The Securities and Exchange Commission (the “SEC”) recently sent a warning to the burgeoning market for initial coin offerings (“ICOs”): assets that exist only on the blockchain may be securities subject to registration, anti-fraud and other requirements under the U.S. federal securities laws. The outcome of the SEC’s analysis was unsurprising, representing a reasonably straightforward application of longstanding securities law principles. However, the SEC’s discussion left several key questions and potential paths forward for ICO issuers and other participants in the ICO marketplace to consider.
The SEC’s guidance came in the form of an investigative report (the “DAO Report”) regarding tokens issued by The DAO. The DAO is an unincorporated organization that issued tokens (the “DAO Tokens”), digital assets that existed only as entries on a distributed ledger. Investors paid for tokens by transferring Ether, another digital asset that serves as a medium of exchange on the Ethereum blockchain. The DAO was created to pool Ether and fund “projects” that would generate returns for holders of DAO Tokens through dividend-like “rewards” and, presumably, capital appreciation. The innovation proposed by The DAO was to use “smart contracts,” computer programs that would act as self-executing agreements, to allow for a form of decentralized management. Rather than have a management team or investment advisor decide how the pool of Ether would be invested, holders of DAO Tokens would be able to vote on which projects to fund. A limited number of “curators” selected by the organization that formed The DAO, a German corporation called Slock.it, would determine which proposals received by The DAO would be put forward for a vote by holders of DAO Tokens. The curators were granted wide discretion in determining which proposals (including both proposed projects to be funded by The DAO and at least some matters regarding The DAO itself, such as replacement of the curators) would be put forward for a vote. Holders of DAO Tokens were incentivized to vote in favor of proposals put forward for a vote because DAO Tokens that were voted could not be transferred until the vote was completed, effectively pressuring holders that objected to a proposal to refrain from voting or transfer their DAO Tokens rather than voting no.
Slock.it and its founders engaged with several third party platforms to provide venues for secondary market trading of DAO Tokens. They also continued to work on behalf of The DAO after it became operational and completed its ICO, in particular on information security matters. They proposed taking additional measures to safeguard the Ether held by The DAO and, when an attack was launched resulting in the diversion of Ether from The DAO’s Ethereum blockchain address to that of the attacker, successfully advocated for an extraordinary revision of the Ethereum blockchain (known as the “hard fork”) to effectively return the stolen funds.
The SEC’s analysis
The SEC affirmed that digital assets such as DAO Tokens should be evaluated under the “investment contract” prong of the definition of “securities” in the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the Securities Act of 1933, as amended (the “Securities Act”). The SEC then went on to evaluate the DAO Tokens under the test laid out by the Supreme Court in SEC v. W.J. Howey Co., to determine if the DAO Tokens were “investment securities.” Under that test, an instrument is an investment contract, and thus a security, if it evidences (1) an investment; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) from the entrepreneurial or managerial efforts of others.
The SEC quickly addressed the first three elements of that test, finding that: (1) the payment of Ether in exchange for DAO Tokens constituted an investment of money; (2) persons purchasing DAO Tokens were investing in a common enterprise (which the SEC stated without analysis); and (3) purchasers of DAO Tokens would have been motivated, at least in part, by the potential for profits generated by returns on investments in projects funded by The DAO.
The SEC’s analysis focused mainly on the fourth part of the Howey test: whether investors’ profits were derived from the managerial efforts of others, given The DAO’s organization as an unincorporated, autonomous, virtual entity operating on the basis of smart contracts. In concluding that holders of DAO Tokens were relying on the entrepreneurial or managerial efforts of others, the SEC focused on the following facts:
- marketing materials and conduct by the creators of The DAO, Slock.it and its co-founders, led the purchasers of DAO Tokens to reasonably believe that its creators would provide “significant managerial efforts after The DAO’s launch”;
- the curators, who were selected by Slock.it and its co-founders, had wide discretion in determining which proposals would be brought to DAO Token holders for a vote;
- at the time of the ICO, “The DAO’s protocols had already been determined by Slock.it and its co-founders, including the control that could be exercised by the Curators,” and the SEC noted that investors “had little choice but to rely on their expertise”;
- it and its co-founders were actively engaged in monitoring The DAO, and the SEC noted their work on information security issues and remediating the effects of the attack on the Ethereum blockchain; and
- voting rights of holders of DAO Tokens were limited by a lack of information regarding the proposals and their inability to effectively coordinate to form blocs large enough to exert control of The DAO, meaning that DAO Token holders had little ability to exercise meaningful control over The DAO through the voting process, similar to the voting rights and power of a corporate shareholder.
The implications of the SEC’s finding that DAO Tokens are securities may have significant consequences. Unregistered offers and sales of securities that do not fall under an exemption from registration under the Securities Act expose issuers to two primary sources of liability: an SEC enforcement action and private suits by the purchasers of those securities. While the SEC declined to take enforcement action in this case, it may feel emboldened to do so in the future now that it has reminded the market that ICOs may involve offers and sales of securities within the meaning of the securities laws. Moreover, the SEC’s decision not to take enforcement action in this case would not preclude purchasers of DAO Tokens or instruments issued in prior or subsequent ICOs from taking action against the issuer for violating the Securities Act. The remedy available to private litigants for a violation of the registration provisions of the Securities Act is rescission – effectively giving the purchaser a put right against the issuer at the price it paid for the security. Additionally, even securities offered and sold in reliance on an exemption from registration under the Securities Act are subject to the antifraud provisions of the Exchange Act, including liability in connection with such offers and sales for any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. Finally, the SEC’s finding affects third party platforms that facilitate trading in DAO Tokens or similar instruments, requiring those entities to register under the Exchange Act as securities exchanges.
Open issues and avenues for further exploration.
The DAO Report addressed only one type of digital asset that was used to raise capital for an ongoing business. It does not expressly reach any conclusions with respect to other forms of digital assets. Whether or not a digital asset is a security will depend at least in part on the economic reality of why it was purchased (e.g., to use as a medium of exchange, participate in the profits or operations of an enterprise or to acquire goods or services). For example, the Supreme Court has held that shares in a co-op are not securities because they were purchased primarily to provide the holders with a place to live rather than as an investment. Digital assets will need to be closely evaluated on a case-by-case basis until additional guidance is released and market practice for different types of instruments develops.
In addition, the DAO Report expressly excludes any consideration of the Investment Company Act of 1940, as amended (the “1940 Act”) or the Investment Advisers Act of 1940, as amended (the “Advisers Act”), in part because The DAO never commenced business operations. A conclusion that The DAO was not an investment company, or an analysis of whether it fell under the “orthodox investment company” or “inadvertent investment company” prongs of the 1940 Act or if it fell within the definition of “investment adviser” under the Advisers Act would have likely necessitated a discussion as to whether or not Ether is a security, which, for purposes of the DAO Report, the SEC characterized as a “virtual currency.”
Treatment of DAO Tokens and similar assets as securities should not preclude the ICO market from continuing to expand. There is a deep market for securities that are privately placed and exempt from the registration requirements of the Securities Act. However, as noted above, even privately placed securities are subject to the anti-fraud provisions of the Exchange Act. As a result, the DAO Report implies that a greater degree of scrutiny as to the disclosure included in white papers and other marketing materials may be needed. It also implies an increased role for intermediaries in ICO offerings to facilitate compliance with private placement restrictions by, for example, and among other measures, pre-qualifying interested persons as “accredited investors” that can participate in private placements.
 The DAO Report is available at: https://www.sec.gov/litigation/investreport/34-81207.pdf (last accessed July 31, 2017).
 328 U.S. 293 (1946).
 The DAO Report at p.12.
 The DAO Report at p.13.
 See United Housing Found., Inc. v. Forman, 421 U.S. 837, 858 (1975).