On July 25, 2017, the U.S. Securities and Exchange Commission (the “SEC”) issued a Section 21(a) Report of Investigation (the “Report”) on the initial coin offerings (“ICO”) in the decentralized autonomous organization (“DAO”) created by Slock.it UG, a German corporation, through the Ethereum blockchain (the “Slock.it DAO”). The Report focused on the fact pattern of the ICO by the Slock.it DAO and whether the digital tokens in the ICO met the test for a “security” under federal law initially adopted by the U.S. Supreme Court in SEC v. W.J. Howey Co.1 (the “Howey Test”). While declining to take enforcement action against the Slock.it DAO, the SEC found that the Slock.it DAO digital tokens offered and sold in the ICO were securities and that the ICO violated U.S. securities laws by making an unregistered offer and sale of securities. The SEC published the Report to caution those in the cryptocurrency space using blockchain enabled means of capital raising that, depending on the facts and circumstances, an ICO of digital tokens could be considered securities and could be an illegal offering of securities unless registered with the SEC or an exemption from the registration requirements of the U.S. Securities Act of 1933, as amended (the “U.S. Securities Act”) is available. In addition, as part of the cryptocurrency ecosystem, the Report also addressed that market participants who provide a secondary market to trade digital tokens meet the definition of an “exchange” and would be required to register as such under U.S. securities laws. Concurrently with the Report, the SEC also released an Investor Bulletin on ICOs to make investors aware of the potential risks of participating in an ICO2.
Below is a brief overview of the ICO landscape, DAOs and the SEC’s Report.
ICO’s AND THE DAO
ICOs are a capital raising technique, unique to the cryptocurrency space, conducted using blockchain technology, the distributed ledger system that serves as the foundation for digital currencies such as Bitcoin and Ethereum. In an ICO a new digital asset (a coin or token) is created by the offering organization in exchange for Bitcoin, Ethereum or another existing cryptocurrency. The purpose of the ICO is to raise funds for a project, such as a DAO, starting at a future date allowing investors in the ICO to participate in the economy created by the project. Each ICO is different and the characteristics of coins issued in each ICO vary. The proposed project and the coins offered in an ICO are described in a White Paper but the information provided is very limited compared to a prospectus used in an initial public offering of securities.
The Slock.it DAO commenced an ICO selling 1.15 billion DAO tokens (“DAO Tokens”) to investors in exchange for 12 million Ethereum approximately equal to U.S.$150 million. The proceeds from its ICO were to be used to fund various projects proposed and voted on by holders of the Slock.it DAO Tokens, with a majority vote required for a project to proceed. However, as part of the process, the Slock.it DAO appointed certain “curators” (the “Curators”) that decided which proposals the holders of Slock.it DAO Tokens would get to vote on, as well as the order and frequency of proposals. Holders of Slock.it DAO Tokens would share in the earnings of proposed projects that moved forward or could also re-sell their Slock.it DAO Tokens on a number of web-based platforms that supported secondary market trading in cryptocurrencies and thereby monetize their investment3.
The Slock.it DAO Tokens Are Securities
The SEC stated that the Slock.it DAO Token were “securities” under Section 2(a)(1) of the U.S. Securities Act as they were an “investment contract” under the Howey Test4. The characteristics of an investment contract require an investment of money in a common enterprise with a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others. The Howey Test is an important piece in the SEC toolbox as it allows for a flexible approach in the consideration of what constitutes a security placing emphasis on the economic realities of the particular financial instrument.
The SEC easily concluded that the investors in the Slock.it DAO Tokens had invested money, noting that money need not take the form of cash5 and that investors reasonably expected profits, given that they were repeatedly informed in marketing materials that The Slock.it DAO’s objective was to fund projects in exchange for a return on investment.
The focus for the SEC was whether the investors were relying on the managerial efforts of others. While the investors had voting rights they did not have meaningful control over the Slock.it DAO due to the “perfunctory” nature of the voting on projects, as well as the inability of the holders to communicate with one another due to wide geographic dispersion. Control rested with the Curators, who were selected based on their expertise and credentials, and held the ultimate discretion over the proposals submitted and the proposals that would actually be voted on by the investors. The SEC also noted the fact that the Slock.it DAO’s founders were responsible for actively overseeing and safeguarding its operation. Essentially, investors had little choice but to rely on the expertise of the Curators and the Slock.it DAO’s founders.
The SEC concluded that the Slock.it DAO was an issuer that was required to register the offer and sale of Slock.it DAO Tokens because such tokens were securities offered and sold in the U.S. without a valid exemption from the registration requirements of the U.S. Securities Act.
The Report did not address ICOs that, rather than for speculative purposes, offer investors a coin or token that has some other practical utility such as accessing a product or service presently or in the future (“Access Tokens”). However, this does not mean that Access Tokens are not securities. Any founder of an Access Token ICO would be wise to keep the Howey Test in mind.
In a footnote to the Report, the SEC states it did not analyze the question of whether the Slock.it DAO was an investment company as defined under the Investment Company Act of 1940 (the “1940 Act”) because the Slock.it DAO never commenced business operations and funding projects. However, this is an important consideration for any DAO. If the business purpose of a DAO is to operate like a fund that would finance and hold interests in other projects that were securities, the DAO would likely fall within the definition of an investment company and would be required to register as such under the 1940 Act or avail itself of an available exemption.
DIGITAL ASSET EXCHANGES MAY BE REQUIRED TO REGISGTER WITH THE SEC
In the Report the SEC notes Rule 3b-16(a) of the Exchange Act which provides a functional test as to whether a trading system meets the definition of an exchange under Section 3(a)(1) of Exchange Act, which requires, in part, a marketplace “for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange”. The test requires that such trading system (i) brings together the orders for securities of multiple buyers and sellers; and (ii) uses “established, non-discretionary methods under which such orders interact with each other,” and that are accepted by those trading on the exchange.
The Report clarifies the SEC’s position that trading venues which allow for the purchase and sale of digital assets, where those assets would qualify as securities, would be required to register with the SEC as national securities exchange or operate pursuant to an exemption from registration (such as under Regulation ATS).
The SEC declined to take enforcement action against the Slock.it DAO and chose to issue the Report to provide guidance to the nascent and rapidly evolving cryptocurrency market. The Report is welcomed guidance and an acknowledgement that ICOs can be an acceptable alternative to a traditional initial public offering for raising capital. However, cryptocurrency market participants should note the following:
- Not all ICOs will be an offering of securities. However, an ICO should be analyzed using the traditional approach (i.e. the Howey Test) to determine whether such ICO is an offering of securities. Each ICO should be analyzed based on the economic realities of the transaction and the facts and circumstances of the ICO, giving priority to function over form.
- It is established that cryptocurrencies are a form of money. Whether or not an ICO is a securities offering will focus on whether investors in the ICO have a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others.
- The SEC’s analysis focused on the “entrepreneurial or managerial efforts of others” prong of the Howey Test. Careful consideration must be given to the actual level of participation required by investors in the contemplated project of an ICO and whether or not meaningful control is provided or such control is simply “perfunctory” in nature.
- An ICO that is an offering of securities must comply with U.S. federal securities laws, including the requirement to register with the SEC or to qualify for an exemption from the registration requirements (such as in a private placement pursuant to Regulation D).
- Any marketplace on which digital assets are traded should consider if any such digital assets constitute a security and whether registration with the SEC as a national securities exchange is required or an exemption from such registration is available.
- Any person who receives compensation in connection with a coin or token sale may be required to register as a broker-dealer.
- Any person who provides advice regarding the investment in or value of the tokens may be required to register as an investment adviser.
- A DAO, depending on its business model, may potentially be required to register as an investment company under the 1940 Act unless there is an exemption from such registration available.
- An ICO of Access Tokens and the associated White Paper should not promote future returns, explicitly or implicitly, and should always consider whether the ICO is an offering of securities.
If you are considering making an investment in or launching an ICO Nauth LPC would be happy to guide you through the current regulatory landscape. Please contact Daniel D. Nauth at 416-477-6031 or firstname.lastname@example.org.
1 SEC v. W.J. Howey Co. et al., 328 U.S. 293 (Oct. 14, 1946).
2 The release by Nauth LPC on the Investor Bulletin can be found here.
3 The White Paper, titled “Decentralized Autonomous Organization to Automate Governance Final Draft – Under Review”, can be found here
4 The SEC decision in Howey formed the basis for analysis in Pacific Coast Coin Exchange v. OSC (1977), a leading case in Canada on the analysis of what constitutes a security. The release by Nauth LPC containing the discussion on Canadian securities law and cryptocurrencies can be found here.
5 The SEC Division of Enforcement made a similar argument in SEC v. Trendon T. Shavers and Bitcoin Savings and Trust, Civil Action No. 4:13-CV-416 (E.D. Tex., complaint filed July 23, 2013), where the Eastern District of Texas concluded that Bitcoin is a form of “money,” satisfying the first prong of the Howey Test.