An investigative report (the "Report") issued by the U.S. Securities and Exchange Commission ("SEC") concludes that blockchain tokens offered and sold by a "virtual" organization known as "The DAO" were securities under U.S. securities laws.
The current ecosystem of crypto-currencies, tokens and other digital assets exceeds C$150 billion (or US$125 billion) and is expected to grow substantially in the near future. While still nascent, blockchain has already proven to be a remarkably distributive technology, particularly for emerging companies looking to access funds outside of traditional means of capital raising. Companies are increasingly looking to blockchain platforms to conduct globally distributed crowd-sales typically known as "initial coin offerings", "ICOs", "initial token offerings" or "token sales", allowing them to raise significant capital quickly and from a broad base of investors. Many of these ICOs are based in foreign jurisdictions and issuers have taken the position that if the issuance does not contravene the laws of the jurisdiction in which the issuer is domiciled, there is no need to consider or comply with securities laws in the jurisdiction of purchase. However, as the Report indicates, in the United States there is no magic dust associated with distributed ledger or blockchain tokens that suspends the ordinary application of U.S. securities laws.
The SEC Investigative Report
The DAO was formed with the objective of operating as a for-profit entity to hold assets through the sale of DAO tokens to investors in exchange for Ethereum cryptocurrency, which would then be used to fund "projects". The DAO tokens entitled holders to vote on proposals to fund projects and the holders of the DAO tokens stood to share in the earnings from these projects. Investors could also monetize their investment in DAO tokens by re-selling DAO tokens on a number of web-based platforms which supported secondary trading in the DAO tokens.
The DAO was particularly popular, raising over US$150 million from approximately 11,000 investors. However, shortly after the DAO tokens were sold, an attacker used a flaw in the DAO's code to steal approximately one-third of the DAO's assets. The Report was, in part, a response to the attack and addressed the threshold question of whether the DAO tokens are securities and subject to U.S. securities laws.
The Report concluded that DAO tokens are securities and therefore subject to U.S. securities laws. It further confirmed that issuers of distributed ledger or blockchain technology-based securities must comply with U.S. securities registration requirements or rely on an exemption therefrom. Furthermore, anyone engaging in the business of trading in such securities must consider whether they need to register as a broker, dealer, exchange and/or alternative trading system. In the U.S., those participating in unregistered ICOs may be liable for violations of U.S. securities laws.
Aspects of the Report are consistent with the opinions expressed by Canadian securities regulators to date, namely that in certain circumstances blockchain tokens may be securities and subject to applicable securities laws. The March 2017 news release of the Ontario Securities Commission advised that businesses that use distributed ledger technologies, such as blockchain, as part of their financial products or service offerings, may be subject to Ontario securities laws.
However, both the Report and the OSC news release suggest that whether or not a particular crypto-asset is deemed to be a security will likely be a factual test carried out on a case by case basis. Indeed, the Report distinguished Ethereum, a "virtual currency", from the DAO tokens, a security. The distinction may provide some comfort to concerned parties, as it signals that not all blockchain tokens will be considered securities by regulators. Of note in this instance is the light-handed approach employed by the SEC in not exercising its discretion to pursue civil penalties and disciplinary action against the relevant parties, despite concluding that the DAO offering had violated U.S. securities laws.
We anticipate that the Report will likely cause Canadian securities regulators to revisit this issue and provide more concrete guidance on what forms of distributed ledger or blockchain-enabled tokens will constitute a security under Canadian securities laws, marking the start of a period of enhanced regulatory scrutiny of crypto-assets in Canada.
Finally, the Report highlights the ongoing struggle faced by regulators, as they seek to facilitate innovative ways to raise capital and promote growth, while also ensuring investors and markets are protected.