Today, the Securities and Exchange Commission (“SEC”) issued an investor bulletin and an investigative report. The investigative report found that companies involved in sales of digital assets via distributed ledger or blockchain technology may be engaged in conduct subject to federal securities laws. While this report is the first of its kind to address initial coin offerings (“ICO”) or token sales and securities regulation, companies looking to launch their own ICOs can learn from the unique circumstances addressed in today’s report.
The SEC began investigating token sales in light of The DAO hack last summer. The DAO and related entities are a “virtual” organization running on blockchain technology. To fund its own development, The DAO developed DAO Tokens, which were then issued to investors through an initial token sale. This sale gave customers a chance to invest in the company by spending their Ether, an Ethereum, blockchain-based cryptocurrency, to purchase DAO Tokens. The revenues from the coin sale funded various projects at The DAO, and investors could make money if their projects were profitable. Additionally, investors could resell their DAO Tokens on secondary platforms. These activities came to the SEC’s attention after a hack caused The DAO to lose a third of its investments (although this was ultimately recovered via a technological solution that reversed the blockchain of The DAO, which was permissible because a majority of the DAO Token holders voted in favor of the reversal).
In its investigative report, the SEC concluded that the DAO Tokens were subject to SEC regulations, even though it chose not to file charges at this time. Specifically, the Commission concluded that all elements of a security, as defined in federal securities law, were met in the sale of the DAO Tokens: (1) Investors used money – in the form of Ether – to invest in The DAO, (2) with a reasonable expectation of profit, (3) that was derived from the managerial efforts of others.
The management of The DAO appears to have been a central concern in the SEC’s evaluation. The DAO was run by others and subject to their oversight. Those people were referred to as “Curators,” and they had a significant amount of control over the projects that would be funded by The DAO. Token holders could only vote on projects that the Curators pre-approved. Further, on top this management problem, the SEC expressed concerns that given the pseudonymous purchases of DAO tokens, the ability of investors to organize to “effect change or to exercise meaningful control.”
At this time and presumably because the ICO industry is new and developing, the SEC has declined to pursue an enforcement action against The DAO and related entities. However, it has used The DAO matter as a case study to examine this novel issue and provide guidance to others involved in ICOs and blockchain-based investments.
This is an innovative and developing area, as noted by SEC Chairman Jay Clayton, who stated today: “The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.” (In addition to the report, the SEC also published an investor bulletin on ICOs.)
Companies interested in funding their ventures through ICOs must take note of this opinion. While the final report notes that the applicability of laws to a token sale “depend[s] on the particular facts and circumstances,” this SEC investigative report should serve as official notice to all companies working in this emerging field that federal securities laws may apply to them. However, the DAO situation is unique and the SEC’s findings are quite narrow, so this report won’t be controlling precedent for every ICO in the future. Because The DAO’s coin sale was purely for investment, denying investors meaningful input into the company, DAO Tokens were classified as securities under the applicable federal laws. In contrast, a company offering coins in a less centralized system where investors have more freedom to manage their coins would avoid being classified as a security.
The Chairman’s statement makes clear that the Commission is still in the learning phase and open to guidance from industry experts. Leaders must take this opportunity to not only educate the regulators, but also to listen to and adapt to regulatory concerns. This is not at all a fatal blow to the market, but companies must ensure their offerings comport with federal securities law while also providing attractive, innovative options to new investors.