On July 25, the SEC released an investigative report warning
that "virtual" organizations' offers and sales of
digital assets may be subject to the requirements of the Securities
Act of 1933 and the Securities Exchange Act of 1934.
The report arose out of the SEC's Division of
Enforcement's investigation into a "virtual"
organization called The DAO and several related entities to
determine whether they violated federal securities laws through the
unregistered offers and sales of DAO Tokens in exchange for "Ether," a
virtual currency. Critics have previously urged investors to
exercise caution regarding such virtual transactions, which have
drawn criticism due to a relative lack of transparency, oversight
and disclosure requirements compared with traditional securities
offerings. However, while the SEC's report does not indicate
that all offerings by virtual organizations are securities, the
report puts the industry on notice that some virtual tokens may be
securities.
The DAO was created by Slock.it, a German blockchain corporation,
which was also subject to the SEC's investigation along with
Slock.it's co-founders and other intermediaries. The DAO was
created as a for-profit crowdfunding entity that would hold assets
raised through the sale of DAO Tokens. The proceeds of this virtual
currency "token sale" – also known as an initial
coin offering (ICO) – would then be used to fund various
projects, with investors standing to gain additional DAO Tokens as
their share of any potential project earnings. However, after the
DAO raised approximately $150 million in a May 2016 ICO, a hacker
exploited a flaw in The DAO's code and stole approximately $50
million before any projects were funded.
In its report, the SEC acknowledged the increased prevalence of
ICOs in recent years, which it indicated prompted it to release the
findings of the investigation "to demonstrate the application
of existing U.S. federal securities laws to this new
paradigm." To that end, it determined that the DAO Tokens
involved in the offering exhibited the typical attributes of, and
therefore were, a security, regardless of their form. Specifically,
the DAO Tokens offering represented an investment contract. Those
participating in the ICO invested money – which the SEC
clarified "need not take the form of cash" but may be in
the form of a virtual currency, such as Ether – and had a
reasonable expectation of profit for doing so. In finding that the
DAO Tokens were securities, the SEC applied the Howey test
(from SEC v. W.J. Howey Co., 328 U.S. 293 1946) to
conclude that the DAO Tokens were investment contracts and, in
turn, securities. Very simply, the Howey test requires
that (1) there is an investment of money in a common enterprise,
(2) the investors had a reasonable expectation of profit and (3)
these profits are derived from the managerial efforts of others.
This last point was supported by the strong role The DAO's
management played in safeguarding investor funds and determining
whether various investments would be considered for investment by
The DAO.
Further, the SEC reminded the industry that Section 5 of the
Securities Act of 1933 prohibits the unregistered offer or sale of
securities in interstate commerce and that the offer or sale of
securities to the public must be accompanied by the "full and
fair disclosure" provided by an entity's registration with
the SEC. Although The DAO was described as a "crowdfunding
contract," through its investigation the SEC determined it
would not have qualified under the traditional Regulation
Crowdfunding exemption as it was not a broker-dealer or funding
portal registered with the SEC and the Financial Industry
Regulatory Authority (FINRA).
The SEC determined it would not pursue any enforcement action in
the matter based on the conduct and activities it uncovered,
choosing instead to communicate the findings as a cautionary tale.
Nonetheless, the investigative report makes clear that ICOs from
such virtual organizations are on the SEC's radar and that, in
the absence of a valid exemption, the regulator intends to hold
such entities to the same regulatory standards as traditional
securities transactions.
Concurrently, the SEC's Office of Investor Education and
Advocacy issued an investor bulletin designed to
further educate investors about ICOs, including definitions of
several key terms. Similar to the investigative report, the
bulletin indicates that virtual coins or tokens may qualify as
securities and be subject to securities laws, including the
associated disclosure requirements and other investor protection
measures. It also reminds investors of the red flags (e.g.,
unsolicited offers, no net worth or income requirements, pressure
to buy right now) related to investment fraud and highlights the
risk of fraud that may arise from investment schemes based on
emerging technologies.
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.
