ICOs and Securities Suits

December 11, 2017

In the wake of Bitcoin’s rapid appreciation, raising capital through cryptographic token sales (usually referred to as initial coin offerings or “ICOs”) has emerged as an alternative for early-stage companies to fund the development of their businesses or platforms.  In 2017, crypto entrepreneurs launched over 200 major token sales, collectively raising more than $3.2 billion.  In this climate, investors are not the only ones chasing the token-sale frenzy: securities regulators—and, most recently, the plaintiffs’ bar—have shown an interest in ICOs as well.  

In July, the SEC issued a Report of Investigation on a cryptographic token called The DAO, finding that it constitutes a security and that the offer and sale of DAO tokens is therefore subject to the federal securities laws.  The SEC reached this conclusion by applying the 70-year-old test from the seminal Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), which deems as a security any investment in a common venture that carries an expectation of profits being derived from the efforts of others.  Another example of the SEC’s interest in cryptographic tokens involved an ICO of “MUN tokens” by Munchee Inc. (Munchee) in November 2017.  Earlier today, the SEC entered into a cease and desist order with Munchee in which the SEC found that MUN tokens were securities under the federal securities laws.  Munchee consented to cease and desist from committing or causing any violations and any future violations of Section 5(a) and (c) of the Securities Act of 1933 (Securities Act).  Munchee also refunded all proceeds from the ICO after the SEC intervened.  Although characteristics of cryptographic tokens run the gamut—and many cryptographic tokens bear little resemblance to The DAO or the MUN token—the breadth of the Howey test and the expansive nature of the definitions of “security” and “offer” under the federal securities laws create uncertainty about whether, and on what basis, the SEC may also designate other cryptographic tokens as securities.

Critically, the potential consequences for being characterized as securities are far-ranging—from subjecting issuers of cryptographic tokens to SEC registration requirements under the Securities Act or the Securities Exchange Act of 1934, to opening the door to liability under various federal securities laws for alleged material misrepresentations and omissions.  SEC regulators will not be the only ones attempting to impose federal securities laws on companies raising capital with cryptographic tokens—so will plaintiffs’ lawyers who could stand to profit handsomely from private securities class actions.  Indeed, the plaintiffs’ bar has wasted little time leveraging the SEC’s DAO report to sue companies selling cryptographic tokens.  Two putative class actions—Baker v. Dynamic Ledger Solutions, Inc., et al., Case. No. CGC-17-562144, and GGCC, LLC v. Dynamic Ledger Solutions, Inc., et al., Case No. 3:17-cv-06779-RS, both taking aim at the Tezos Foundation (Tezos) and its $232 million token sale for its tokens called “Tezzies”—have already been filed thus far, and more are likely to follow.

The Baker action, filed on October 25, 2017, in San Francisco Superior Court, brings claims under the federal securities laws and state unfair-competition laws on behalf of an estimated 30,000 investors against Tezos; Dynamic Ledger Solutions, the company that purportedly owns the Tezos-related intellectual property; Kathleen and Arthur Breitman, Tezos’s founders; Johan Gevers, Tezos’s president; and Strange Brew Strategies, LLC, the public relations firm that promoted the ICO.  Switzerland-based Tezos promoted its token sale like a typical crowdfunding campaign—launching a website explaining its plans and its beliefs in the commercial viability of its platform.  The complaint alleges that Tezzies are securities and, as such, Tezos violated Section 5 of the Securities Act by selling them without SEC registration.  It also alleges that Tezos’s attempts to generate online excitement for its product—including a plan to convince a small nation-state to recognize Tezzies as its official currency—are false and misleading statements that violate Section 17(a) of the Securities Act.  In addition, the complaint contains various state-law causes of actions, including alleged violations of California’s truth in advertising law, Cal. Bus. & Prof. Code. § 17500, and California’s unfair competition law, Cal. Bus. & Prof. Code § 17200.  

Making similar allegations, the GGCC action, filed on November 26, 2017, in the United States District Court for the Northern District of California, also seeks to prosecute a putative class action on behalf of all individuals and entities who participated in the Tezos ICO.  The complaint seeks to recover against Tezos and Dynamic Ledger Solutions for offering and selling Tezzies without SEC registration in violation of Sections 5 and 12(a)(1) of the Securities Act.  Further, the GGCC plaintiffs seek to recover against the Breitmans for control person liability under Section 15 of the Securities Act.

Some of the more obvious deficiencies in the complaints show that plaintiffs’ attorneys are still fine-tuning their cryptographic token theories.  For example, numerous courts have found that Sections 5 and 17(a) do not recognize a private right of action.  In addition, plaintiffs will need to address, among other things, issues concerning the applicability of the choice-of-law and class action waiver provisions in the ICO’s terms, and, in the case of the foreign defendants, personal jurisdiction.  And assuming that plaintiffs can establish that the tokens are securities in the first place—which is no small order—plaintiffs will have to contend with the prohibition against the extraterritorial application of the federal securities laws, which was curtailed in the Supreme Court case Morrison v. National Australia Bank, 561 U.S. 247 (2010), as well as the potential availability of extraterritorial exemptions under Regulation S or otherwise.

There is no question that the token sale boom may make some companies undertaking token sales appear to be lucrative targets.  The complexity of the federal and state securities laws gives creative plaintiffs’ lawyers fertile ground to concoct new theories of liability.  Going forward, companies need to consider how the design and functionality of their token sale terms and conditions will interact with this rapidly evolving field of US law and the multi-jurisdictional nature of token sales and decentralized technologies.  Regardless of whether a particular token could reasonably be considered a security, companies selling tokens may be well-advised to include carefully crafted disclosures and offering procedures in order to mitigate potential risks.  And if a token is designated as a security, the company will have to comply with the full panoply of SEC regulations, and it may also have to defend itself against possible legal action by the SEC, plaintiffs’ attorneys, or both.  


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William Pao, an O'Melveny partner licensed to practice law in California, Eric Sibbitt, an O'Melveny partner licensed to practice law in California and New York, Rob Plesnarski, an O'Melveny partner licensed to practice law in District of Columbia and Pennsylvania, Jake Leraul, an O'Melveny associate licensed to practice law in California, James M. Harrigan, an O'Melveny associate licensed to practice law in District of Columbia and Maryland, and Andrew Weisberg, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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