Margaret A. Dale and Mark D. Harris ()
The flurry of recent Initial Coin Offerings (ICOs) have raised questions as to whether, and in what circumstances, virtual currencies and digital tokens may be considered securities whose offer and sale are subject to federal registration requirements. A recent report by the U.S. Securities and Exchange Commission cautioning investors that digital assets may be securities is a turning point for the token marketplace and other blockchain-based mechanisms of alternative fundraising. SEC Release No. 81207, “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” July 25, 2017.
A blockchain is an electronic distributed ledger that is maintained by participants in a network of computers. In a typical ICO, a blockchain-based product or service provider offers proprietary digital assets (“tokens”) in exchange for working capital, usually provided in the form of a cryptocurrency such as Bitcoin or Ether (ETH). One of the first truly significant ICOs was carried out by The DAO, whose name stands for Decentralized Autonomous Organization. The virtual organization was created by a company called Slock.it to operate as a for-profit entity that would create and hold assets through the sale of tokens to investors. Those assets would then be used to fund “projects,” selected by a group of Curators. Ownership of a DAO Token vested certain limited voting and ownership rights in the holder. The holders of DAO Tokens would vote on proposed projects and stood to share in the anticipated earnings from those projects as a return on their investment in DAO Tokens. DAO Token holders could also monetize their investments in the tokens by re-selling or transferring them. From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens, valued at approximately $150 million. Id. at 2-3. In June 2016, a hacker used a flaw in The DAO’s coding to steal approximately one-third of The DAO’s Token assets, totaling more than $50 million. To avoid any loss to the investors, Slock.it’s co-founders implemented a protocol to enable DAO Token holders to exchange their tokens for ETH.
On July 25, 2017, the SEC issued an investigative report regarding potential federal securities violations involving The DAO and related entities. Although it decided not to pursue enforcement action against The DAO, the SEC concluded in its report that the digital tokens issued by The DAO in its ICO qualify as securities under the Securities Act of 1933 and the Securities Exchange Act of 1934 and the investors’ tokens are an “investment contract” under the federal securities laws.
The ‘Howey’ Test
Whether an investment contract exists must be resolved on a case-by-case basis in accordance with the economic realities of the given transaction. While there is no bright-line rule, for more than 75 years this analysis has proceeded under a multi-factor test first laid out by the U.S. Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946). Under the Howey test, an investment contract is defined as: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. To find that an investment contract exists, all four prongs must be satisfied.
The SEC’s report applied the Howey test to The DAO organization and its token offering. First, the SEC concluded The DAO’s ICO involved an investment of money. This was based on the well-established principle that an investment may take the form of goods and services or some other exchange of value. See, e.g., Uselton v. Comm. Lovelace Motor Freight, 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey‘s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”). The SEC found that investors in The DAO used ETH to make their investments, and DAO Tokens were received in exchange for ETH. Second, the SEC concluded that investors in DAO Tokens were invested in a common enterprise because the ETH was pooled and available to The DAO to fund projects. Third, the SEC explained that the investors who purchased DAO Tokens reasonably expected to earn profits when they sent ETH to The DAO’s platform with the intention that the projects they were funding would be profitable, causing a return on their investment.
Finally, the SEC concluded that the investors’ profits were to be derived from the managerial and entrepreneurial efforts of The DAO’s co-founders to manage The DAO and propose profit-generating proposals. The DAO’s creators developed and maintained the technological platform, facilitated communications between its users through online forums, and publicized rules for how The DAO would work and the anticipated role of token holders. The SEC found that through their conduct and marketing materials, The DAO’s co-founders held themselves out as experts in blockchain protocols and led investors to believe they could be relied on to provide the managerial efforts required for The DAO to succeed. The SEC also found that The DAO did not provide token holders with sufficient information to make informed voting decisions and that their voting powers were limited in comparison to the Curators. Furthermore, the pseudonymity and dispersion of the token holders made it difficult for them to join together to effect change. These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder. These factors led the SEC to find that the final prong of the Howey test had been satisfied.
The report also noted that The DAO had been described as a “crowdfunding contract.” However, the SEC concluded that The DAO would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and FINRA. SEC Release No. 81207 at 4, n.11.
Considering that The DAO is no longer operational, the real significance of the SEC’s report is what it means for crypto-exchanges, other ICO issuers, and the token marketplace as a whole. For blockchain developers considering an ICO, the SEC has provided a roadmap of the facts and circumstances it will evaluate to determine whether a token constitutes a security. In addition to the Howey analysis, the SEC may consider the vesting of voting or other ownership rights in the tokens. If tokens are deemed securities, developers may choose to register their tokens under the Securities Act and issue them in a public offering. This choice, however, is unlikely to appeal to those who seek the flexibility and ease of an ICO.
Another option is to craft the features of the token, and the network on which it operates, so that the offering would be exempt from registration under the Securities Act. An ICO may qualify for an exemption if made to accredited investors or subjected to limitations on resales or transfers. Alternatively, public securities ICOs may still be conducted outside the United States as long as no offers or sales are made to U.S. investors. Or an offeror may do an ICO as a private placement within the country so long as it complies with the requirements of Rule 505 in terms of the number and value of the tokens and the number and type of investors. Another option may be to design tokens that are valuable primarily for their use-value. One example of this may be the ETH itself, which is designed to be consumed as virtual fuel for when applications run on the Ethereum blockchain network. Building these types of functional tokens is something that many developers are already doing, or claiming to do.
The SEC’s report did not state whether The DAO was an “investment company” under the Investment Company Act, in part, because The DAO never commenced its business-operations funding projects. But in a footnote, the SEC warned that ICO issuers should consider their potential Investment Company Act obligations. Id. at 1, n.1.
Although the SEC’s report only addressed federal securities laws, ICO sponsors should consider potential obligations under the U.S. Bank Secrecy Act, compliance with the Commodity Exchange Act, and taxation considerations. In addition, cybersecurity breaches (like The DAO attack) pose risks of reputational harm and financial loss. Blockchain developers considering an ICO should be mindful of federal and state cybersecurity regulations, in addition to SEC and FINRA re- quirements.
As for the ICO marketplace more generally, it is likely the SEC’s involvement will cause some initial chilling effects, specifically as a result of requiring exchanges to register as securities exchanges and comply with the associated requirements. On the other hand, the added legitimacy and more reliable offerings could attract more mainstream, risk-averse investors, thereby expanding the market and benefiting existing market participants. We will have to wait and see what impact the SEC’s report will have on ICOs and other blockchain-based mechanisms of alternative fundraising.