Since the inception of cryptocurrencies like Bitcoin, distributed ledger or blockchain transactions have provided creative entrepreneurs with an opportunity to circumvent financial regulations. In response to the emergence of new digital currencies that support more versatile uses of the technology, new companies have begun to offer their own blockchain tokens to potential investors in lieu of stock or other securities. This use of the distributed ledger technology has now garnered the attention of the Securities and Exchange Commission.
On July 25th, the SEC issued an investigative report targeting this recent trend of blockchain organizations raising capital by offering or selling of digital tokens, commonly referred to as “Initial Coin Offerings” or “Token Sales.” In its report, the SEC concluded that such offers and sales may be considered securities and therefore subject to the requirements of the federal securities laws. This report was issued after an investigation into “The DAO”, a decentralized autonomous organization, that in Q2 2016 offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether, the virtual currency used on the Ethereum Blockchain.
The blockchain industry awaited the SEC’s report with great anticipation, concerned with the effect the investigation of The DAO would have on similar transactions. Undoubtedly many in the industry will consider the report evidence of the SEC’s intent to constrain this otherwise viable alternative method of financing between sophisticated parties. However, the conclusions reached by the SEC were not entirely unforeseen and ultimately were in line with expectations of securities experts.
In its report, the SEC committed to reviewing each blockchain offering individually to determine whether it met the Howey test definition of an “investment contract.”1 Thus the SEC will consider whether a particular distributed ledger transaction “involves the offer or sale of a security… will depend on the facts and circumstances, including the economic realities of the transaction.”2 For the SEC, and all parties involved, the challenge here is that the tokens themselves can be, and often are, used for dual purposes: (a) fundraising to support the development and maintenance of the platform and the underlying company managing that platform and/or (b) providing licenses to the users to access and transact on the platform.
The SEC further acknowledged it would look past the form of the digital token transaction to the underlying function of the offering or sale itself to determine if the transaction was for an investment purpose rather than simply to provide an investor user access to the given platform. The SEC signaled that if the function of the underlying token was for the expectation of profit derived from the entrepreneurial or managerial efforts of others, the SEC would likely find that the United States federal securities laws apply “regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchases using U.S. dollars or virtual currencies, and regardless of whether they are distributed in certificate form or through distributed ledger technology.”3
Consequently, distributed ledger technology organizations and companies seeking to raise funds to support the development of their platform likely must register their offerings or sales of digital tokens unless a valid securities exemption applies, such as the common Regulation D offering or crowdfunding under the JOBS Act.4 Furthermore, digital token trading systems involved in the same transaction must also likely register as a national security exchange.5 Despite these findings, the SEC stated that it would not bring any charges or make any findings of violations against The DAO at this time. This result is likely because the SEC did not want to chill the industry by starting its regulatory process by punishing participants in this emerging space.
Nevertheless, the SEC report leaves open several questions, including where to draw the line between an “investment contract”, under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, and a grant of a virtual license or franchise right that would presumably still be outside of securities registration under the federal laws.
The SEC investigation of The DAO arose out of security concerns during the offering where an unknown individual or group rapidly diverted a third of the raised digital currency into a controlled account, which resulted in the adoption and implementation of a “Hard Fork” by the platform users to revert the entire network back to its prior state before the hack. With blockchain transactions, which are automatically executed, cleared, and settled within a matter of minutes, security breaches by bad actors cannot be reversed without agreement among the platform community to re-write the base code to undo the fraud.
Accordingly, because The DAO hack raised significant concerns as to the viability of the technology as a vehicle for investment, it is undetermined how the underlying facts of this particular distributed ledger technology organization will impact the SEC’s future enforcement efforts in this area. However, the SEC at least made clear that it intends to further its stated mission of protecting investors through the application of securities regulations to blockchain transactions, especially in cases where digital tokens are exchanged for the expectation of future profits arising from the new technology company that is funded by the offer or sale.
1 An “investment contract” under the Howey test is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See Report of Investigation Pursuant to Section 21(a) of Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207, *11 (July 25, 2017) (citing SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946)).
2 Id. at 17-18.
3 Id. at 11-13, 18.
4 Id. at 15-16.
5 Id. at 16-17.