The SEC has recently taken several actions to make clear that it is focused on and actively monitoring the market for ICOs.
On July 25, 2017, the SEC’s Division of Enforcement issued a Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (DAO Report). This report states that “The DAO is one example of a Decentralized Autonomous Organization, which is a term used to describe a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” The DAO Report concludes that the digital tokens, which were issued for the purpose of raising funds for projects, may be deemed to be securities under the federal securities laws. Accordingly, the SEC concluded that such securities must be registered with the Commission or eligible for an exemption from the registration requirements. The same day, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin, addressing the topic of ICOs more generally. The Investor Bulletin also highlights the risks of ICO investing and provides guidance for potential investors. Concurrently, the SEC’s Divisions of Corporation Finance and Enforcement released a joint statement supporting the DAO Report and Investor Bulletin. In their statement, the Divisions noted that “the issue of whether a particular investment opportunity involves the offer or sale of a security – regardless of the terminology or technology used in the transaction – depends on the facts and circumstances, including the economic realities and structure of the enterprise.”
Although the conclusion in the DAO Report was the result of a fact-based inquiry, the SEC described its views with respect to ICOs in terms of general applicability, indicating the SEC’s intention to implement these views broadly in the future. Because they do not otherwise appear under the definition of security, the SEC sought to characterize The DAO tokens under the “investment contract” test initially adopted by the U.S. Supreme Court in SEC v. W.J. Howey Co., where the Supreme Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others.2 Under the SEC’s analysis of the Howey test, not all tokens are securities, and potential issuers should consider the expectations of potential investors and the rights afforded in connection with an ICO under such test. While the SEC decided not to pursue enforcement in the matter of The DAO, the DAO Report is a reminder that all offerings of tokens within the United States must be conducted in accordance with the federal securities laws or fall within an exemption. The DAO Report also raises a serious concern that, absent an exemption, platforms that operate as U.S. exchanges to trade such tokens may need to register as a national securities exchange or alternative trading system. Furthermore, any person who receives compensation from the sale of tokens may need to register as a broker-dealer, and any person who provides investment advice with respect to a token sale may need to register as an investment adviser. Further, the DAO Report warns “[t]hose who would use virtual organizations” to review their obligations under the Investment Company Act of 1940.
Shortly thereafter, on August 28, 2017, the SEC published an Investor Alert “warning investors about potential scams involving stock of companies claiming to be related to, or asserting they are engaging in, [ICOs].” The Investor Alert warns that potential scammers may use the lure of new and unfamiliar technology to convince investors to participate in what may be scams, “includ[ing] ‘pump-and-dump’ and market manipulation schemes” in connection with publicly traded companies trying to take advantage of the hype associated with these new technologies. The Investor Alert acknowledges that ICOs themselves may be “fair and lawful investment opportunities,” while cautioning that publicly traded companies may try to use an ICO “to affect the price of the company’s common stock.” According to the Investor Alert, the SEC recently halted trading in the securities of four issuers “who made claims regarding their investments in ICOs or touted coin/token related news.” In addition to halting trading in the securities of issuers, at least one start-up in the process of raising money through an ICO has reported that it was contacted by the SEC.
Since the publication of the Investor Alert, several SEC officials have made public remarks regarding ICOs. Steven Peikin, Co-Director of the SEC’s Enforcement Division, reportedly stated, in connection with ongoing investigations into potential fraudulent activities by companies in the blockchain and digital currency space, that some of these companies “are really just trying to steal people’s money.”3 At a separate speaking engagement, Wesley Bricker, the SEC’s Chief Accountant, noted that for ICOs deemed to be securities, “The SEC's registration requirements … include various requirements for filing of audited financial statements.”4 Mr. Bricker cautioned that ICO issuers should consider both accounting and reporting guidance, such as U.S. GAAP, when preparing related financial statements.
Most recently, on September 25, 2017, the SEC announced the creation of a Cyber Unit within the SEC’s Enforcement Division, which is intended to build on the Division’s “ongoing efforts to address cyber-based threats and protect retail investors.”5 The Cyber Unit will focus on, among other things, “[m]anipulation schemes involving false information spread through electronic and social media” and “[v]iolations involving distributed ledger technology and initial coin offerings.”
Since the publication of the DAO Report on July 25, 2017, more than $600 million has been raised through ICOs.6 It is thus not surprising that the SEC, along with regulators in a growing number of foreign jurisdictions, are sharpening their focus on the rapidly developing market for ICOs. For additional information regarding considerations in determining whether an ICO is a security, please refer to Dechert OnPoint, SEC Focuses on Initial Coin Offerings: Tokens May Be Securities Under Federal Securities Laws.