On July 25, 2017, the SEC announced to the cryptocurrency community that it is closely watching initial coin offerings ("ICOs") and, going forward, may consider tokens sold in ICOs to be "securities," subject to regulation under U.S. law. Importantly, the SEC did not say that all coin offerings are securities; rather, whether a given coin offering constitutes a security will depend on the individual "facts and circumstances" of each case. Nevertheless, the SEC's warning no doubt presages future investigations and enforcement actions in the virtual currency and ICO space, as the agency looks to assert its regulatory authority over the new technology. 

The SEC's Enforcement staff issued a Report of Investigation ("ROI") following an inquiry into a German corporation behind a group called "The DAO" (for "Decentralized Autonomous Organization") which raised $150 million in an ICO in mid-2016. While the ROI's conclusions nominally pertain only to The DAO, the SEC staff clearly signaled its intention to apply the position outlined in the ROI market-wide. 

The SEC's key conclusions were: 

  • The DAO tokens, which stood to share in the anticipated earnings from projects selected and funded by the community of DAO token holders, are "investment contracts" and therefore, "securities," requiring token issuers to register with the SEC under Section 5 of the Securities Act; and 
  • Platforms used by DAO token holders to buy and sell tokens in the secondary market using virtual or fiat currencies are an "exchange[s]," required to be registered with the SEC under Section 6 of the Exchange Act. 

In addition, the SEC also hinted strongly that the founders and managers of The DAO, who were responsible for reviewing, curating and selecting a menu of potential investments from which token holders chose to fund business opportunities, may be "[i]nvestment adviser[s]" under Section 202(a)(11) of the Investment Advisers Act of 1940. 

In finding that The DAO tokens were "securities," the SEC, applying the well-known Howey test, relied on the following facts and circumstances concerning The DAO: 

  • The investment of the cryptocurrency Ether ("ETH") in The DAO was the same as the investment of "money";
  • Purchases of DAO tokens were investments in a "common enterprise" with the "reasonable expectation of making profits" because ETH was pooled and available to The DAO to fund projects aimed at making money and distributing profits to token holders; and
  • Any profits made by DAO token holders derived in significant part from the managerial efforts of others — namely The DAO management, which was responsible for vetting and selecting projects for potential funding. And while non-management token holders retained voting rights that influenced the investments, those rights were narrow and, under the circumstances, left them with little practical control over the business endeavors.

Beyond the immediate impact on pending or future ICOs, the SEC staff's newly-announced position also raises important second-order questions over how the federal securities laws will apply to this technology. For example, SEC-registered coin issuers — or unregistered issuers whom the SEC later determines should have been registered — become subject to Regulation FD and insider trading laws, among countless other regulations. Regulation FD requires that issuers disclose material information to all investors at the same time, and insider trading laws prohibit the purchase or sale of securities based on material non-public information. Therefore, issuers and their personnel who selectively release or withhold information from token holders, or those who buy and sell tokens while in possession of material information, could be exposed to significant liability under U.S. law.

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