The SEC’s published report of its first investigation focused on tokens sold in the context of an ICO sets the framework for future token offerings and raises red flags and legal hurdles to the resale or transfer of previously issued cryptocurrency tokens.
On July 25, 2017 the US Securities and Exchange Commission (SEC) issued a report (Report) on its investigation of a “decentralized autonomous organization,” referred to as the DAO, from the viewpoint of US securities law.
The DAO is one example of the decentralized autonomous organization concept representing an organization existing as computer code implemented on the Ethereum blockchain. The Ethereum blockchain is renowned for its ability to build “smart contracts”—sets of computer code that implement without human participation or with limited human participation.
The DAO was launched on April 30, 2016 as a decentralized investment vehicle based on a set of smart contracts instead of local policies and bylaws. The DAO offered its backers returns on investments made by the DAO and voting rights to determine the projects for investment. During the offering of its tokens in May 2016, the DAO raised the equivalent of approximately US$150 million (in virtual currency) from its backers in exchange for DAO tokens (DAO Tokens).
In the Report, the SEC analyzed the concept of a decentralized autonomous organization and weighed in on certain aspects such as how the DAO was created and is funded and run. The SEC concluded that the DAO Tokens are securities within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. In reaching this conclusion, the SEC applied the classic Howey test of an “investment contract” in analyzing the DAO Tokens’ nature and concluded, among other things, that the DAO’s investors
- made the type of “contribution of value” that can create an investment contract by using Ether (a cryptocurrency used in the Ethereum blockchain) to make their investments, and DAO Tokens were received in exchange for Ether;
- expected a return on their investments through a share of potential profits from projects to be undertaken by the DAO, a common enterprise; and
- for such return, relied on the managerial efforts of the DAO’s founders and curators, in particular because the investors’ voting rights did not provide them “with meaningful control over the enterprise.”
Deriving from its finding that the DAO Tokens qualify as securities, the SEC concluded the following:
- The DAO, as issuer, was required to register the offer and sale of DAO Tokens under the Securities Act of 1933 (absent an exemption).
- Any platform offering secondary market trading of DAO Tokens must register with the SEC as a national securities exchange under the Securities Exchange Act of 1934 (or operate within a recognized exemption).
Key Takeaways from the Report
Although the Report is based on the facts of a particular case, the SEC repeatedly described its views in broad terms, emphasizing their general applicability and indicating the SEC’s intention to implement them in the future. It took the unusual step of issuing the Report for the express purpose of communicating those views to all who would use a DAO entity “or other distributed ledger or blockchain-enabled means for capital raising,” as well as those who facilitate later sales or exchanges of such assets—serving as notice that the US securities laws may apply to various digital currency activities, including distributed ledger technology.
The SEC’s views expressed in the Report could be extrapolated to current or planned offerings of other forms of so-called “equity tokens,” e.g., tokens that offer their backers revenue sharing or control over a decentralized organization.
Although the SEC decided not to pursue enforcement in the matter of the DAO, such action is possible with respect to any other or future offerings of equity tokens that likewise are viewed as securities and are offered or sold within the territorial reach of US securities law. If such transactions are to be conducted to, from, or within the United States, care should be taken to ensure compliance with registration requirements or the perfection of an exemption. The Report also raises a serious concern for platforms that operate as US exchanges to trade tokens issued during an offering, essentially requiring them to register as an exchange or alternative trading system. If these requirements were found to apply, violations could lead to not only enforcement proceedings and injunctive relief, but also potential civil liability for the offeror and its controlling persons in appropriate cases.
Further, the Report also warns “those who would use virtual organizations” to review their activities from the viewpoint of the Investment Company Act of 1940. However, the SEC did not apply the 1940 Act to the DAO’s case, in part because that entity did not commence its planned investment activities.