Food for Thought
The Securities and Exchange Commission (SEC) has ruled that the Decentralized Autonomous Organization (DAO) tokens were indeed securities and that their sale in 2016 should have been registered as a security with the SEC.
The ruling sent shockwaves through the cryptocurrency world, as details of the ruling and implications of it were fleshed out.
The SEC released a detailed investigative report and accompanying staff statement concluding that the 2016 token sale by The DAO was an unregistered securities offering, called the “DAO Report” and “DAO Statement,” and which are available here and here, respectively.
The SEC’s Office of Investor Education and Advocacy also released a general investor bulletin on “Initial Coin Offerings” the “Investor Bulletin,” available here.
Significant findings by the SEC
There are a number of significant findings by the SEC, which will have particular implications for the ICO and cryptocurrency markets.
- DAO tokens qualified as investment contracts under the SEC’s definition of a security.
- The DAO was the issuer of those securities, in spite of their being an autonomous organization embodied in computer code and executed on a Blockchain.
- The offering should have been registered as a security with the SEC or conducted under the SEC exemption policies.
- Any platform that allowed for trading of the DAO tokens should have registered as an exchange with the SEC.
- DAO’s plan to invest in companies and fund projects would have classified it as an investment company and would have required registration as such with the SEC.
- By implication, those who assisted in the sale of the tokens, or purchased them with the intent to resell them at a later time are underwriters within the SEC definition.
- Those who participated in the sale of DAO tokens on the secondary market would be considered traders and should have registered with the SEC.
- The officers, participants and assistants who helped to manage the DAO offering are also subject to the securities laws of individual states.
Key takeaways for investors and market participants
1. The purpose of the SEC ruling at this time
The question should be obvious. If the SEC finds that the DAO violated the laws surrounding the offering of securities, why did they not immediately file legal action against the DAO? The answer is threefold.
First, a ruling like the current SEC statement can be issued rapidly while a legal battle requires a long period of time.
Second, the SEC ruling provides certainty in terms of formalizing the SEC position on ICOs and investment vehicles. A legal fight always carries with it the risk of losing, which could confuse the SEC message.
Third, a court battle could cause confusion, depending on the legal strategies employed, while the SEC statement makes the legal position crystal clear.
2. ICOs and Blockchain token sellers are subject to SEC securities laws
While many had already concluded that ICOs were securities under the SEC definition, the SEC ruling ends any question about the matter.
The argument that smart contracts are not particularly securities because they do not have a proper issuer is specifically addressed by the ruling, and will no longer be considered valid as an exemption for ICOs.
The DAO Report notes that an “unincorporated organization” is a “person” that can fall within the relevant definition of “issuer,” and leaves no question that the SEC has the authority to identify an issuer if the token issued is a security.
3. Any ‘participant’ may be subject to SEC regulations
The Investor Bulletin issued by the SEC has massive implications for those who participate or help in ICOs.
Specifically, the report states that ‘participants’ in ICOs are subject to the rules and regulations of the SEC.
A ‘participant’ is a person who, without which, the token would not be able to be sold. This means that those who advise on ICOs, write the necessary code for the sale of a token, receive or manage the proceeds of a sale or help to find investors or manage purchases all may fall under the legal umbrella of SEC regulations and should be careful to evaluate their role in such sales.
4. The ruling does not mean that all tokens are securities
The SEC made it clear in the report that not every token sale was a security, and that they would apply the contract test outlined in SEC v. W.J. Howey Co. (“Howey”).
The test is essentially a four part question: was there an investment of money, in a common enterprise, with expectation of profits from the managerial efforts of others?
A cursory read of the report makes it clear that the SEC does understand Blockchain technology and would be willing to apply the Howey test whenever necessary.
5. The SEC is open to distributed ledger and Blockchain technologies
The SEC is not saying that token sales are illegal. Rather, they are simply requiring that issuing such tokens is classified as securities offering and is therefore under their specific registration requirements.
The reports makes clear:
“Distributed ledger and other emerging technologies have the potential to influence and improve the capital markets and the financial services industry. Interest in and funding for these technologies appears to be growing at a rapid pace. We welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities. We are particularly hopeful that innovation in this area will facilitate fair and efficient capital raisings for small businesses. We are also mindful of our obligation to protect investors and recognize that new technologies can offer opportunities for misconduct and abuse.”
6. Exempted tokens should avoid ‘investment’ verbiage
It is critical that any token wishing to fall outside the scope of the SEC ruling should be careful to avoid terminology related to ‘investment.’
The report makes it clear that the SEC combed through the communication of the DAO principals looking for language that made purchasers believe that the tokens were investments.
Any communication by a token issuer, including email, is fair game for the SEC ‘investment’ test, and token distributors seeking exemption should be very careful to avoid such language.
7. Tokens offering utilities may not require registration
Some tokens which offer purchasers specific utility with their sale such as access to software or a platform, or participate in a project may fall outside the registration requirements.
The SEC reserves the right to evaluate each token based on the ‘facts and circumstances’ of the token’s purpose.
8. ICO participants should obtain legal counsel in order to evaluate their position with the SEC
It is critical that participants in ICOs seek out and obtain legal counsel to help in evaluating their positions with the SEC.
The report specifically says that the SEC ruling represents:
“…a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities.”
This simply means that the SEC has not created any bright line test that can be applied to every token offering, and anyone wishing to issue a token should be careful to take legal counsel and even contact the SEC with specific questions.