Challenging the Utility Token Argument

December 16, 2017

Lisa LeFever

The inherent novelties of cryptocurrencies make it difficult to ascertain their standing under the law and the appropriate agency of oversight. Contrary to the assertion that virtual currencies operate largely unregulated, the industry contends with a multitude of regulators, inconsistent in their views, attempting to exercise jurisdiction over blockchain-based products. [1] 

In 2013, the Department of Treasury’s Financial Crimes Enforcement Network (FinCEN)[2] described virtual currencies as “digital representations of value” that can function as mediums of exchange, units of account, and/or stores of value.[3] It distinguished virtual currencies from “real” currencies, like the U.S. dollar, in that virtual currencies “do not have legal tender status in any jurisdiction,” though “convertible” virtual currencies may have an equivalent value or act as a substitute to “real” currencies.[4]

FinCEN reported that those engaged in the administration or exchange of virtual currencies are “money service businesses” (MSBs) under the BSA, though mere users are not.[5] It  alerted the market that virtual currency businesses could be operating as unlicensed money transmitters and  subject to criminal sanctions.[6] 

In 2014, the IRS released guidance in which it declared virtual currency transactions to be taxable as “property.”[7] The CFTC purported that virtual currencies like bitcoin are properly categorized as “commodities” under the Commodity Exchange Act (CEA).[8]  The SEC asserted that, while not all virtual currencies constitute securities, most of the blockchain tokens resulting from so-called initial coin offerings (ICOs) involve the sale of unregistered securities.[9] 

The SEC initially observed a restrained approach to token products, opting to not proceed with an enforcement action in light of its view that the tokens issued by The DAO, the virtual organization that raised over $150 million from April to May 2016, were unregistered securities pursuant to the Howey test.[10] The Report was the first regulatory indication that not all virtual assets constitute as securities.[11] 

The SEC cast doubt on the utility token argument in a cease-and-desist order against Munchee, a California-based company which raised about $15 million from its token sale to fund the development of its blockchain-based food review app.[12] Munchee’s whitepaper asserted that the MUN tokens would not “pose a significant risk of implicating federal securities laws” because of their utility.[13] 

The SEC found the tokens to constitute as “investment contracts” based upon the investors’ expectations that the tokens would appreciate in value based upon Munchee’s efforts in improving the app, creating the MUN “ecosystem,” and promoting a secondary market for the tokens.[14] Though the tokens were pre-functional, the SEC stated that even if the tokens were functional at the time of their sale, they would not be precluded from being categorized as securities.[15] 

The information provided is for informational purposes only. It does not constitute legal or investment advice.

[1]  Securities and Exchange Commission, Release No. 34-80206, Order Disapproving a Proposed Rule Change (March 10, 2017) (rejecting an ETF proposal on the basis that bitcoin is too unregulated). 

[2] Congress established FinCEN in 1990 as a bureau within the U.S. Treasury Department to oversee the administration of the Currency and Financial Transactions Reporting Act of 1970 (the Bank Secrecy Act or BSA), as amended by the USA PATRIOT Act of 2001 and subsequent legislation. Treasury Order Numbered 105–08 (April 25, 1990); Treasury Order 180–01 (Mar. 24, 2003). The BSA, also referred to as “anti-money laundering” law (AML), requires reports of large cash transactions and suspicious activity that could signify money laundering, tax evasion, or other criminal activity such as terrorism. See 31 U.S.C. §§ 5311–5314. 

[3] Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001 (March 18, 2013). 

[4] Id. FinCEN further provided that convertible virtual currency could be either centralized or decentralized with no central repository, no single administrator, and “that persons may obtain by their own computing or manufacturing effort.” Id. 

[5] Id.

[6] Id.

[7] IRS Virtual Currency Guidance: Virtual Currency Is Treated As Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply, IR-2014-36 (March 25, 2014). 

[8] See In the Matter of Coinflip Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015); In re TeraExchange LLC, CFTC Docket No. 15-33, 2015 WL (CFTC Sept. 24, 2015); CFTC, A CFTC Primer on Virtual Currencies, Lab CFTC, 14 (Oct. 17, 2017). The CFTC’s jurisdiction is invoked where a virtual currencies are used “in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce.” Id. “Beyond instances of fraud or manipulation, the CFTC generally does not oversee ‘spot’ or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage, or financing.” Id.

[9] See Dave Michaels, Paul Vigna, SEC Chief Fires Warning Shot Against Initial Coin Offerings, The Wall Street Journal (Nov. 9, 2017), available at https://www.wsj.com/articles/sec-chief-fires-warning-shot-against-coin-offerings-1510247148.

[10] SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.

[11] See Securities Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities and Exchange Act of 1934: The DAO (July 25, 2017) (stating that the DAO tokens qualified as “securities” under the Howey test but attempting to distinguish ether as a pure virtual currency), available at https://www.sec.gov/litigation/investreport/34-81207.pdf. 

[12] In the Matter of Munchee Inc., No. 3-18304 (Dec. 11, 2017).

[13] It also referred to its token sale as a “token generation event” as opposed to an ICO. Id. at 5.

[14] Id. at 2.

[15] Id.