On July 25, 2017, the United States Securities and Exchange Commission (SEC) issued a report of investigation (Report) concluding that the digital currency “tokens” sold by DAO (DAO Tokens) in a 2016 initial coin offering (ICO) are securities for purposes of federal United States securities laws. This conclusion could have far-reaching implications for businesses that have completed or are contemplating an ICO, businesses dealing with tokens or cryptocurrencies, such as cryptocurrency exchanges, as well as the still-developing legal landscape relating to ICOs and distributed ledger or “blockchain” technology.
Beginning in 2013, many entities that use blockchain technology as their operational foundation have raised funds through ICOs. While precise data is not available, various sources estimate that since the beginning of 2016, between 84 and 139 ICOs have been completed, raising gross proceeds of between U.S.$281 million and U.S.$1.35 billion.(1) In some cases, ICOs have sold out in a matter of seconds, such as the Basic Attention Token ICO in May 2017 which raised U.S.$35 million in less than 30 seconds.(2)
Pursuant to an ICO, an entity offers digital currency tokens to purchasers, typically in exchange for digital consideration such as Bitcoin or Ether. The rights attaching to these tokens vary greatly, with some resembling “kick-starter” style crowd-funding in that token holders have pre-paid for goods or services offered by the entity and others resembling common shares in a company in that token holders have certain voting rights and certain rights to dividend-like payments from the entity.
Considering the rapid development of the digital asset industry and the fact that tokens do not typically fit neatly within the definition of “security” under securities legislation, it is not surprising that securities regulators in Canada and the United States have declined to publish any comprehensive conclusions regarding whether and in what circumstances tokens would be regulated as securities. Instead, regulators have limited themselves to more general statements, such as the OSC’s March 8, 2017 news release, which generally advised that businesses that use distributed ledger technologies may be subject to securities law requirements. The news release also encouraged such businesses to contact its Launch Pad, a team of OSC staff with a focus on financial technology issues, with questions about how securities laws might apply to their business.
Notwithstanding the foregoing, on July 25, 2017 the SEC issued the Report, which concluded that the DAO Tokens are securities and accordingly are subject to securities regulation, including the requirement for DAO to prepare and file a prospectus in connection with the sale of the DAO Tokens (subject to an available exemption).
DAO, formed by the co-founders of Slock.it UG, a German corporation, is an unincorporated decentralized autonomous organization embodied in computer code and executed on a distributed ledger or blockchain. The proceeds from its ICO were to be used to create and hold a portfolio of assets which could be used to fund various projects proposed and voted on by holders of the DAO Tokens after vetting by curators chosen by Slock.it. Earnings from these projects would then be distributed to holders of the DAO Tokens as a return on investment. The DAO ICO was open from April 30, 2016 to May 28, 2016, during which time DAO sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether (valued as of May 28, 2016 at approximately U.S.$140 million).(3)
In concluding that the DAO Tokens are securities, the SEC applied the test from SEC v. W.J. Howey (1946) (which formed the basis for analysis in Pacific Coast Coin Exchange v. OSC (1977), a leading case in Canada on the analysis of what constitutes a security). The SEC’s key conclusions in the Report were: first, that the potential for a return on investment through earnings from the projects created a reasonable expectation of profit in the DAO Token holders, which is a hallmark of a security; and second, that any profit so received would be derived from the managerial efforts of others, principally the Slock.it co-founders and the “curators” who act as gatekeepers in respect of the projects, another such hallmark. On this second point, the SEC noted that the DAO Token holders did indeed have the right to propose projects and vote on which projects would receive funding, but that the curators held ultimate discretion in choosing which projects would be voted upon.
In addition, we note that the DAO white paper, which set out details about the DAO Tokens for investors, likened an investment in DAO Tokens to an investment in shares of a company. While the Report stressed that form will trump substance when analyzing whether something is a security, we suspect that this type of language made it easier for the SEC to conclude that the DAO Tokens are securities.
While no Canadian regulators have published anything similar to the Report, we believe that U.S. and Canadian approaches to the definition of “security” are sufficiently similar that Canadian regulators may come to a similar conclusion if faced with the same facts.
In light of the SEC’s Report, businesses that have completed or are contemplating an ICO should review the terms of their tokens and consider whether they share any similarities with the DAO Tokens or would otherwise be a security for purposes of securities laws. Such businesses are cautioned, however, that simply because their tokens may differ from the DAO Tokens or simply because a white paper does not analogize the tokens to common shares does not mean that such tokens could not be considered securities, as each token must be considered on its own facts.
In addition, businesses that deal with the tokens on a day-to-day basis must also consider whether their operations might now be subject to securities regulation. For example, digital currency exchanges that facilitate trades in the DAO Tokens might now be considered to be performing acts in furtherance of trades of securities and might be required, absent an exemption, to be registered as an investment dealer.
It is difficult to say whether regulators will consider tokens structured differently from the DAO Tokens to be securities, both because the Report addresses only the facts relating to the DAO Tokens and also because regulators’ prior statements on the topic have been so general. Considering the speed at which this industry is developing, however, industry participants may not have to wait long before finding out.