Gayton Law

This month:

• In the Matter of Munchee, Inc.
• SEC v. PlexCorps
• Twentieth Century Fox Television v. Empire Distribution, Inc.

Technology News

Below are two SEC cases involving Initial Coin Offerings or ICOs. Based on signaling from the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), 2018 is shaping up to be a regulation-driven year for cryptocurrencies, tokens and other digital assets. There will be increased scrutiny of ICOs and other fundraising schemes which allege large returns and make false or misleading statements to the public. In addition, it has to be remarked upon that many cryptocurrency, token and blockchain-based entities created over the past several years, asserted that they could avoid litigation due to the alleged decentralized nature of the business structure as well as participant anonymity. These cases make clear that more law enforcement and investor fraud strategies include monitoring websites, social media, chat rooms, podcasts and videos to collect evidence against individuals whether or not a legally recognized business entity exists.

Settlement offer accepted by SEC related to restaurant review app and related token sale by Munchee Inc. In the Matter of Munchee Inc., SEC AP file No. 3-18304, order dated December 11, 2017.

Summary. The Securities and Exchange Commission (SEC) issued an order in response to its decision to institute cease-and-desist proceedings against Munchee Inc. The SEC accepted Munchee’s settlement offer and its consent to the entry of the SEC’s order.

Background. Munchee created a U.S.-only iPhone restaurant review app in 2015 and launched it in Q2 of 2017. Munchee had a website, Twitter account, Facebook page and other online message boards where it posted information, including a whitepaper about its business. It offered and sold tokens variably called MUN or MUN tokens to be issued on an Ethereum-based blockchain. It created 500 million tokens. Munchee intended to raise $15 million in Ether through an ICO for app improvements and stated that these improvements would encourage MUN-related transactions. Munchee said that it would sell 225 million tokens and offered 10 and 15 percent discounts on the offering price. Munchee would retain the remaining tokens and use them to support its business, pay employees and finance rewards. In addition, Munchee said that it could burn some MUN tokens when a restaurant paid Munchee an advertising fee. They also had a membership plan.

The whitepaper said that Munchee “will ensure that MUN token is available on a number of exchanges in varying jurisdictions to ensure that this is an option for all token-holders.” Munchee also said that it would buy or sell MUN tokens to support “a liquid secondary market in MUN tokens.” All of this was intended to increase token value.

Munchee claimed in its whitepaper that, based on its own Howey analysis which was not provided in the whitepaper, the MUN was a utility token and would not “pose a significant risk of implicating federal securities laws.” On 10/31/2017, Munchee started selling MUN tokens where 1 Ether (valued at $300 USD) or 1/20 Bitcoin (valued at $6,500) would buy 4,500 MUN.

On 11/1/2017, Munchee stopped sales after being contacted by the SEC and unilaterally terminated the contracts of sale and returned money to investors which numbered 40 people who paid about 200 Ether.

Legal Analysis

Securities Acts. Under Section 2(a)(1)of the Securities Act, a security includes an investment contract which is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others” otherwise known as the Howey test outlined by the Supreme Court in 1946. Munchee did not register the MUN token as a security which was in violation of Sections 5(a) (failure to register a security) and 5(c) (unlawful to offer for sale any unregistered security in interstate commerce by use of transportation, communication or the mails) of the Securities Act. According to the SEC, Munchee’s activities rendered the MUN token a security under the Howey test. Specifically, MUN token purchasers had entered into an investment contract where the purchasers expected future profits based on Munchee’s efforts. According to the SEC, whether a token is a security or a utility does not turn on labels but on an assessment of “the economic realities underlying a transaction.”

Evidence. Munchee’s promotional activities, in addition to the information available on its website, provided ample evidence for the SEC to show that the MUN token was a security rather than a utility token. On October 30, 2017, it posted “7 Reasons You Need to Join the Munchee Token Generation Event” and included among the reasons, that as more users joined, the more valuable the tokens would become and that Munchee itself would burn tokens to raise MUN token value. On October 23, a Munchee founder said on a podcast that the MUN offering would increase in value over time as more restaurants were engaged and incentives were provided for its user base. In addition, Munchee appeared to endorse profit claims by others, including a YouTube video alleging 199% gains. Another YouTuber with 15k followers indicated that MUN token purchasers would only see a profit once the platform was active and suggested that purchasers try and hold the token until 2019.

There was no evidence that Munchee advertised its app to the restaurant industry or related industry media. Instead, it focused its promotional attention on people and forums interested in cryptocurrency investments. According to the SEC “[m]ore than 300 people promoted the MUN token offering through social media” and Munchee offered MUN tokens to people who published promotional videos, articles or blog posts.

Order. Because the SEC accepted Munchee’s settlement offer and decided not to impose a civil penalty in consideration of Munchee’s prompt remedial acts and cooperation, Munchee was ordered to “cease and desist from committing or causing any violations and any future violations of Sections 5(a) and (c) of the Securities Act” and incurred no other penalties.

Here, the SEC appears to take a lenient stance against Munchee because it took steps to return funds to investors as soon as the SEC started asking questions. It is probably not an indication of how the SEC will respond to similar cases in the future. It is more likely that until there is regulatory and case law clarity and consistency, the SEC will continue to measure its responses on a case-by-case basis.

Emergency Asset Freeze Order granted due to complaint filed by SEC alleging PlexCorps  investor fund misappropriation. SEC v. PlexCorps. Case: 1:17-cv-07007-DLI-RML, complaint filed in USDC EDNY, December 1, 2017.

Summary. The SEC filed a complaint on December 1, 2017 against PlexCorps and affiliated individuals for investor fund misappropriation in the U.S. District Court for the Eastern District of New York (EDNY). It sought relief in the form of a temporary and preliminary restraining order; a request to temporarily and preliminarily freeze assets; and an order temporarily and preliminarily enjoining defendants from destroying, altering, concealing or otherwise interfering with the SEC’s access to relevant documents, among other prayers for relief.

Background. On 12/1/17, the SEC filed a complaint against PlexCorps, an unincorporated business based in Quebec, Canada, and other defendants in the EDNY requesting an injunction based on PlexCorps alleged illegal misappropriation of investor funds through a fraudulent and unregistered offer and sale of PlexCoin securities via an ICO.

According to the complaint, from 8/2017 to 12/1/17, PlexCorps obtained $15 million from tens of thousands of investors which included over 1,500 transactions with U.S. investors. PlexCorps a/k/a and d/b/a PlexCoin and Sidepay.CA as well as individuals residing in Quebec Dominic Lacroix and Sabrina Paradis-Royers were responsible for the enterprise.

Starting in 2011, Lacroix was the subject of several fraudulent securities legal proceedings in Canada. From 6/2017 to 12/2017, PlexCorps marketed, offered and sold investors PlexCoin. The ICO was open from 8/7/17 until 10/1/17, but tokens continued to be sold beyond the October close date.

Legal Analysis

Materially false and misleading statements. The SEC said that most false statements were made in PlexCorps’s whitepaper, on webpages as well as social media accounts. The SEC alleged four false and misleading statement categories in order to meet violation requirement.

Specifically, PlexCorps made false and misleading statements related to:

1. Expertise and Place of Business. PlexCorps said that it had worldwide experts with a principal place of business in Singapore. According to the SEC, PlexCorps’s team was comprised only of Lacroix’s employees and affiliated persons and businesses in Quebec;

2. Expert Leadership and Business Control. PlexCorps said that its leadership was hidden to prevent competitor poaching and that that their team consisted of “more than 48 [from] all around the world.” The SEC said that the leadership was not revealed because Lacroix was known as a Canadian securities law violator and had been enjoined under Quebec securities law for securities fraud. Both Lacroix and Paradis-Royer were enjoined from engaging in the unregistered offering of PlexCoin tokens from 9/12/17. PlexCorps’s website announced its controlling relationship to the token by stating “PlexCorps presents: PlexCoin.” Under its website’s FAQs, it informed interested investors that they could participate in a pre-sale on August 7 and receive a discounted price and priority as well as a return of 1,354% on their investments. It also provided a definition of ICOs as “a derivative from the known expression IPO (Initial Public offering or share market launch) which refers to cryptocurrency fundraising.” In another FAQ response, it said that investors’ return on investment was related to when the investor purchased items, so the actual ROI would vary. Lacroix registered PlexCoin and PlexCorps Facebook pages and his credit card was affiliated with those accounts. In addition the enterprises’ URL domain names were registered and paid for by Lacroix.

3. Offering’s Purpose. PlexCorps explained to potential investors that proceeds would be used to develop other products. The SEC responded that PlexCorps actually intended to fund Lacroix and Paradis-Royer’s expenses including home décor projects. Funds raised were passed through fiat bank and cryptocurrency accounts belonging to the defendants. Over $800k of raised amounts were in accounts controlled by Lacroix and his associates. About $200k may have been spent on personal expenditures. In addition, there was no public disclosure that the funds were going to be used for personal expenses.

4. Returns. PlexCorps said that investors would receive “enormous” and “real” returns on PlexCoin token investments. According to the SEC, there was no reasonable basis upon which they could project those returns. There was no meaningful market maintenance or project development.

Illegal Offering. The defendants did not register the token as a security and there was no applicable registration exemption. The defendants made a general solicitation to the public and sold the token to several investors in the U.S. In order to avoid securities registration requirements, the SEC alleged that Lacroix attempted to label PlexCoin tokens a cryptocurrency, similar to Bitcoin. Under the Howey test, certain elements have to exist in order for a contract to be an investment contract and the related token be considered a security. Specifically, 1. an investment of money in a common enterprise, 2. with a reasonable expectation of profits, and 3. be derived from the entrepreneurial or managerial efforts of others. In this case, PlexCorps promised returns from appreciation in PlexCoin token through PlexCorps’s investment with proceeds from the PlexCoin ICO as well as managerial efforts by the PlexCorps team; that profits would be distributed to investors; and that the appreciation of value included listing the token on digital asset exchanges. Lacroix and PlexCorps promised that if all tokens were sold, early investors would be rewarded at 1,354% over their investment in 29 days from August 7.

PlexCorps, Lacroix and Paradis-Roger used several online payment services through which investors could buy tokens including PayPal, Square, Shopify and Stripe for their enterprise. The first service, PayPal became suspicious of the transactions and “almost immediately flagged the account for suspicious activities and reversed most of the payments to the investors.” Shopify and Stripe were used subsequently. According to the Complaint, the defendants “falsely told a Shopify online representative that they had a ‘gaming’ company and that they were selling ‘some items in our game’ that the customers would ‘use … in our game.’” The Shopify account was registered in the name of Paradis-Royer. As accounts were suspended or closed, the defendants used false names to open new accounts on Shopify and Stripe.

The SEC alleged that the business SidePay.com was created to trick the service providers. The SEC said that the HTML source code for SidePay.com revealed that the payment portal for someone interested in buying PlexCoin via SidePay was sending money to defendants’ PlexCoin account at Shopify.

There were several securities related violations alleged including 5(a) and (c), 17(a) and (c) of the Securities Act and 10(b) of the Securities Exchange Act. Paradis-Royer was alleged to have aided and abetted PlexCorps and Lacroix’s violations.

Relief. The SEC sought 1. A temporary restraining order (TRO) and preliminary injunction against defendants prohibiting them from future violations of the Securities Act and the Securities Exchange Act and prohibiting Lacroix and PlexCorps from participating in any offerings of unregistered securities; 2. An order freezing defendants’ assets and allowing expedited recovery, preventing document destruction and alteration, return to the Court registry assets moved from U.S. based accounts and provide verified investor proceeds accounting; and 3. Final judgment permanently enjoining the defendants from the acts described in the complaint and disgorging “ill-gotten gains” and pay prejudgment interest, prohibiting Lacroix and Paradis-Roger from participating in an offering of digital securities and pay civil penalties.

The case is ongoing.

Based on the complaint, the Commission obtained an emergency asset freeze against Lacroix and Paradis-Royer on December 4. On December 14, the Court granted a preliminary injunction and asset freeze on PlexCorps. The reason for the delay against PlexCorps was because, according to the defendants, PlexCorps was not a business entity but a “concept” and therefore not suable. A PACER monitor summary of the order and minute entry says: “Although counsel for Plaintiff asserts that PlexCorps is a suable unincorporated organization, counsel for the Individual Defendants asserts that PlexCorps is not a suable entity. Still, counsel for the Individual Defendants represents that, to the extent that the Individual Defendants control PlexCorps, they will have PlexCorps comply with the Stipulation and Order.” The SEC found that Sidepay Limited was incorporated in the UK with Paradis-Royer listed as a person with significant control. Despite the order issued against the defendants, Lacroix and Paradis-Royer continue to challenge the orders by re-asserting the claim that PlexCoin is like Bitcoin and their assets were illegally frozen because the court lacked personal jurisdiction. The defendants filed a motion requesting a pre-motion conference about dismissing the complaint for lack of personal jurisdiction and staying discovery which was granted on December 28. This case, along with the new class action case filed against Tezos, marks significant investor fraud inquiries for at least the remainder of 2018. As of January 8, 2018, the PlexCoin site has not been shut down.

Intellectual Property – Trademark

Declaratory judgment action related to whether the Twentieth Century Fox’s television program “Empire” violated the trademark rights of record label, Empire Distribution, Inc. Twentieth Century Fox Television v. Empire Distribution, Inc.. Opinion, U.S. District Court of Appeals for the Ninth circuit, D.C. No. 2:15-cv-02158-PA-FFM, November 16, 2017.

Summary. In this appeal from a district court’s decision to grant summary judgment in favor of Twentieth Century Fox (“Fox”), Empire Distribution, Inc. (“Distribution”) claimed that the district court erred in finding that Fox’s use of the name “Empire” is protected by the 1^st Amendment.

Background. Empire Distribution is a record label known for hip hop, rap and R&B releases starting in 2010. The “Empire” television show premiered on Fox in 2015 and has a fictional music label named “Empire Enterprises.” Columbia Records releases show-related music from the show. In addition to the music, there is show-related merchandise which displays the show name “Empire.” Distribution sent a claim letter to Fox and Fox filed a suit on 3/23/15 seeking declaratory judgment that the show and music don’t violate Empire Distribution’s trademark rights, the Lanham Act or California law. Distribution counterclaimed for trademark infringement, dilution, unfair competition and false advertising looking for injunctive and monetary relief. Empire opposed Fox’s request for summary judgment. The district court granted summary judgment to Fox on all claims and counterclaims. Distribution appealed.

Claims. Generally, a trademark infringement case involves a “likelihood of confusion” test. However, when the alleged infringing use involves a title of an expressive work, the Rogers v. Grimaldi test is applied in the 9^th Circuit. This test comes from the 2^nd Circuit and, like that circuit, the 9^th Circuit has two reasons for using a different test for expressive works: 1. The 1^st Amendment right of free speech is implicated and 2. Consumers are “less likely to mistake the use of someone else’s mark in an expressive work for a sign of association, authorship, or endorsement.” The 9^th Circuit has extended the test to include an alleged infringing use within the body of an expressive work.

On appeal, Distribution said that Fox’s use of the mark is in violation of the Lanham Act under the Rogers test. According to the Roger’s test, an expressive work does not violate the Lanham Act unless “the title has no artistic relevance to the underlying work … or, if it has some artistic relevance, unless the title explicitly misleads as to the source or content of the work.” Distribution said that some of Fox’s uses are not within the scope of an expressive work, specifically, that Fox’s use is “an umbrella brand to promote and sell music and other commercial products.” The court responded that “[a]lthough it is true that these promotional efforts technically fall outside the title or body of an expressive work, it requires only a minor logical extension of the reasoning of Rogers to hold that works protected under its test may be advertised and marketed by name and we so hold.”

The Rogers Test. Distribution alleged that the title had no artistic relevance to the work. The Court found that Fox used the common English word “Empire” “for artistically relevant reasons: the show’s setting is New York, the Empire State, and its subject matter is a music and entertainment conglomerate, “Empire Enterprises,” which is itself a figurative empire. The Court also said that the second prong of the test, e.g., that use of the mark would mislead customers, fails. Fox would have to explicitly mislead customers with an overt claim or explicit misstatement that caused customer confusion. The court did not find that Fox explicitly mislead the public by overt claims or explicit references to Empire Distribution.

Conclusion. The court affirmed the district court’s judgment finding that the use of the name “Empire” by Fox was protected by the 1^st  Amendment, as well other judgments in favor of Fox.

This case highlights trademark right limits as it relates to the freedom of expression promised by the 1^st Amendment. This case also highlights the problem of using common words when seeking trademark protection. When considering a trademark, think also about where the potential mark lies in the trademark protection spectrum. The mark most likely to be protected is an “arbitrary” or “fanciful” mark. Please contact Gayton Law if you are considering registration for a federal trademark.

Programs and Publications

Art on the Blockchain (AOTB)

Cynthia Gayton will be attending the Rare Digital Art Festival January 13, 2018 in New York along with AOTB co-host and co-founder with Jeff Clarkin. Learn more here.

Legal Aspects of Engineering, Design and Innovation 10^th edition by Cynthia Gayton

This edition was released in January 2017 and is available through the publisher, Kendall-Hunt publishers and on Amazon.com in paper and e-book form. This book is used in several engineering courses and is a useful reference for anyone interested in contracting, intellectual property, engineering practice, and other general legal issues. This new edition includes separate chapters for each intellectual property type, introduces and explanation of blockchain smart contracts, discusses trends in product liability, and has recent case law to highlight chapter topics. It also expands from a primarily engineering perspective to include design professionals and innovation-specific coverage.

Thank you for reading and for your business!

The information contained in this newsletter is for general guidance on matters of general interest only. The application and impact of laws can vary widely based on specific facts. The information contained in this newsletter should not be construed as a substitute for consultation with professional advisors. Certain links in this newsletter connect to other websites maintained by third parties over whom Gayton Law has no control. Gayton Law makes no representations as to the accuracy or any other aspect of information contained in other websites.

© 2018 Gayton Law

Filed under: Blockchain, Business Entities, Intellectual Property, Technology, Trademark Tagged: | blockchain, CFTC, contracts, cryptocurrency, First Amendment, Howey test, investor fraud, IP, Lanham Act, SEC, Securities Exchange Act, Security Act, smart contracts, trademark