ICOs and Regulatory Woes
Last year, the SEC broke its long silence regarding the regulation of initial coin offerings (“ICOs”), token generation events and other similar means of raising capital using blockchain technology. On July 25, 2017, the SEC issued a press release, investigative report, and investor bulletin exploring these concepts in the context of The DAO (a “Decentralized Autonomous Organization”) an innovative but ultimately failed organization which made use of the Etherium blockchain. While substantive regulations likely are distant, the pronouncements lend much needed color to the SEC’s posture regarding cryptocurrency.
The DAO represents the first large-scale attempt to create a “virtual,” code-based organization through the use of distributed ledger and “smart contract” technology. The DAO was created by Slock.it and its co-founders (together, “Slock.it”), and was intended to raise funds, and to hold a body of assets, through the sale of DAO Tokens. Proceeds from token sales were to be used for funding various “projects.” Such projects were to be selected by Slock.it and presented to token-holders for voting. Each holder of DAO Tokens was to vote on which projects to adopt, and would share in the earnings generated by such projects. In addition, token holders had the ability to liquidate their DAO Token holdings through a number of platforms which supported secondary trading.
From April 30, 2016 through May 28, 2016, approximately 12 million Ether, the primary virtual currency used on the Etherium blockchain, were exchanged for more than 1.15 billion DAO Tokens, which equated to a value of approximately $150 million. Following the sale of the DAO Tokens, but before any projects were funded with the proceeds, a code-based attacker stole nearly one third of The DAO’s assets, and put a halt to its operations. Needless to say, an SEC spotlight was trained on the ensuing investigation.
The SEC’s analysis of The DAO centered on whether DAO Tokens constitute securities under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). Under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, an “investment contract” is considered a security. Applying a test based on the “facts and circumstances” of each case, courts have generally treated as an investment contract, and therefore a security, an (i) investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profits, (iv) to be derived from the entrepreneurial or managerial efforts of others. As you may have predicted, the majority of the SEC’s analysis centered on whether profits from The DAO—an organization touted as autonomous—were derived from the managerial efforts of others.
The central inquiry was “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” The SEC first drew attention to the investors’ reliance on the efforts of Slock.it to maintain The DAO, and to propose projects that could generate profits for token-holders. Next, the SEC noted that the expectations of token-holders were “primed by the marketing of The DAO and active engagement” between Slock.it and token-holders.
The SEC also drew attention to the pseudonymity and significant dispersion of token holders to conclude that token holders bore greater resemblance to corporate stockholders than limited partners. These attributes of token holders, compounded by their sheer numbers, contributed to a system in which investors had little ability to “consolidate their votes into blocs powerful enough to assert actual control,” and generally exerted minimal control. As a result, the SEC concluded that DAO Tokens were functionally equivalent to more traditional securities, and should be subject to similar regulations.
The SEC report does not mince words- blockchain token sellers are not exempt from federal securities laws. Moreover, the argument that smart contracts operate autonomously and therefore remove managerial control from token issuers just became less attractive. The upshot for any company contemplating an ICO, however, is that not all tokens will be considered securities- such a determination will be based on the “facts and circumstances” of each case. Moreover, the SEC broadly endorsed the use of blockchain technology, stating “We welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities.”
In order to remain on the friendly side of the SEC, however, issuers who seek to avoid regulation should consider the following:
- “Utility Tokens” Remain a Valid Alternative to “Securities Tokens”.
Utility tokens, as opposed to tokens on which purchasers expect a return on investment, provide holders with some specified utility or functionality. Utility coins could be used, for instance, to fund development of software, to purchase software, or to access additional functionality within software. While the value of utility tokens may fluctuate with demand for any corresponding products or services, utility tokens do not entitle the holder to ownership rights, and thus are more likely to avoid onerous regulation. It is important to note, however, that in its report on The DAO, the SEC stated that its investors were “motivated, at least in part, by the prospect of profits on their investment.” While the report did not explicitly delineate the boundary between utility tokens and “securities tokens,” it certainly implies that non-investment-based expectations should be the only expectations of utility token holders.
- Avoid “Investment-Like” Communications.
Communications with token holders and potential token holders should avoid language which mistakenly creates the expectation of profit through the issuer’s efforts. The SEC meticulously analyzed communications by Slock.it in its white paper and elsewhere to determine the extent of the issuer’s efforts as well as the expectations of coin holders. Issuers of utility tokens should avoid language concerning return on investments altogether.
- Voting Rights are not Enough.
While it may not come as a surprise, voting rights do not constitute significant efforts on the part of token holders, such that they should be considered akin to limited partners. In other words, voting rights alone are not “essential managerial efforts which affect the failure or success of the enterprise.”1 After all, voting rights are often granted for shares of stock and other traditional securities. In order to shift significant “managerial efforts” from an issuer of tokens to token purchasers, such purchasers would be required to play a much more essential role in making the enterprise profitable.
As it stands, the majority of coin issuers must make a choice-attempt to create a “pure utility” coin which does not meet the SEC definition of a security, or meet that definition and concede the liquidity and scale of investment offered by public trading. While some have found a third path in the wake of the SEC report- excluding contributions from citizens or resident of the US altogether- the dilemma remains for the majority of issuers. Compounding the trepidation of potential issuers, the Exchange Act provides that a person who buys an unregistered security can, on his own, sue the seller for return of his investment. In such a case a judge, rather than the SEC, can determine whether an ICO constitutes a securities offering. With such looming uncertainties, coin issuers require more clarity than ever before. Until clear regulations are set forth, however, “securities” tokens are increasingly likely to be treated like securities of any other kind, and it’s anyone’s guess what effect that will have on the market.
1 SEC v. Glenn W. Turner Enters., Inc. at 482.