After much anticipation, in July 2017, the U.S. Securities and Exchange Commission (“SEC”) announced that it would assert jurisdiction over initial coin offerings (“ICOs”) to the extent that the interests—commonly referred to as “tokens”—meet the traditional test of the definition of a “security” under U.S. securities law.
The announcement came in the form of a public report (“Report”) by the SEC of an investigation into an ICO by “The DAO,” a decentralized autonomous organization, which is a phrase used to describe a “virtual” organization existing only in cyberspace.
In this article, we discuss the factors that the SEC relied upon in reaching its determination that tokens may be investment contracts, and therein securities, and provide additional guidance as to the current U.S. regulatory regime impacting digital currencies.
In April and May of 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for about 12 million Ether (a virtual currency). The total offering raised approximately $150 million. A DAO Token provided the owner with both voting rights and a profit participation. Specifically, DAO Tokens gave their owners the ability to vote whether or not to fund certain proposals previously selected by The DAO management and a group of “Curators.” Profits generated by the proposals would be shared on a pro rata basis by owners of the DAO Tokens.
Additionally, the DAO Tokens were freely transferable and were traded on various electronic platforms. In its Report, the SEC noted that, from May to September 2016, one platform executed more than 550,000 spot transactions in DAO Tokens by more than 15,000 U.S. and non-U.S. customers.
Tokens Can Be Securities Under the Howey Test
Under federal securities laws, the Howey test is the traditional test used by the SEC and courts to determine whether a particular investment may be an “investment contract” (i.e., a security). Under the Howey test, “an investment contract 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.” As noted by the SEC, the test is flexible and one that “is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Here, the SEC found the DAO Tokens constituted an investment contract. First, although DAO Tokens were purchased with Ether, the SEC held that this “type of contribution of value” was sufficient to be considered an investment of money satisfying the first element of the Howey test. Second, The DAO was considered to be a “common enterprise” due to its collective nature as a “for profit entity.” Third, purchasers of DAO Tokens had a reasonable expectation of profits from projects funded by The DAO. Finally, to the extent that The DAO was managed by its founders and the “Curators,” and not by individual investors, profits would be derived from the “efforts of others.” Based on the foregoing, the SEC concluded that DAO Tokens were securities.
Registration Unless Exempt
Section 5(a) of the Securities Act of 1933 provides that it is unlawful to engage in an offer or sale of securities in interstate commerce unless a registration statement is in effect for the securities. As noted by the SEC in its Report, violations of Section 5 do not require scienter. While there are exemptions to Section 5 of the Securities Act, such as private placement exemptions provided for in Regulation D, reliance on a private placement exemption usually requires some type of affirmative action by the issuer of the securities, such as a notice filing, in order to perfect the exemption. Thus, to the extent DAO Tokens were securities that were offered and sold without a registration statement on file with the SEC, or in reliance on one of the private placement exemptions, such offers and sales would be in violation of Section 5 regardless of whether The DAO intended to comply with U.S. law.
Securities Exchange Issues
In addition, the SEC found that the electronic platforms upon which the DAO Tokens were traded should have been registered as “national securities exchanges” under Section 6 of the Securities Exchange Act of 1934. While “alternative trading systems” or “ATS” are generally exempt from registration, compliance with the exemption provided for in Regulation ATS requires, among other things, that the ATS register as a broker-dealer.
The SEC’s DAO determination is the latest in a string of determinations by other U.S. regulators with respect to cryptocurrencies. In September 2015, for example, in a matter involving Coinflip, the U.S. Commodity Futures Trading Commission (“CFTC”) took a significant step in asserting jurisdiction over cryptocurrencies when it issued an order determining that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” Later, in June 2016, the CFTC filed charges against Hong-Kong-based Bitfinex, which operates an online platform for trading in digital currencies, including bitcoins, for violating the CFTC’s “retail commodity transaction” requirements.
In its Report, the SEC has issued a clarion call to market participants exploring an ICO. An offering of tokens can be, and likely will result in, a securities offering subject to the federal securities laws. With the pronouncement by the SEC, coupled with the recent actions by the CFTC, cryptocurrency regulation has entered a new age.