The year 2017 was the year of the crypto as evidenced by the Bitcoin price chart. The price of Bitcoin surged from under $2000 to over $19,000 in under 12 months, fueling a frenzy of activity in the marketplace. Perhaps even more impressive than Bitcoin’s bull run is the amount of money raised in 2017 via Initial Coin Offerings (“ICOs”), an unregulated and incredibly uncertain fundraising vehicle. The most amount of money was raised in September to the tune of over 4.7 billion dollars. The month of June came in close second with over 4.3 billion raised.
Thousands of tech startups, businesses, and corporations tapped into this new fundraising mechanism through which a company can raise capital by selling digital tokens in exchange for established cryptocurrencies such as Bitcoin (“BTC”) and (“ETH”). This extremely popular crowd-based form of funding has allowed companies to raise millions of dollars in mere minutes --, e.g., Filecoin - $257 million; Tezos - $232 million; EOS - $180 million.
The companies raising money are not the only ones receiving a windfall. Investors in ICOs have reaped returns that more closely resemble lottery ticket winnings than the return for even the most speculative of investments. The returns of some coins, are simply astonishing: NXT coin returned over 1,105,721% since August of 2017; IOTA returned 405,638% since Q4 2015, and NEO coin returned 337,095% since August 2017. This brief mention hardly scratches the surfaces of the lucrative opportunities that abound in the ICO market recently.
Now, Giga Watt, a cryptocurrency mining startup that successfully executed a multi-million dollar ICO back in July, is being sued by investors who claim they never received the tokens they were promised. A group of investors who contributed over $20 million in cryptocurrencies (now worth $100 million) in exchange for Giga Watt Tokens (“WTT”) filed the complaint. Per the ICO terms, Giga Watt promised to grant investors: (i) a digital token that represented the investors’ exclusive right to use the Giga Watt mining facility rent-free for 50 years; or (ii) mining equipment to be set up and maintained by the Giga Watt team. The crux of the lawsuit is whether the Giga Watt tokens sold to investors are in fact securities.
The Securities and Exchange Commission (“SEC”), the federal agency in charge of protecting investors by maintaining orderly functioning securities markets, offered guidance on this issue twice. The lack of guidance is a byproduct of the uncertainty surrounding the function of individual cryptocurrencies and the amorphousness of the Howey Test. It is clear that the SEC prefers to take a piecemeal approach to categorizing digital tokens, which makes sense since the Howey Test is a fact intense analysis. The Giga Watt case presents yet another opportunity for judicial actors and regulators to illuminate missteps companies must avoid to prevent their token from being categorized as a security.
Token Regulation:
The seminole case on what we will call “token categorization” is the Decentralized Autonomous Organization (“DAO”) case, where the SEC relied on Section 21(a) of the Securities Exchange Act of 1934 to categorize the DAO token as a security. DAO’s ICO offered and sold 1.15 billion tokens in exchange for approximately 12 million Ether Tokens (“ETH”), the equivalent of $150 million. After the DAO tokens were sold, but before DAO was able to commence funding projects, a user of the platform used a flaw in the DAO’s code to steal approximately one-third of the DAO’s assets. More importantly, beyond the immediate applicability to the DAO ICO participants, the SEC report affirmed that a cryptocurrency can be a security pursuant to U.S. securities laws.
Shortly thereafter, on December 11, 2017, the SEC targeted an ICO launched by the company Munchee Inc., which raised $15 million to develop an App that used blockchain technology to allow users to write restaurant reviews. The team stated it would both pay food reviewers and allow restaurant owners to purchase advertising in MUN tokens. By attracting more people to use the token, it would appreciate in value.
The Cease-and-Desist Order issued by the SEC applied the factors outlined in the seminole Supreme Court case SEC v. W. J. Howey, Co., 328 U.S. 293 (1946) to determine whether the MUN token was in fact a security. Specifically, it asked: (1) whether the token holders made an investment of money, (2) in a common enterprise; (3) from which they expected to profit; (4) due to the efforts of others. The SEC determined that the MUN tokens qualified as securities since the tokens were sold to the general public and investors reasonably expected a profit from the rise in value of the token derived from the efforts of Munchee and its agents. Specifically, Munchee promised a rise in value due to the coin becoming listed on an exchange and due to its promotion of the coin. Notably, the SEC stated its analysis would not have been altered even if the MUN tokens had a practical use at the time of its release.
Application to the Giga-Watt Case:
In May 2017, Giga Watt promoted a turnkey mining operation that would provide “full range of mining services from hosting, maintenance, and repair” as well as extremely low electricity costs to ICO participants. Giga Watt also offered, for a separate crypto investment, miner delivery, setup and hosting at Giga Watt Facilities in Wenatchee, WA. Prior to launch, each investor was given WTT tokens. Token distribution to investors was contingent on an evaluation of the mining projects development and functionality, which was supposed to transpire by July 15, 2017. Essentially, investors were given a future right to receive tokens or mining equipment. At the time of the ICO, the WTT token was valued at between $1.00 - $1.20, which, according to investor-plaintiffs, was expected to rise dramatically upon project completion.
Plaintiffs claim that on more than one occasion, after the ICO and before the time each investor would receive the tokens, representatives from Giga Watt stated that the value would “dramatically increase.” Giga Watt also circulated a newsletter that touted the coin’s profitability. Moreover, the Complaint states that Giga Watt represented to investors that all tokens from the ICO were to be converted to cash, released from escrow, and deposited into the Giga Watt operating account. Therefore, the investors claim that the WTT token should be considered a security because each class member invested valuable assets into what looks like, functions like, and fits the definition of a security.
Analyzing the DAO and Munchee precedent, the Giga Watt investors may well be correct that the WTT token functions precisely like a security. While the blockchain community does a half-decent job regulating itself by weeding out scams via messenger channels, subreddits, and online forums, the fact remains that the current legal landscape leaves much to be desired. U.S. based regulators are certainly trying to protect the unsuspecting consumer that enters the world of ICOs and esoteric white papers. In fact, recent comments from the CFTC Commissioner, J. Christopher Giancarlo indicate the regulatory perspective is much more focused on combating ICO fraud while allowing blockchain based technologies to develop further.
However, the scarce regulatory space results in legal issues like Giga Watt. This does not necessarily mean federal regulation is the solution. Our federalism based system allows states to function as regulatory laboratories to test and create best practices that federal regulators can then couple together to create a more broad regulatory framework. For example, Wyoming instituted a bill that would allow those holding, trading, and using cryptocurrencies to operate tax free. Outside of New York State’s Bitlicense, the Wyoming bill serves as a progressive step towards acknowledging the explosion of interest within the blockchain community as well as focusing on providing benefits to those willing to operate in the space. Indeed, clearly the Wyoming legislature sees the underlying benefit of blockchain. The question remains, at what point will federal regulators provide more clarity?
Overall, the Giga Watt case provides the U.S. judiciary and federal regulators an opportunity to weigh in on and further clarify the most contested question in the blockchain and cryptocurrency industry. Indeed, as more precedent is set, those operating in the space will be able to move along the regulatory path without focusing on avoiding regulatory compliance at all costs. Although, even in the Munchee case, we’ve see how a blockchain business can do everything in its power to focus on utility, yet still be deemed a security.
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