Yesterday, the Securities and Exchange Commission published a Report of Investigation that concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or Blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement. (Click here to access the Commission’s Report.)
The SEC’s Report follows an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by Slock.it UG, a German corporation, were securities subject to the SEC’s registration requirements. According to the SEC, investors purchased DAO tokens through transactions on the Ethereum Blockchain in exchange for approximately 12 million Ether (“ETH,” a virtual currency) that was valued at approximately US $150 million at the time.
Notwithstanding its finding, the SEC determined not to take an enforcement action against the DAO entity, Slock.it, any of the natural person founders of the DAO entity or any entity that offered secondary trading in DAO tokens “based on the conduct and activities known to the Commission at this time.” The Commission also declined to take an enforcement action against any intermediary, including any trading facility, involved in the transactions.
According to the SEC, US federal securities laws “may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.” The SEC acknowledged in its Report that virtual organizations and associated persons are increasingly using distributed ledger technology to raise capital, sometimes in the form of “initial coin offerings” or “token sales.”
The SEC said that DAO’s founders designed the DAO entity as a for-profit enterprise that would create a number of assets to be funded through the sale of DAO tokens. Ownership of a DAO token would entitle a holder to vote on potential projects and to receive “rewards” that would essentially be ETH received by the DAO entity from funded projects.
As designed, “contractors” would submit proposals to the DAO entity. This would be done through a smart contract on the Ethereum-distributed ledger. Prior to any vote by DAO token holders, a proposal would be vetted by a group of curators chosen by Slock.it. Curators, said the SEC, “had ultimate discretion as to whether or not to submit a proposal for vote by DAO token-holders.”
After initial issuance, DAO tokens could be traded in a secondary market on various web-based platforms, including one US web-based platform. As it turned out, just prior to the expiration of the offering period of DAO tokens, an unknown hacker or hackers, illicitly diverted ETH raised from investors from the DAO entity to a web address controlled by the malfeasant. Ultimately, a majority of the Ethereum network agreed to a change in the Ethereum protocol that effectively restored DAO token holders’ investments as if the attack had never occurred, and permitted them to avoid any loss.
The SEC based its conclusion that DAO tokens were securities on the four-part test articulated in a landmark 1946 US Supreme Court decision, SEC v. W.J. Howey (click here to access). There, the Supreme Court ruled that a security includes an “investment contract” and an investment contract constitutes an (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. Applying this test to the DAO entity and DAO tokens, the SEC concluded that purchasers of DAO tokens (1) invested money in the form of ETH (2) to invest in a common enterprise, the DAO entity, (3) with an expectation of profits from projects. Moreover, the Commission concluded (4) that since the profits of the DAO enterprise would be derived significantly from the managerial efforts of Slock.it, its co‑founders and the DAO’s Curators, the fourth prong of the Howey test was also satisfied.
Simultaneously with the issuance of the Commission’s Report, the SEC’s Divisions of Corporate Finance and Enforcement issued a cautionary note that “Sponsors in an exchange of something of value for an interest in a digital or other novel form for storing value should carefully consider whether they are creating an investment arrangement that constitutes a security.” (Click here to access the Division’s joint statement.) The Commission also issued an Investor Bulletin cautioning investors regarding risks of participating in initial coin offerings. (Click here to access the SEC’s Investor Bulletin.)
The issuance of the Commission’s Report follows by one day the approval by the Commodity Futures Trading Commission of LedgerX as the first derivatives clearing organization authorized to provide clearing services for fully collateralized digital currency swaps. (Click here to access a copy of the CFTC’s Order.) Previously, LedgerX was approved by the CFTC as a swap execution facility for certain institutional customers known as “eligible contract participants” to execute transactions in swaps based on digital currencies. (Click here to access a copy of the CFTC Order.)
My View: Not all digital tokens are created equal. Some, like Bitcoin, function as a digital currency and are created through a process where miners solve mathematical formulas and are rewarded with an allocation of Bitcoin. Others, apparently like DAO tokens, are issued by entities to fund projects effectively controlled by a management team. The CFTC has determined that Bitcoin and other virtual currencies are commodities under applicable law and the offer and sale of derivatives based on digital currencies must be done in accordance with provisions of the Commodity Exchange Act and CFTC regulations. The SEC now warns that digital tokens that effectively represent investment contracts are securities subject to applicable securities laws and SEC regulations. Presumably, any digital token falling into this category is also potentially subject to state securities laws. What will be particularly challenging to navigate going forward is the gray area between or slightly outside these two types of digital tokens. There may be some virtual currencies that begin their life as mechanisms to raise funds to develop the relevant digital currency and later morph into pure digital currencies, and there may be digital tokens that represent ownership in a common enterprise where the holders may have more unique rights than did DAO token-holders (e.g., rights to mine, rights to access the system on preferential terms, rights to charge license fees directly) and be less dependent on the managerial efforts of others. Time will tell how regulators exercise jurisdiction over these other types of digital tokens. Hopefully, the result with not stifle the evolution of distributed ledger technology and derived applications.