On July 25, the US Securities and Exchange Commission (SEC) issued a Report of Investigation (Report), along with a companion investor bulletin, telling the world that if you use distributed ledger (blockchain) to raise capital, you must comply with federal securities laws. Is this a surprising development? We believe not.
The subject of the Report is The DAO and its related parties and founders. The DAO is an unincorporated organization styled as a “decentralized autonomous organization,” a form of virtual organization that conducts its commercial activities on a distributed ledger. The Report describes The DAO as a for-profit business that creates and holds assets through the sale of virtual DAO tokens (Tokens) to investors in exchange for virtual currency. These assets were to be used to fund a variety of “projects” generally entailing the automation—through a blockchain—of corporate governance and decision-making mechanisms, either within or outside of a traditional corporate structure.
Projects in the form of “smart contracts” would be submitted by eligible outside parties, reviewed and approved by “curators” chosen by DAO-related parties, and, if approved, Token holders would have the opportunity to vote on the projects. In turn, if these projects were funded by The DAO, Token holders could receive from The DAO earnings generated by the projects. Token holders also could freely sell their Tokens in the secondary market through (among other media) web-based platforms that agreed to allow trading in the Tokens. Such sales by various enterprises of instruments like the Tokens have become commonly known as “initial coin offerings,” or ICOs.
In reviewing The DAO matter, the SEC discussed three issues:
- Whether the Tokens were “securities” under the Securities Act
- If the issuance of the Tokens for virtual currency was subject to the Securities Act registration requirements
- Whether the platforms accepting the Tokens for secondary market trading were securities “exchanges” subject to registration and regulation under the Securities Exchange Act
The SEC’s analysis of these issues in the context of this admittedly high-tech activity was traditional, straightforward, and unremarkable. The SEC had little difficulty in concluding that the Tokens were “securities”—relying on a classic “investment contract” analysis (often known as the Howey analysis) that was first established in the early 1940s, which defines an “investment contract” as “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
In the SEC’s view, it was clear that Token purchasers invested money (virtual currency) with the expectation of profit in a common enterprise managed by The DAO’s founders and related parties. From that determination, it was a relatively straightforward matter for the SEC to conclude that the Tokens should have been registered under the Securities Act and that the secondary market trading platforms for the Tokens should have been registered as “exchanges” under the Securities Exchange Act.
The Report was issued as a “report of investigation” under Section 21(a) of the Securities Exchange Act, an infrequently used regulatory tool that the SEC employs to issue public reprimands for federal securities law violations short of formal enforcement proceedings. Accordingly, while The DAO and its associates were publicly rebuked for selling and trading unregistered Tokens, no sanctions or penalties were imposed on any person.
The Report made clear that the determination of whether a particular ICO involves the offer or sale of securities requires a fact-intensive analysis. ICOs are being developed with diverse legal, financial, and technological characteristics, and not all ICOs will necessarily involve the sale of securities. In this case, because The DAO served as a collective investment vehicle for participants to invest in startup blockchain projects, the facts readily lent themselves to the investment contract analysis. Other types of ICOs (e.g., where such virtual “tokens” or “coins” are intended to be used on a platform that offers goods or services) may present more difficult issues for the SEC. Regardless of the specific product, however, the Report made clear that the SEC will apply traditional securities law concepts and framework of analysis to address ICOs (and presumably other high-tech, virtual transactions that continue to be created and innovated in the fintech/digital age).
At one level, the SEC’s reluctance to take actual enforcement action reflects the agency’s caution in applying federal securities laws concepts and principles to new technologies in the enforcement context without giving the public advance notice of its views (an approach that, frankly, we would like to see certain other federal financial agencies adopt). That said, the SEC’s legal analysis in the Report was neither aggressive, nor creative, nor groundbreaking. If anything, the Report was a straight-down-the-middle federal securities law analysis. Further, the SEC has long made it plain—as it did in the Report—that the medium through which securities activities occur does not reduce or modify the applicability of the federal securities laws, meaning that businesses and persons operating in the financial technology space—in this particular case, the realm of blockchain and virtual currency—already should be on notice of the SEC’s position.
It may only be because this matter involved a rapidly developing and (perhaps for many) incompletely understood financial technology that the SEC was willing to stay its enforcement hand. The next ICO or other fintech subject of SEC interest, however, may not be so fortunate.