On July 25, 2017, the US Securities and Exchange Commission (“SEC”) issued an investigative report stating that US securities laws apply to sales of securities in the United States purchased with virtual currencies or distributed with blockchain technology. At the same time, it issued an Investor Bulletin on so-called “Initial Coin Offerings” (ICOs) to caution potential investors about such transactions.
The Investigative Report focused on an organization called The DAO and the applicability of the US federal securities laws to its offer and sale of DAO Tokens to US investors. After a lengthy analysis of The DAO, its participants and the features of the DAO Token, the SEC concluded that the DAO Tokens were “securities” under the federal securities laws.
However, the SEC decided not to bring charges in this case, but used the opportunity to make clear its position that the requirements of the US federal securities laws apply to those who offer and sell securities in the United States, “regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
Although the SEC emphasized that whether or not a particular transaction involved the sale of securities would depend upon the facts, circumstances and “economic realities” of the transaction, the report provides important guidance for the Fintech industry, especially those who seek to raise capital by issuing digital tokens or virtual currencies.
The SEC analyzed whether DAO Tokens constituted an “investment contract” under the four part test established by the US Supreme Court in the leading case of SEC v. W.J. Howey Co. from 1946 and which is still used today, having been affirmed by the Supreme Court as recently as 2004.
The SEC concluded that the DAO Tokens met all four parts of the Howey Test, and as a result, found that it was a securities contract and thus subject to the US federal securities laws:
- Investment of Money. The SEC determined that Ether (“ETH”), the Ethereum cryptocurrency used by investors to purchase DAO Tokens, was an “investment of money,” noting that “[s]uch investment is the type of contribution of value that can create an investment contract under Howey.”
- Common Enterprise. The SEC also determined that purchasers of DAO Tokens were investing in a common enterprise, focusing on The DAO’s promotional materials, which “informed investors that The DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment” by pooling the ETH raised from the sale of DAO Tokens.
- Reasonable Expectation of Profits. The SEC also looked to The DAO’s promotional materials to conclude that “[i]nvestors who purchased DAO Tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise…,” and that because DAO Tokens entitled investors to a share in potential profits, a “reasonable investor would have been motivated, at least in part, by the prospect of profits on their investment of ETH in The DAO.”
- Derived from the Managerial Efforts of Others. The SEC concluded that the investors relied on the “managerial and entrepreneurial efforts” of The DAO’s creators and others selected by the creators to assist them to generate profits for investors. The SEC focused in part on the active involvement of The DAO’s creators, who held themselves out as experts in Ethereum and provided active oversight of The DAO.
The Investor Bulletin discusses ICOs more generally, discussing the basics of how they work, why the federal securities laws might apply and what potential investors should consider (and avoid) when deciding to invest in them.
In April, the SEC denied proposals to list and trade shares of two bitcoin trust exchanges. Our post on those actions can be accessed here.
In addition, the US Commodity Futures Trading Commission (“CFTC”) continues to exercise its own oversight over virtual currencies, most recently approving an application by LedgerX – a platform for trading and clearing Bitcoin options – for registration as a swap execution facility and derivatives clearing organization. Please see our blog post on the approval here.
In 2015, the CFTC had determined that Bitcoin and other virtual currencies are “properly defined as commodities” for purposes of the Commodity Exchange Act. Our blog post on that order can be accessed here.
Click here to access the Norton Rose Fulbright Knowledge webpage on “FinTech law and regulation: blockchains, distributed ledgers, smart contracts and cryptocurrencies.”