On June 25, 2018, a magistrate judge of the U.S. District Court of the Southern District of Florida released a report finding that cryptocurrency tokens issued in an initial coin offering (“ICO”) by the startup company, Centra Tech, are securities under the federal securities laws. This report was released in connection with a class action lawsuit filed by former investors claiming that Centra Tech and its founders violated the federal securities laws through a token sale that ultimately raised $30 million in cryptocurrencies. The former investors allege that the sale of the Centra Tech tokens was an unregistered offer and the sale of securities was in violation of the Securities Act of 1933 (“Securities Act”).
From July 2017 through September 2017, Centra Tech held an ICO in which it offered to the general public a “utility token” of its own creation in exchange for cryptocurrency, such as Bitcoin or Ether. The capital generated in the ICO was for the development of a debit card that would allow individuals to pay for goods and services with cryptocurrency, and the potential development of an online marketplace referred to as cBay. Centra Tech represented that the public would need to own Centra Tech tokens in order to utilize the products that Centra Tech planned but had yet to develop. The ICO was not registered with the Securities and Exchange Commission (“SEC”).
In analyzing the characterization of the Centra Tech tokens, the court applied the SEC’s traditional Howey test to conclude that the Centra Tech tokens were investment contracts, and thus securities, for purposes of the federal securities laws. Under the Howey test, an investment contract is defined as (1) an investment of money (2) in a common enterprise (3) with the expectation of profits to come solely from the efforts of others. In the report, the court concluded that the offering of the token satisfied all three prongs for an investment contract.
Specifically, the report stated that because an investment of money required for an investment contract need not be made in cash, the investment of Bitcoin and/or Ether in Centra Tech satisfies the first prong of the Howey test. The report also found that a common enterprise existed because “the fortunes of individual investors in the Centra Tech ICO were directly tied to the failure or success of the products the Defendants purported to develop” and because an individual investor could not exert control over the success or failure of his or her investment. Finally, the report determined that because the success of Centra Tech and the products that it purported to develop was “entirely dependent on the efforts and actions of the Defendants, the third prong is satisfied.” Consequently, the report concluded that “the offering of the Centra Tokens was an investment contract under the Securities Act, such that the Defendants sold or offered to sell securities by virtue of the Centra Tech ICO.”