On June 25 U.S. federal Chief Magistrate Judge Andrea Simonton issued a Report and Recommendation concluding that Centra Tokens, issued by tech startup Centra Tech, were investment contracts and therefore securities. There are reports in the press that this is the first time a US court has found that the issuance and sale of tokens through an ICO must comply with federal securities laws.
The case in question, Rensel v. Centra Tech, Inc., is a class action claiming that Centra Tech violated federal securities laws by selling unregistered securities in the form of Centra Tokens. Centra Tech conducted an ICO from July 30, 2017 to October 5, 2017 in order to raise capital for further development of its Centra Debit Card, Centra Wallet, and online marketplace. Centra Tech allegedly raised more than $30M through this process. The complaint was filed against Centra Tech on December 13, 2017.
In response to the plaintiff’s motion for a temporary restraining order and asset freeze, Magistrate Judge Simonton was required to consider whether the plaintiffs had a likelihood of succeeding on the merits of their substantive claims. In doing so, she applied the seminal test set down by the Supreme Court in SEC v. Howey Co. to determine whether Centra Tokens were investment contracts.
The Howey test establishes that an investment contract requires: (i) an investment of money (ii) in a common enterprise (iii) with an expectation of profits derived primarily from the efforts of others. The first two prongs were satisfied easily. The investment of money need not mean cash and, thus, investment in the form of Ether and Bitcoin was sufficient. There was a common enterprise because an individual investor could exert no control over the success or failure of his or her investment. It is the third prong of the Howey test which has prompted the most debate regarding its application to cryptocurrencies. Here, Magistrate Judge Simonton held that, “[b]ecause the success of Centra Tech and the Centra Debit Card, CTR Tokens, and cBay that it purported to develop was entirely dependent on the efforts and actions of the Defendants,” it was clear that there was an expectation that profits were to be derived from the efforts of the others and not the investors. Thus, Magistrate Judge Simonton concluded that the Centra Tokens were securities.
The approach and direction of the court should not be surprising. In 2017, the SEC issued a report of its investigation into The DAO, which had issued DAO Tokens in exchange for ether. In that case, the SEC applied the Howey test to conclude that DAO Tokens were securities. Similarly, in June 2018 the SEC Director of the Division of Corporate Finance applied the Howey Test to bitcoin and ether as part of a speech to the Yahoo Finance All Markets Summit on cryptocurrency. In other words, the SEC has signalled for some time that digital tokens will be facing the same rules as more traditional financial assets. Magistrate Judge Simonton’s findings in the current case show that the courts may have the same view.