A federal court recently ruled that digital assets sold in an initial coin offering (ICO) did not meet the definition of “security.” It is the first court decision against the Securities and Exchange Commission (SEC) on this issue, suggesting the analysis might not always be as clear-cut as the SEC maintains.
SEC’s Securities Fraud Charges Against Blockvest
In October, the SEC filed a Complaint against Defendants Blockvest, LLC and Reginald Buddy Ringgold, III a/k/a Rasool Abdul Rahim El alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5(b); fraud in violation of the Securities Act of 1933 (Securities Act); and violations of Sections 5(a) and 5(c) of the Securities Act for the offer and sale of unregistered securities. Defendant Reginald Buddy Ringgold, III (Ringgold), is the chairman and founder of Defendant Blockvest, LLC (Blockvest). The SEC complaint alleges that Defendants have been offering and selling alleged unregistered securities in the form of digital assets called BLV’s via an ICO.
According to the SEC’s complaint, Blockvest conducted pre-sales of BLVs in March 2018 and had sold 18 percent of the tokens being offered (around 9 million tokens) by September. The SEC alleges that Blockvest and Ringgold promoted the tokens by falsely claiming their ICO has been “registered” and “approved” by the SEC and that their ICO has been approved or endorsed by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). In addition to utilizing the official logos and seals of the SEC and CFTC, the Defendants also created a fictitious regulatory agency, the Blockchain Exchange Commission (BEC), creating its own fake government seal, logo, and mission statement that are nearly identical to the SEC’s seal, logo and mission statement.
In defense of the charges, Ringgold asserted that Blockvest has never actually sold any tokens to the public. Rather, the company has only one investor, Rosegold Investments LLP, (Rosegold) which he runs and funds through his own money. Ringgold further maintained that Blockvest utilized BLV tokens during the testing and development phase and a total of 32 partner testers were involved. During this testing, 32 testers put a total of less than $10,000 of Bitcoin and Ethereum onto the Blockvest Exchange where half of it remains today. The other half was used to pay transactional fees to unknown and unrelated third parties. No BLV tokens were ever released from the Blockvest platform to the 32 testing participants. In the future, Blockvest intended to issue a new utility Token BLVX on the NEM Blockchain for exclusive use on the Blockvest Exchange.
As detailed in the complaint, Ringgold personally invested over $175,000 in Rosegold and Michael Sheppard, Blockvest’s CFO invested about $20,000. Other investors in Rosegold included friends and family of Sheppard and Ringgold. At times, these investors loaned Ringgold or Sheppard money personally and they in turn, invested the money into Rosegold as their personal investment. Most of these individuals confirm that they did not buy BLV tokens or rely on any of the representations the SEC has alleged were false. However, the SEC did offer evidence that some investors had written “Blockvest” or “coins” on their checks to the company. Nonetheless, Ringgold maintained he never received anything of value from the offer or sale of BLV tokens to anyone.
Howey Test Applied to Digital Tokens
While U.S District Judge Gonzalo Curiel of the Southern District of California previously froze assets linked to the purportedly fraudulent ICO, he recently. To obtain a preliminary injunction, the SEC was required to show (1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.
Judge Curiel denied the SEC’s request after concluding that the SEC had failed to demonstrate that the BLV tokens purchased by the 32 test investors were “securities” as defined under the securities laws. In reaching his decision, Judge Curiel relied on the so-called “Howey Test.”
In SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), the Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others. As explained by the Court, this definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Judge Curiel specifically found that the SEC failed to satisfy the second prong because it failed to demonstrate that the 32 test investors had an “expectation of profits.” As Judge Curiel explained, “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.” Judge Curiel added: “Merely writing ‘Blockvest’ or ‘coins’ on their checks is not sufficient to demonstrate what promotional materials or economic inducements these purchasers were presented with prior to their investments.”
The court’s decision does not mean that digital assets don’t qualify as securities, but that the analysis is often fact specific. In this case, the court found that the way the tokens were bought and sold did not meet the definitional requirements, at least based on the facts before it at this point.
For businesses interested in conducting an ICO, the latest decision highlights that the legal landscape continues to evolve. It also confirms that one of the key issues is the rights, expectations, and participation of token holders. For detailed guidance, it is always advisable to consult with an attorney experienced in securities offerings.
If you have any questions, please contact us
If you have any questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.