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.
On March 15, 2016, national retailer Lord & Taylor agreed to settle FTC charges that it “deceived consumers by paying for native advertisements.” The settlement is the first of its kind following the December 2015 guidance memorandum, Native Advertising: A Guide for Businesses, issued by the FTC. Under the terms of the settlement, Lord & Taylor is prohibited from “misrepresenting that paid ads are from an independent source, and is required to ensure that its influencers clearly disclose when they have been compensated in exchange for their endorsements”.
On the day the settlement was announced, the FTC also published a copy of the underlying complaint. The complaint alleges that Lord & Taylor developed plans to promote a clothing line for women which included a comprehensive social media campaign of blog posts, photos, native-advertising editorials in online fashion magazines, and a team of “influencers” recruited for their fashion sense and audience on social media. The FTC alleged that Lord & Taylor edited, pre-approved, and paid for a favorable Instagram post that was uploaded to the account of a fashion magazine called Nylon. The regulatory agency further alleged that Lord & Taylor reviewed, pre-approved, and paid for a favorable article in Nylon. In both cases, however, Lord & Taylor failed to disclose its commercial arrangement with Nylon. Similarly, the FTC alleged that Lord & Taylor gifted a dress from the clothing line to fifty “influencers” who were paid between $1,000 and $4,000 to post favorable photos and comments about the dress on social media. Again, Lord & Taylor did not disclose or require influencers to disclose that they had been paid for their posts. Based on Lord & Taylor’s alleged misrepresentations and failure to disclose, the FTC accused Lord & Taylor of engaging in unfair or deceptive acts or practices in violation of the Federal Trade Commission Act.
What is Native Advertising?
Native advertising, also known as sponsored content, is designed to fit in with original online content in a seamless, non-intrusive manner. It allows advertisers to directly reach online consumers, without severely interrupting the original content on the publishing website, video game, or mobile app. In the past few years, this advertising has reached all corners of the internet.
FTC Concerns With Native Advertising
As native advertising has grown, so have the FTC’s concerns about the possibility of deceiving consumers. Therefore, at the close of 2015, the FTC released the guidance memorandum, Native Advertising: A Guide for Businesses, which provides details and illustrative examples for businesses that use native advertising as part of their online marketing campaigns.
Native advertising creates a particular challenge for advertisers. Advertisers want to design an advertisement that appears native to the original content, but must do so without potentially confusing the consumer, who may mistake the advertisement for non-advertising content.
To assist advertisers in complying with these rules, the FTC issued its December 2015 guidance memorandum with examples and tips to ensure advertisers remain compliant. Most of the memorandum focuses on seventeen examples of advertising, including on news sites, in videos, through content recommendation widgets, and in video games. These examples illustrate how and why consumers might be confused by certain native advertising tactics. Most of the examples show how a native advertisement might bear too much similarity to the original content, which means the consumer might not understand that what they are viewing is, in fact paid-for, sponsored content.
Complying With FTC Native Advertising Requirements
The take-away from the Lord & Taylor settlement is that advertisers should avoid placing paid ads that appear to be independent editorial content. Put simply, advertisers must choose between control and disclosure. In other words, advertisers who want to make use of native advertising and “influencers” on social media must either relinquish influence or control over the advertising content or disclose the nature of the marketing arrangement. Bottom Line: Paid advertising must be identifiable as advertising.
The FTC’s December 2015 memorandum provides a variety of tips on how to appropriately disclose native advertising. The disclosures should be three things: (1) placed near the advertising; (2) prominent; and (3) clear. By ensuring that native advertising follows these disclosure guidelines, companies will avoid misleading consumers into thinking their native advertisement is non-sponsored, publisher content.
Finally, the memorandum specifically notes who is affected by these disclosure rules. The enforcement is not limited to just the sponsoring advertiser. Advertising agencies and operators of affiliate advertising networks are also obligated to adhere to the FTC’s disclosure requirements.
Put simply, if a reasonable consumer might see your native advertising and believe it to be non-advertising content, the FTC will likely take issue with your native advertising tactics. This is exactly what we saw in the Lord & Taylor settlement.