The U.S. Securities and Exchange Commission has provided welcome guidance by publishing its most comprehensive statement to date on the treatment of digital assets – and the offer and sale of such assets by "virtual" organizations – under the federal securities laws. Such offers and sales, which organizations typically conduct using distributed ledger or blockchain technology, have been referred to, among other things, as "initial coin offerings" (or “ICOs”) or “token sales.” These transactions have proliferated recently, attracting the attention of the SEC and no doubt other regulators.
On July 25, the SEC issued an investigative report into a German group known as The DAO, a so-called “decentralized autonomous organization” that used blockchain technology to raise funds. The SEC found that The DAO used distributed ledger or blockchain technology to operate as a “virtual” entity and sold tokens representing interests in its enterprise to investors in exchange for payment with virtual currency. Investors could hold these tokens as an investment with certain voting and ownership rights or could sell them on web-based secondary market platforms. The SEC report concluded that the tokens such as those used in The DAO’s ICO are “securities” under the U.S. securities laws, and, among other consequences, the offers and sales of such tokens should be treated as securities offerings under the Securities Act of 1933, which act requires that any such offering either be registered with the SEC or carried out pursuant to some exemption from the SEC registration requirements.
The SEC report thus confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption from registration applies. Those participating in unregistered offerings may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities themselves must register with the SEC unless they are exempt. The SEC noted that the registration and other requirements of the federal securities laws apply to those who offer and sell securities in the United States, whether or not the issuing entity is a traditional company or a decentralized autonomous organization, those securities are purchased using U.S. dollars or other fiat currencies or virtual currencies, or they are distributed in certificated form or through distributed ledger technology.
Despite the novel technologies and other techniques that The DAO employed and which are employed in the crypto-currency industry at large, the SEC’s legal analysis relied on a basic and fundamental assessment of the definition of a security under the “investment contract” test and whether the tokens in question met that definition. In the statement announcing the publication of the report, the SEC staff reaffirmed the fundamental principle that the “hallmark of a security is an investment of money or value in a business or operation where the investor has a reasonable expectation of profits based on the efforts of others,” and explained that The DAO transaction satisfied that test and noted that anyone who solicits something of value in exchange for an interest in a digital or other novel form of storing value should carefully consider whether they are creating an investment arrangement that constitutes a security. According to the SEC, “[t]he definition of a security under the federal securities laws is broad, covering traditional notions of a security, such as a stock or bond, as well as novel products or instruments such as digital instruments, including crypto-currencies, tokens and the like, where value may be represented and transferred in digital form.”
Having found that the tokens in question constituted a security, the SEC concluded that the sponsor neither registered its offer and sale nor conducted the offer and sale in a way that qualified for an available exemption from registration, thus violating the Securities Act.
Apart from highlighting the basic Securities Act registration and disclosure requirements, the SEC cautioned that market participants in this area must also consider other aspects of the federal securities laws if they conclude that the assets in question meet the definition of a security under its guidance. According to the SEC, additional potential obligations include the following:
- if a platform facilitating transactions in such securities is operating as an “exchange,” the platform may require registration as an exchange or “alternative trading system” under the Securities Exchange Act of 1934;
- if the composition of assets of the entity offering and selling the security causes it to meet the definition of an “investment company,” even if inadvertently or temporarily, the entity may require registration under the Investment Company Act of 1940; and
- if a person provides advice about an investment in the security, it may be deemed an “investment adviser” and may need to register as such under the Investment Advisers Act of 1940.
The SEC report and accompanying statements provide valuable guidance in this fast moving and rapidly evolving field and at the same time make very clear that structuring an offering that involves digital instruments of value or operates using a distributed ledger or blockchain does not remove that activity from the requirements of the federal securities laws.