. v. Goldmuntz, 464 F.2d 876, 891 (2d Cir. 1972).
See Juan Batiz-Benet, Marco Santori, and Jesse Clayburgh, The SAFT Project: Toward a Compliant Sale Framework, (Oct. 2, 2017), available at http://www.saftproject.com/static/SAFT-Project-Whitepaper.pdf.
15 U.S.C. § 77l(a).
15 U.S.C. § 78a(11), 78l(g).
17 C.F.R. § 240.3a11–1.