United States: SEC Issues Guidance On Initial Coin Offerings And Digital Assets

Michael T Boardman is an Associate at our Los Angeles office



HIGHLIGHTS:

  • The U.S. Securities and Exchange Commission (SEC) has issued a "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO," weighing in on what are known as Initial Coin Offerings (ICOs).
  • The SEC's Report is a clear warning that ICOs offered or sold in the United States and digital assets traded in the U.S. may be subject to the federal securities laws.
  • The SEC's Report also firmly puts to rest the misguided notion that ICOs are a loophole to the SEC's regulatory oversight of capital-raising.

The U.S. Securities and Exchange Commission (SEC) on July 25, 2017, issued a "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO," weighing in on what are known as Initial Coin Offerings (ICOs).1 The SEC's Report is a clear warning that ICOs offered or sold in the United States and digital assets traded in the U.S. may be subject to the federal securities laws.

To date, ICOs have facilitated the raising of hundreds of millions of dollars in capital, often without regulatory oversight, by selling digital "tokens" that are tradable across a blockchain network. Analyzing a recent high-profile offering from an entity known as The DAO, the SEC concluded that, depending on all of the surrounding facts and circumstances:

  1. An ICO may constitute an offer or sale of securities that is subject to the registration and disclosure provisions of the federal securities laws
  2. Any person or entity who brings together orders for securities (which include digital assets generated through the ICO process) of multiple buyers and sellers must register as a national securities exchange or operate pursuant to an exemption from such registration
  3. Virtual organizations such as The DAO might constitute "investment companies" and, therefore, be subject to the extensive regulatory requirements of the Investment Company Act of 1940
  4. Individuals who participate in such activities without complying with the federal securities laws may be subject to personal liability

The SEC's Report firmly puts to rest the misguided notion that ICOs are a loophole to the SEC's regulatory oversight of capital-raising. All individuals and entities who are considering becoming involved in ICOs (including facilitating trading the resulting digital assets) in the United States are now on notice that 1) their activities may be subject to the federal securities laws and 2) the SEC will enforce compliance with such laws.

The DAO and Its Offering

In Spring 2016, a small group of entrepreneurs launched The DAO, a revolutionary new form of fundraising over the internet. The DAO issued what it called "tokens" on the Ethereum blockchain network, which could be purchased with Ether (ETH), Ethereum's native cryptocurrency. The DAO was intended to be a democratically controlled organization in which owners of its digital tokens would be able to vote, on a pro rata basis, on project proposals on which The DAO could deploy its capital. The DAO Tokens were also treated as investment opportunities that were expected both to generate profits and to increase in value as they increased in popularity, and could be sold in secondary markets. Within a month, The DAO had raised more than 11 million ETH (then valued at nearly $150 million) from 18,000 stakeholders. Using today's exchange rate for ETH (approximately $220), this translates to nearly $2.5 billion.

The Hack and Resulting Hard Fork

Shortly after The DAO offering closed, an unknown attacker took advantage of a faulty line of code in the smart contract that controlled the flow of ETH virtual currency within The DAO's control and diverted approximately 3.6 million ETH units (nearly one-third of The DAO's capital) from The DAO's blockchain address to the attacker's address. The attacker was ultimately stymied, however, because provisions in The DAO's code required the ETH virtual currency to remain effectively frozen for 27 days. During that time, the Ethereum network agreed to implement a "hard fork" of the Ethereum blockchain that copied all of the existing information in the Ethereum blockchain onto a new blockchain. It also enabled the transfer of all ETH funds raised by The DAO to a recovery address so that DAO Token holders could exchange their tokens back to ETH virtual currency and recoup their initial investment. A majority of the Ethereum community chose this pragmatic approach, rejecting the more dogmatic notion that to effectively unwind a transaction on the blockchain was a violation of the fundamental premise that blockchains are immutable ledgers.2

Some refused to participate in the hard fork and have continued to support and propagate the original Ethereum blockchain, which is now known as Ethereum Classic (ETC). In this competing reality, the individual responsible for the attack is able to keep the spoils of its theft, albeit in the form of ETC, not ETH. ETC virtual currency currently trades at a $15 per unit market price, which means that the culprit is still sitting on some $54 million of ETC virtual currency units.3

Despite these problems, The DAO's successful debut inspired a wave of other ICOs; to date, there have been hundreds of ICOs, with dozens (possibly hundreds) more in the pipeline.

Digital Tokens Issued in an ICO Are Securities Under Federal Securities Laws

Perhaps because of The DAO's overnight success and the fact that its vulnerability to theft had not been disclosed to investors, the government quickly took an interest in ICOs. The SEC's Report applied the Howey test4 to The DAO Tokens and determined that they constituted "investment contracts," meaning that they were "securities" under federal law. (See Report at 11.) Under the Howey test, an investment contract is "an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others." (Id.)

In concluding that the Howey test was satisfied, the SEC's Report expressly noted that "[i]n determining whether an investment contract exists, the investment of 'money' need not take the form of cash" and that an investment of a cryptocurrency such as ETH "is the type of contribution of value that can create an investment contract under Howey." (Id.) After examining all of the relevant facts and circumstances surrounding The DAO offering, the SEC's Report also concluded that the Howey test was met because investors in The DAO Tokens had a reasonable expectation of profits that depended on the managerial efforts of others. (Id. at 11-14.)

As a result, the SEC found that The DAO was an issuer of securities within the meaning of the federal securities laws. (Id. at 15-16.)5 This meant that The DAO offering was subject to the same registration and disclosure rules that apply to any issuer of securities in the U.S.:

Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws. The registration requirements are designed to provide investors with procedural protections and material information necessary to make informed investment decisions. These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology. (Id. at 18.)

And, because the DAO Tokens are securities under federal law, persons who facilitate their trading or exchange in the U.S. must register as a National Securities Exchange or come within an exemption from such registration:

In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration. (Id.)

Finally, the SEC's Report raised the specter that organizations conducting ICOs might constitute "investment companies" and, therefore, be subject to extensive regulatory requirements of the Investment Company Act of 1940.6

Conclusion

The SEC's Report is a clear warning that any entity or individual involved in an ICO or the trading of digital assets may be subject to the federal securities laws and to an enforcement action by the SEC for noncompliance with those laws. The SEC has extensive enforcement powers and may seek, among other things, injunctive relief, the disgorgement of all ill-gotten gains and pre-judgement interest thereon, civil money penalties and bars against individuals serving in certain capacities. Given the SEC's enforcement interest in this area, any person contemplating involvement with an ICO or the trading of digital assets in the U.S. should strongly consider obtaining advice from legal counsel who is both schooled in the federal securities laws and has a sufficient understanding of the relevant technologies.

Holland & Knight has both highly experienced SEC defense counsel as well as a well-established team dedicated to blockchain and distributed ledger technology, with more than 20 lawyers throughout the country involved in the practice.    

Footnotes

1 Reports of Investigations under Section 21(a) are uncommon (this was the eighth such report issued over the last decade) and are intended to alert the public about enforcement positions the SEC will take going forward.

2 In an ironic twist, the individuals who created The DAO had been associated with the mantra: "Code is law." A common meaning of this phrase is that computer code is a superior form of contracting versus our traditional human prose contracts because of its highly deterministic outcome. Proponents of the "code is law" mantra believed that, by distilling the governance of The DAO to computer code, recourse to traditional laws would be unnecessary. After the removal of the ETH tokens, however, the individuals who created The DAO supported the hard fork in order to prevent the "theft" of the ETH tokens. Many in the blockchain community were quick to remind them and other proponents of The DAO that if the code permitted the individual to withdraw the tokens, then that was the "law" and his or her actions could not properly be considered theft.

3 Markets have signaled that ETH will be the dominant currency going forward, but ETC will continue to battle for legitimacy.

4 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

5 Bitcoin should be largely unaffected by the SEC's Report, as it has no issuer, does not distribute any profits and because new tokens are issued only to people who actually provide a service to the network by batch processing transactions into data objects known as "blocks" (i.e., mining).

6 The SEC's Report stated that it had not analyzed this question, but pointedly warned that "[t]hose who would use virtual organizations should consider their obligations under the Investment Company Act." (Report at footnote 1.)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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