SEC v. Munchee – Will the crypto-currency community listen?

 Just about 2 years ago I wrote a blog article about the first Securities and Exchange Commission (SEC) enforcement action involving equity crowdfunding, SEC. v. Ascenergy.  The SEC action against Ascenergy highlighted the need for the crowdfunding industry to step up and protect the investors from fraud.  That made good common sense because the crowdfunding industry needs investors to survive.

Notwithstanding, most of the crowdfunding industry ignored that enforcement action.  It still largely refuses to carefully vet the offerings that are put on the platforms for investors’ consideration or conduct meaningful due diligence to verify that what the companies are telling investors is true.

Recently the SEC brought what is considered its first action against an Initial Coin Offering (ICO), SEC. v. Munchee Inc.  An ICO is essentially a sub-set of crowdfunding and each offering should be governed by the JOBS Act and the anti-fraud provisions of the securities laws.

A lot of people in the ICO industry will disagree because they believe that they can construct an ICO offering that is not selling securities. The SEC has been clear that it has not seen an ICO that was not a securities offering. Most good securities lawyers agree with the SEC.

Accepting that simple truth would put many people in the ICO industry out of business.  I am referring to the many ICO consultants who charge a lot of money for bad advice. Some of the people who advised Munchee are well known in the crypto industry. Anyone want to bet that they will never mention their participation in the failed, non-compliant and illegal Munchee offering when someone asks about their track record?

On the same day as it announced the Munchee Cease and Desist Order, SEC Commissioner Jay Clayton issued a statement about how the Commission will likely view ICOs. Much of the commentary since has focused on the Commissioner’s statement and not on the enforcement action. That is a mistake.

The Commissioner’s statement covers more ground and speaks in somewhat general terms. It represents the view of the most important regulator in the ICO world, but it is still a statement about generalities that is open to some interpretation.

The enforcement action actually gives more of the “meat” of what the SEC deems illegal conduct. A cease and desist order may become the subject of litigation or appeal. The SEC staff tends to choose its words carefully. It sets forth the facts and the offending conduct, the jurisdictional basis for the action and the reasons why the conduct violates the law.  It is a road map of how not to conduct an ICO offering and everything in it should be scrutinized carefully.

So what, exactly, did Munchee do wrong?

Munchee claimed it was offering “utility” tokens and not securities. It claimed to have performed an analysis of the offering using the test denoted in SEC v. Howey case. I suspect that it did not.  The Munchee white paper lists a dozen officers and advisors not one of whom is an attorney. It provides links to a half dozen PR pieces about the offering but not the attorney’s analysis that these tokens were not securities. The failure to provide a copy of that evaluation was not lost on the SEC staff. They mention that fact specifically in the order.

If an attorney had done the analysis Munchee would set forth the attorney’s name or provided a copy of the evaluation. “Advice of counsel” can be a defense to an SEC action such as this one and Munchee declined to set forth that defense.

A lot of people claim to understand Howey and a lot of articles have been written by people who are not qualified securities lawyers and are claiming to explain it. An evaluation of the offering under the Howey test involves a lot more than just reviewing Howey.

The Order in Munchee refers to Howey and also the SEC’s July 2017 Dao Report.  That report reviews over 30 other cases that have applied the Howey test to various investment offerings. The Order specifically refers to several of those cases which are important to any discussion of this subject.

A lot of people seem to think that if you can use the token for some commercial purpose it is a “utility” token. The Order in Munchee should dispel that idea once and for all.

Purchasers of a Munchee token (MUN) would join a network of people writing reviews of various restaurants. Munchee would pay users in MUN for writing the reviews and would sell both advertising to restaurants and “in app” purchases to app users in exchange for MUN tokens.

Munchee also said it would work with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users–perhaps those who visited the restaurant or reviewed their meal in MUN tokens. As a result, MUN tokens would increase in value.

Howey defines a security as an investment premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The argument here might have been that MUN owners might get a profit based upon their own efforts.

But Munchee intended to do much more. It intended to cut off the number of MUN at a fixed amount.  It intended to facilitate a secondary market where people could buy and sell MUN. Because you could buy MUN, not use them or do anything and later sell your MUN for an appreciated price, it should be abundantly clear that your expectation of profits had nothing to do with you and must therefore be derived from the efforts of others.

Let me offer a simple example: You can purchase a membership in COSTCO. The membership allows you to shop in their stores and buy goods in bulk at a discount. You also get free snacks and inexpensive hot dogs. The membership is recorded on the company’s records and you get an ID card with your picture that is checked every time you enter the store so it cannot be transferred to anyone else.  No one would think that a COSTCO membership is a security. But the SEC has declared some other memberships to be securities.

If COSTCO decided to cut off the number of memberships and allow them to be transferred, it might be fair to assume that the price would appreciate. That alone might make them into securities. Transferability, or the lack of it, is not itself the only indicator. A lot of unregistered securities cannot be freely transferred. But once your token can be transferred at a potentially appreciated price, you should certainly consider that you have crossed the line.

The other big issue raised by the SEC staff in the Munchee Order was the way in which the MUN were sold. Munchee posted information about the offering and the MUN White Paper through posts on the Munchee Website, and on a blog, Facebook, Twitter, and Bitcoin Talk.

This type of general solicitation is specifically permitted by the JOBS Act and is the type of marketing that is needed when a company is trying to raise $15 million without a brokerage firm selling the securities for them. If Munchee had accepted the fact that these were securities, this would not have mattered as long as they did not exaggerate the facts or the potential return.

At the same time, Munchee did not advertise the offering of MUN tokens in restaurant industry media to reach restaurant owners and promote how MUN tokens might let them advertise in the future which is what you might expect if the tokens were being sold for their “utility”. The SEC staff picked up on that fact.

Instead, Munchee and its agents promoted the MUN token offering in forums aimed at people interested in investing in Bitcoin and other digital assets. Munchee made public statements or endorsed other people’s public statements that touted the opportunity to profit, not necessarily the opportunity to use the MUN.

The Order states: “MUN tokens were to be available for purchase by individuals in the United States and worldwide.”  It notes that Munchee intended to use “10% of the offering proceeds ($1.5 million) to make sure Munchee is compliant in all countries.” While that sounds fairly innocuous, as I said, the SEC staff chooses the language it puts into these orders carefully.

There are countries where no crypto-currency or tokens can be sold, so saying it can be sold “worldwide” indicates that the offering is a scam. In a securities offering, it is common for the offering materials to set forth the countries where the offering is being made.  Most telling is the fact that you need to be certain that you are “compliant” before you make the offering, not after. The Howey test does not apply anywhere except the US.

The simple truth is that I would have been happy to help this company raise $15 million for a lot less than $1.5 million in full compliance with securities laws. I would have advised them to sell stock in the company and then memberships separately. They would have had a successful offering and money to market and sell memberships at a lower, more reasonable price where many more people might have joined.

The lesson here should be obvious. If you are claiming to offer a utility token, demonstrate its utility and sell it to people who may want to use it. If you are seeking investors, then stop telling yourself you are not selling a security. Hire lawyers and comply with the rules.

The time, effort and expense that the founders of Munchee expended developing their app and their business, went nowhere.  With the JOBS Act the opportunity for funding a small business has never been greater. If you want money from investors, stay between the white lines.

Remembering Bre-X- The First Big Internet Stock Scam

It has been 20 years since the Bre-X stock scam.  It may not be completely accurate to call it the first internet stock manipulation, but it was certainly the largest for its time. The scam was based upon false information that the company originally circulated on the internet. After a while large companies and the mainstream media jumped on the bandwagon. Then large investors followed.

Bre-X was a Canadian penny stock company whose share price went from about $.30 per share in 1993 to over $250 in 1997. The stock was originally traded on the Alberta Stock Exchange and later the Toronto Exchange and then moved to NASDAQ.

At the end, it took only about one month or so for Bre-X to unravel completely.  When the stock collapsed, investors had lost somewhere in the neighborhood of $5-$6 billion.

Bre-X has a fairly simple story. The company claimed to have located a huge deposit of gold, perhaps the largest single deposit ever discovered, deep in the jungle on the island of Borneo which is part of Indonesia.

People have been scamming investors with claims of huge gold discoveries for a long time. And as they say “greed is a powerful motivator”.

As far as anyone knows the entire a scam was the product of no more than 3 people.  The primary players were David Walsh the founder and largest shareholder of Bre-X, John Felderhof the chief geologist and Michael de Guzman the on-site geologist in Borneo.

Walsh purchased the property located in the middle of a jungle in 1993 on the advice of Felderhof.  The on-site geologist, de Guzman, took samples which were assayed. He initially estimated that the deposit was equal to 2 million Troy ounces of gold. The estimate of the site’s size and worth increased over time. In 1995 the estimate was raised to 30 million ounces, in 1996 it was raised to 60 million and finally in 1997 the estimate was 70 million ounces.

There was actually no gold at the site. It was later revealed that de Guzman was “salting” the samples he was sending to be assayed, i.e. he was adding gold shavings to the samples.  There is nothing particularly new about this scam. People had salted gold and silver mines to gain investors before. What was new is that the fake information was disseminated over the internet.

The internet in 1994-1997 was very different than it is today. Computer screens still had no color. You could not upload or attach documents. There were no search engines.  E-mail was primitive and very few people had an e-mail address. There were 3 primary services that you could use for internet access; America On-Line, Prodigy and CompuServe.

I was an early CompuServe user. I say early because my account number had only six digits. I would usually access CompuServe in the evenings via my dial-up modem.  It was primarily a collection of forums and primitive chat rooms where users could swap information and discuss various subjects.  There was a section dedicated to stocks.

Bre-X was certainly one of the most often talked about stocks during this period. There might only be one or two dozen people who left comments but you knew that many more were silently lurking and reading them.  I was reading the comments late in the evening on the West Coast. There were certainly people who were writing comments and other people reading them on the East Coast the next morning.  There was a lot of information about Bre-X to post and discuss.

As new assays were supposedly being taken and the estimates about the size of the potential strike went up and up, larger players tried to put their hand into the cookie jar.

First there was a failed take-over attempt by Placer Dome which was a much larger mining company. Next, the government of Indonesia (then a corrupt dictatorship) tried to bring Barrick Gold on board. The government claimed to be concerned that a small company like Bre-X might not be able to handle a large mining operation,

Later, the government brokered a deal whereby Freeport-McMoran a third large mining company, would have a majority interest and run the mine.  Members of Indonesian President Suharto’s family and their cronies got a cut of that deal as well.

Once the shares were on the NASDAQ in 1996, Lehman Brothers and other big firms started to follow the stock. There were articles about it in the Wall Street Journal and the mainstream media.

Everyone seemed to think that the gold deposit that had been discovered in the middle of the jungle on Borneo might be larger than expected and that other sites in the jungle might be the next to be explored.  The “smart money” seemed to think that it was only a matter of time before more gold was discovered.

Freeport-McMoran began its due diligence by drilling samples in early February 1997. The internet chat rooms were on fire with the speculation that the results might show richer deposits than did previous samples.  But it was not to be.

The scam ended abruptly in mid-March when the geologist, de Guzman, supposedly fell (or was pushed) out of a helicopter over the jungle. The body that was recovered days later was badly disfigured and identified through dental records.  The body quickly disappeared from the local morgue. People have claimed to have sighted de Guzman in Canada and elsewhere in the years since.

Freeport McMoran reported the results from its test a few weeks later stating that there was little or no gold on the site.  There were a few subsequent tests which concluded that the gold in the original samples had come from elsewhere which is how we now know that the early samples were salted.

The stock, of course, collapsed.  Trading was suspended in Toronto and on NASDAQ and the company filed for bankruptcy. The bankruptcy revealed that three large Canadian public pension funds had been big investors and hence, big losers.

Walsh claimed innocence of the whole affair, moved to the Bahamas and died of natural causes. Felderhof was charged with insider trading (he had apparently sold millions of dollar’s worth of stock along the way) but was eventually acquitted.  Class actions brought on behalf of shareholders returned virtually nothing to them.

Just before the end, Bre-X had blamed the meltdown of the share price on the internet.  Walsh claimed that the rumors that the company had no gold had emanated from enemies of the Indonesian government and that the people in the internet chat rooms were short sellers who wanted to see the company fail.

It is certainly correct to argue that the stock would never have run-up if the “news” about the alleged gold discovery had not circulated in the chat rooms.  It is certainly fair to assume that the stock price would have gone higher if many more people had visited these chat rooms.  As the share price went up, more and more people became convinced that the people saying it will go higher must know what they are talking about.

It is appropriate to consider just how high the price of Bre-X might have gone if there had been as many internet users then as there are now.  In the 1990s the internet was just flexing its muscles. Today it can easily move the price of any investment up or down. People who know nothing can sound like geniuses if the the stock price goes up after they say that it should.

Bre-X is actually a model for a modern pump and dump schemes.  All you need to do is acquire a lot of shares in a penny stock, set up one or more investment newsletter websites and drive traffic to those sights by sending e-mails to lists of investors.  The SEC has closed down internet investment sites that have done just that.

If there is anything that any investor should learn from the Bre-X scam it is that you should only take investment advice from people that you know and trust.  A lot of what you hear on the internet is just not real.