The Securities and Exchange Commission (SEC) announced on September 15, 2020, that it charged online esports gaming and gambling platform Unikrn with violations of Section 5 of the Securities Act of 1933 (Securities Act) for conducting an unregistered initial coin offering (ICO) of digital asset securities. To settle the matter, Unikrn agreed to pay a $6.1 million penalty, substantially all of the company’s assets. In a rare commissioner dissent, SEC Commissioner Hester Peirce criticized the penalty.
Commissioner Peirce’s dissent focused on the SEC’s Howey analysis of whether the Unikrn offering constituted an investment contract that would require Unikrn to comply with Section 5 of the Securities Act, noting that the “idiosyncratic” analysis of what constitutes a securities offering “does not produce clear guideposts for entrepreneurs and others to follow” and risks stifling economic growth and innovation. Commissioner Peirce argued for a regulatory safe harbor to address “this unhappy dilemma.”
Section 5 and the Howey Analysis
Section 5 of the Securities Act states that offers and sales of securities must either be registered with the SEC or qualify for an exemption from the registration requirements. But as an initial matter, a digital token in an ICO must be an “investment contract” in order to fall under the ambit of the Securities Act. A digital token is an investment contract only if it represents the (i) “investment of money” (ii) “in a common enterprise” (iii) “with profits to come solely from the efforts of others.” (See SEC v. W.J. Howey)
Between June and October 2017, Unikrn raised $31 million through the sale of UnikoinGold (UKG), a digital token, in a pre-sale and public ICO. The UKG allowed investors to access a variety of products and services with their UKG tokens, including placing bets on professional esports and video game matches, and Unikrn promised that more features would become available over time.
Although the terms of the public token sale agreement required purchasers to agree that they were buying UKG tokens for their utility and not as an investment, the SEC believes that Unikrn’s promotion of the ICO to investors suggested otherwise. Some of the promotions identified by the SEC include:
- Unikrn’s description to investors of how the company’s efforts to expand the UKG’s functionality would increase the value of the tokens
- Unikrn’s statements that as the company added and improved the products and services for use with the UKG, the betting volume and turnover of the UKG tokens on Unikrn’s platform would increase, in turn increasing turnover and betting volume and the value of the UKG
- Unikrn’s representations that they were committed to maintaining a “stable ecosystem” for UKG and that the company would limit the number of tokens sold in the ICO in order to maintain its value and limit the number of tokens in the market
The SEC’s order also points to the fact that Unikrn hired a blockchain marketing firm to promote the ICO in forums focused on investments in digital assets, which the firm described UKG as a “good long-term hold” and claimed that, although the token does not confer voting rights or equity in Unikrn, “that does not mean a token purchaser would not get a good return on it.”
Before and after the UKG tokens were distributed to investors, Unikrn sought to have UKG “listed” on various digital asset trading platforms. Following the ICO, UKG were traded on multiple digital asset trading platforms. ICO participants were not required to use the tokens on Unikrn’s platform before trading them on the secondary market.
The SEC’s order goes into more detail, but largely based on the above facts, the SEC determined that the UKG were investment contracts under the Howey test.
The SEC charged Unikrn with violations of Section 5 of the Securities Act because a registration statement was not filed or in effect for the ICO, and the ICO did not qualify for any exemption from registration. Unikrn agreed to permanently disable UKG and pay a $6.1 million penalty.
SEC Commissioner’s Dissent
Commissioner Peirce criticized the monetary penalty and the lack of clarity in the SEC’s analysis as to whether the UKG is an investment contract under Howey. After recognizing that registration violations under Section 5 of the Securities Act are serious, Commissioner Peirce asserted that the SEC “should strive to avoid enforcement actions and sanctions … that enervate innovation and stifle the economic growth that innovation brings,” and added that “this action and its accompanying sanctions will have such consequences.” Commissioner Peirce has advocated for a regulatory safe harbor to address the lack of clarity inherent in the “idiosyncratic” Howey analysis and the dilemma for entrepreneurs when they are “forced to choose between unpalatable options: expending their limited capital on costly legal consultation and compliance or forgoing their pursuit of innovation due to fear of becoming subject to an enforcement action.”
A More Sensible Regulatory Approach
Consistent with her dissent, Commissioner Peirce’s proposed regulatory safe harbor for digital token offerings would address concerns about how the Howey test is applied and whether digital tokens constitute investment contracts. Such a safe harbor could have allowed Unikrn to further develop and refine its platform, while still being subjected to anti-fraud laws, rather than close up shop.
As Commissioner Pierce stated to the press, “we need a common sense framework pursuant to which tokens can be distributed to the public without fear of running afoul of the securities laws.” But the implementation of such a framework is still a distant goal, if it ever comes to pass. SEC Chairman Jay Clayton would need to bring Commissioner Peirce’s proposal forward and the five SEC Commissioners would then have a vote. Digital asset proponents continue to advocate for Commissioner Pierce’s proposed safe harbor. Like many other policy issues, movement forward on the safe harbor or other similar reforms that would allow digital asset projects to proceed without unreasonable fear of SEC enforcement action will likely have to wait until after the November elections.