December 28, 2018
by James K. Goldfarb


A purchaser of tokens in an initial coin offering adequately alleged that the tokens are securities, a district court judge has held.  See Solis v. Latium Network, Inc., No. 18-10255 (SDW) (D.N.J. Dec. 10, 2018).  Accordingly, the court denied a motion to dismiss a putative class action alleging that a blockchain-based company and its co-founders violated Sections 12 and 15 of the Securities Act of 1933.  The decision breaks no new ground, but adds to a growing body of district court decisions rejecting, at the pleading stage, the argument that tokens are not “securities” subject to the federal securities laws.  The issue has not been addressed by a federal court of appeals or definitive guidance from U.S. regulators.

The case arose from an ICO for Latium X (“LATX”), a token for use on the blockchain-based tasking platform Latium.  The ICO included a private presale, a limited whitelist sale, and a general sale.  Purchasers paid for LATX with dollars or Ether.  The offering raised over $17 million.  Solis purchased $25,000 of LATX,  then sued (i) Latium for allegedly violating Section 12(a)(1) for failing to register the offering pursuant to Securities Act Section 5; and (ii) Latium’s co-founders for control person liability under Section 15.

The defendants moved to dismiss the complaint on the ground that LATX was not a “security,” as defined by the Securities Act.  They conceded that LATX satisfied the first prong of the Howey test (an investment of money), and instead focused on the second (common enterprise) and third (profits solely from the efforts of others) prongs.  The court rejected the defendants’ arguments, noting that they were better suited for summary judgment.

Addressing the second prong – a common enterprise – the court held that Solis sufficiently pleaded horizontal commonality, that is, “a pooling of investors’ contributions and distributions of profits and losses on a pro-rata basis among investors.”  Solis had alleged, for example, that funds raised by the offering were pooled to develop and maintain Latium’s tasking platform, and that a purchaser’s return would be directly proportional to the purchaser’s financial stake and number of LATX tokens owned.

Turning to the third prong – profits solely from the efforts of others – the court rejected the argument that LATX was a utility token.  “Defendants led investors … to expect profit from the purchase of LATX tokens,” the court stated, quoting from the complaint.  The court pointed to supporting allegations, including:

  • promotional material, advertising methods, and public statements that “stressed the limited supply of tokens” and referred to the offering as a “unique investment opportunity” that would “generate better financial returns”;
  • a whitepaper that stated the tokens would be “used to compensate [Latium] executives with equity in the company; and
  • a platform that, at the time of the ICO, had only “limited functionality” and “had not been launched for public use.”

The court also rejected the defendants’ argument that profit would not come solely from the efforts of others.  “Solely” “is not to be read literally,” the court observed, citing Third Circuit precedent.  An investment contract can exist so long as an investor’s duties “are nominal or limited and would have little direct effect upon receipt by the participants of the benefits promised by the promoters.”  Because Solis and other investors allegedly were “completely dependent” on the defendants for (i) conducting the ICO, (ii) developing, building, maintaining, and marketing the tasking platform, and (iii) maintaining LATX’s listing on crypto-exchanges for trading, the court concluded that Solis had adequately alleged “any potential return on his investment … would have primarily resulted from Defendants’ efforts.” 

The court also concluded that plaintiff had adequately pleaded Section 15 control person claims given the co-founders’ alleged power to influence the offering and their positions and public statements during the offering.

Solis is a stark reminder that unregistered utility token sales carry significant legal risk.  Recent regulatory pronouncements and court decisions like Solis have dampened that market for now.  Issuers intent on proceeding – perhaps to test Howey’s limits – should carefully consider whether the proposed token has sufficient utility and whether the sales material and related statements position the offering as an investment opportunity.  As for issuers that have sold unregistered tokens, they should take note of the November 2018 Statement on Digital Asset Securities Issuance and Trading from the SEC’s Divisions of Corporation Finance, Investment Management and Trading and Markets.  The Statement, released the same day the SEC issued settled orders in AirFox and Paragon, describes a path to compliance with the federal securities laws for previously unregistered token sales.


About Blockchain Law Center

Blockchain technology utilizes a distributed digital ledger to record and track information, and can be leveraged to gain transparency and certainty in transactions ranging from cryptocurrency to supply chain tracking.  This blog provides information on the legal developments surrounding implementation of blockchain technology, with an initial focus on the financial services sector.