The SEC announced yesterday that “offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.” Although not coming as a surprise, the SEC’s announcement affirms that companies seeking to involve US investors in an initial coin offering (ICO) must register offers and sales with the SEC or else qualify for an exemption.
The SEC chose the token offering by the Distributed Autonomous Organization (DAO) in April-May 2016 as the focus of the study. The DAO was built on top of the Ethereum blockchain by the German unincorporated organization Slock.it, and the success of its token offering ushered in the current wave of ICO activity. Although questions surrounded the DAO offering in terms of its prospective treatment under US securities laws, the DAO made headlines when it suffered an exploitation that led to the loss of $50 million in Ether. Although the SEC found that DAO “may have violated federal securities laws,” it decided against pursuing an enforcement action, choosing instead to use DAO as a demonstrative for future ICOs (“to advise those who would use a Decentralized Autonomous Organization … or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws”).
To reach its conclusion that DAO fell under U.S. securities laws, the SEC applied a traditional four step analysis derived from U.S. case law (most notably SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946)). Under that analysis, the SEC held that:
- Foundational principles of the securities laws apply to virtual organizations or capital raising entities making use of distributed ledger technology
- Investors in The DAO invested money
- These investors had a reasonable expectation of profits
- The profits were to be derived from the managerial efforts of others
Accordingly, the DAO should have registered—and entities planning operations similar to the DAO must register—offers and sales of tokens, and they must register as national securities exchanges, unless certain exemptions apply.
The SEC report, together with the Investor Bulletin on ICOs also issued by the SEC, provide the beginning of long-awaited SEC guidance for companies contemplating ICOs. (See Steptoe’s analysis of the SEC Investor Bulletin: Initial Coin Offerings here.) Some companies might pull ICOs out of U.S. markets altogether following the announcement. But others see SEC regulation as an opportunity to gain legitimacy and weed out illegitimate or fly-by-night ICOs. Registration with the SEC is an involved process, but it certainly can be done by ICO companies. San Francisco-based Blockchain Capital raised $10 million a few months ago after registering its token as a security.
The story is still unfolding, but whichever way the companies react, there’s no doubt that the SEC report is an ICO game-changer.
Read the SEC report here.
Read the SEC press release here.