The wake of the SEC’s guidance on classification of digital assets (here) and no-action letter to digital token issuer TurnKey Jet, Inc. (here), many may have forgotten or ignored that the final arbiter of the definition of “security” under federal law is not the SEC; it is the federal judiciary. On March 31, 2019, Judge Vernon Broderick of the United States District Court for the Southern District of New York weighed in, denying a motion by digital token issuers to dismiss a class action securities lawsuit and holding that, at least as alleged, the token at issue constituted a security.
- Defendants allegedly conducted a public sale of an unregistered token that was promised to work with a future blockchain and provide purchasers with a return on the investment. Defendants never completed the blockchain, the token plummeted in value, and Plaintiff sued in the Southern District of New York on behalf of a putative class of investors, alleging Defendants had conducted an unregistered sale of securities.
- Defendants moved to dismiss, arguing among other things that the token did not constitute a security. The court rejected this argument and denied the motion, reasoning that Defendants had marketed the tokens as an investment that depended nearly wholly on the creation of the new blockchain.
- One question that arises is how to square this decision with the SEC’s position that pure cryptocurrencies (such as Bitcoin) do not constitute securities, as many pure cryptocurrencies were also sold or distributed to investors, in some cases as an investment, and depended on a new blockchain. The likely reconciliation is that the pure cryptocurrency blockchains existed at the time of distribution, were not to be created with the sale proceeds, and were subsequently run by a distributed network, not the issuer.
According to the class action complaint, Defendants Edward Ng and Herbert Hoover are co-founders and officers of Defendant ATBCOIN LLC (“ATB”), a tech start-up aimed at facilitating rapid, low-cost digital financial transactions through blockchain technology. In 2017, Defendants conducted an initial coin offering, through which ATB offered ATB Coins to the public in exchange for other digital assets (specifically Bitcoin, Ether, and Litecoin). Defendants did not file a registration statement for the sale with the SEC. According to the complaint, the primary purpose of the sale was to raise capital to enable Defendants to create and launch a new blockchain on which ATB Coins would operate. Defendants made a wide range of vague promises about their technology, for instance, that it would be “an innovating decentralized cryptocurrency incorporating the advanced technologies that tailor the needs of primary market players”. Defendants issued a range of promotional materials touting the ICO as an investment opportunity. Ultimately, ATB raised over $20M from thousands of investors, including Plaintiff Raymond Balestra. As of several months after the close of the sale, ATB had failed to provide working versions of the promised technology, and the value of Balestra’s coins had decreased by more than 85%.
Balestra, individually and on behalf of a class of other purchasers, filed suit in the United States District Court for the Southern District of New York against ATBCOIN LLC, Ng, and Hoover, alleging that they violated the Securities Act by selling unregistered securities. Defendants filed a motion to dismiss for lack of personal jurisdiction under Federal Rule 12(b)(2) and for failure to state a claim under Federal Rule 12(b)(6). With respect to the Rule 12(b)(6) motion, Defendants argued that the allegations fail to state a claim for sale of an unregistered security because the ATB tokens did not meet the definition of a “security.”
Court Ruling and Opinion
Southern District Judge Vernon Broderick denied the motion, holding that under the facts as alleged ATB Coins constitute securities. Both parties agreed that the well-known Howey test controlled the analysis, but Defendants claimed that ATB Coins did not satisfy the test because ATB did not meet the requirements of a common enterprise and because Plaintiff did not seek profits derived solely from the efforts of others.
Judge Broderick disagreed. Regarding the common enterprise element, Judge Broderick noted that the element may be met where the fortunes of each investor are tied to each other and to the success of the overall venture. Here, Judge Broderick found this element satisfied because the complaint alleged that the goal of the ICO was to raise capital to create a new blockchain, the success of which would increase the ATB Coin value for all purchasers. Regarding the element requiring profit derived from effort of others, Judge Broderick noted that courts determine this by considering whether the enterprise was marketed as an investment. Judge Broderick easily found this the case, noting that ATB extensively marketed the coins as an investment, the success of which depended entirely on launch of the ATB blockchain.
In our view, ATB is one of the more nuanced digital asset opinions from a federal court. On its face, ATB seems like many other issuers hit with unregistered offering charges by the SEC or investors: It promised a digital product, sold a freely tradeable token that derived value via use of the product, encouraged purchase for investment, and didn’t register. But the product ostensibly comprised only the underlying blockchain, not an application separate from the underlying blockchain (like, say, Munchee). If the product comprises only the blockchain, ATB Coin may look a lot like pure cryptocurrencies, such as Bitcoin or Ether, which the SEC has stated do not constitute securities because, among other reasons, the distributed ledger networks don’t constitute a “common enterprise” (see the SEC’s recently published digital asset guidelines).
Can we square this? Probably. The differences between ATB and the pure cryptocurrencies likely lie in the facts that the money raised from the ATB sale was intended to fund the creation of a future blockchain; this was not true in the case of the initial Ether sale or initial Bitcoin distribution, since both worked on blockchains existing at the distribution. In holding that ATB satisfies the common enterprise element of Howey, Judge Broderick took note that the proceeds were intended to fund the blockchain creation. And the SEC’s newly issued digital asset guidelines state that relevant considerations in the Howey analysis include whether “the distributed ledger network and digital asset are fully developed and operational” and whether “holders of the digital asset are immediately able to use it.” It may also be relevant whether the ATB blockchain would have been a private blockchain run by ATB or run by distributed nodes like the Bitcoin or Ethereum blockchains; in its guidelines, the SEC recently stated that Howey is more likely to be satisfied when the network is run by a central provider, rather than a decentralized network. But the ATB court’s opinion did not address this potential distinction.
In any event, the opinion marks only the end of the beginning for the case, which will now likely proceed to discovery. Perhaps by the time ATB reaches summary judgment or class certification, other courts will have weighed in and provided additional clarity on the Howey analysis as applied to digital assets.