The Securities and Exchange Commission (SEC) announced on Tuesday, July 25, 2017, that Initial Coin Offerings (ICOs) and other market participants offering digital assets by “virtual” organizations may be subject to the requirements of federal securities laws. The SEC made clear that simply because there is new technology involved, the SEC still looks at the conduct involved to determine whether a security has been issued. The SEC guidance was issued as part of its investigative report into DAO Tokens where it concluded that such tokens were of a character as to fall under the definition of a security under current law. The implications of the ruling are broad and still somewhat unknown, as the SEC left the door open to the possibility that not all tokens may constitute securities, but also stated that “[t]hose participating in unregistered offerings also may be liable for violations of the securities laws.” Unfortunately, the guidance did not provide significant further insight into the SEC’s view as to when a token sale crosses over the line to becoming a security. The SEC’s full decision and related releases can be found here.
THE HISTORY AND THE SEC’S CONCLUSION THAT THE DAO VIOLATED SECURITIES LAWS
The announcement follows the SEC’s investigation of The DAO’s 2016 token sale and subsequent cyber-attack that diverted one-third of the entity’s value, in terms of Ethereum. The SEC announced that it would not be bringing charges against The DAO, but determined that DAO Tokens are securities under the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC found that an investment contract existed between The DAO and participants in the entity’s ICO, because the offering fell within the purview of the Howey Test. Importantly, the SEC detailed why the offering should have been registered under federal securities laws, since investors’ invested their money with a “reasonable expectation of profits” derived from the “managerial efforts of others,” including the co-founders of The DAO and the entity’s “Curators.” Further, the SEC found important that the token holders’ voting rights were limited, in that they did not exercise “meaningful” managerial control over The DAO’s decisions, similar to the rights of a corporate shareholder.
THE GUIDANCE
The SEC concluded that whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction. The announcement does not categorize all digital assets offered or sold through ICOs as securities, rather it confirms that the foundational principles of securities laws apply to virtual organizations or other capital-raising entities making use of distributed ledger technology. The SEC stated that the automation of certain functions through decentralized ledgers, “smart contracts,” or other computer code, does not remove conduct from the purview of federal securities laws.
Moreover, the SEC announced that those who participate in an unregistered offer and sale of digital assets that constitute securities not subject to a valid exemption are liable for violating Section 5 of the Securities Exchange Act of 1934. This section makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange, or is exempted from such registration. This Section encompasses any person who participates in the offer or sale of an unregistered, non-exempt security.
SOME IMPORTANT TAKEAWAYS
- The SEC is not asserting that all token sales constitute securities, just those whose characteristics match existing securities laws and regulations. This is important, as it permits non-securities-like token sales to proceed without complying with securities laws. However, if a token sale qualifies as a security, and the SEC is likely to take a broad view of what constitutes a security, the issuer of the tokens must register the offering with the SEC, or rely on an exemption. Similarly, if the issuer is operating a trading system under the securities laws, the issuer must register as a national securities exchange or rely on an exemption.
- The SEC maybe indicating some tolerance for past token sales, but it is now putting everyone on notice that from this date forward, any token sale that constitutes a securities offering must comply with securities laws, or the issuer and participants risk an enforcement action.
- The SEC referred to “those participating in unregistered offerings” which includes those beyond the issuing company, and may include executives and ICO consultants.
- Beyond discussing The DAO ruling, the SEC did not provide additional guidance as to when a token sale crosses the line into becoming a security.
*This alert was published by Goodwin’s Digital Currency + Blockchain Technology practice on July 26, 2017; it is also accessible on our website.