A Restatement of Principles: The SEC’s Analysis of TheDao and the implications for ICOs.
First, the tldr;
TheDao was a security (and a mess), ICO issuers can’t hide behind tech, need to make real defensible disclosures, exemptions that apply to securities apply to ICOs that are securities, issuers of ICOs that are securities need to be broker/dealers, and virtual currency exchanges may be violating SEC regulations by allowing trading of unregistered securities and by operating without SEC registration or exemption.
Now, let’s dive in:
In a much anticipated move, the Securities and Exchange Commission issued a press release and investigative report on TheDao, concluding that theDao was a security, and warning that SEC regulations may apply to ICOs of cryptotokens. A rundown:
- No enforcement actions.
Nobody is going to jail, at least not right now. The SEC elected not to pursue an enforcement action against theDao.
2. Restates core securities principles.
Although ICO’s may have been thought to exist in unaddressed territory and (depending on the specific governance and function of the token) may appear more or less like a security, the SEC guidance did not attempt to lay out an analytical framework or new rules for ICOs. Instead, the SEC clearly restated that the existing rules that apply to securities may apply to ICOs that qualify as securities, regardless of technology.
“…the 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.”
“All securities offered and sold in the United States must be registered with the Commission or must qualify for an exemption from the registration requirements. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration”
This suggests that if an ICO is a security, it will be treated like a security, and by implication, that exemptions that apply to securities are available for ICOs.
This does not say that all ICO’s are securities or that no ICO’s are securities. This says that depending on facts, some ICOs may be securities. However, the analysis of theDao as a security found on pages 10–18 of the investigative report should be studied closely by anyone interested in using an ICO, and their counsel. And anyone considering using an ICO should get capable counsel conversant in the issues.
3. A series of warnings.
a. Substance over form.
That’s right, friends, the regulator doesn’t care about your tech, or your blockchain, or your smart contract. If your ICO is a security, it’ll be treated like every other security.
The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws.
In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” United Housing Found., 421 U.S. at 849.
Whether or not a particular transaction involves the offer and sale of a security — regardless of the terminology used — will depend on the facts and circumstances, including the economic realities of the transaction.
b. Use a FINRA broker/dealer.
That’s right. No more issuing tokens out of back alleys (I kid, I kid…) If it’s a security, it needs to be issued by a broker dealer, even if it’s a crypto-token.
The DAO would not have met the requirements of Regulation Crowdfunding, adopted under Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 (providing an exemption from registration for certain crowdfunding), because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority (“FINRA”).
c. Don’t Skirt on Disclosures
“Investors need the essential facts behind any investment opportunity so they can make fully informed decisions, and today’s Report confirms that sponsors of offerings conducted through the use of distributed ledger or blockchain technology must comply with the securities laws,” said William Hinman, Director of the Division of Corporation Finance.”
The registration provisions of the Securities Act contemplate that the offer or sale of securities to the public must be accompanied by the “full and fair disclosure” afforded by registration with the Commission and delivery of a statutory prospectus containing information necessary to enable prospective purchasers to make an informed investment decision.
Registration entails disclosure of detailed “information about the issuer’s financial condition, the identity and background of management, and the price and amount of securities to be offered … .” SEC v. Cavanagh, 1 F. Supp. 2d 337, 360 (S.D.N.Y. 1998), aff’d, 155 F.3d 129 (2d Cir. 1998).
Offerors of ICOs should provide disclosures that would pass muster with the SEC. The days of ICOs with a flimsy white paper and an offering deck are likely over.
d. Token-holder voting doesn’t necessarily divest platform creators or controllers of “control” for securities analysis purposes.
Part of the inquiry undertaken to determine if something is an investment contract hinges upon whether a reasonable expectation of profits is derived from the managerial efforts of others. TheDao included a voting system where DaoToken holders would vote whether to fund proposals that were to provide expected returns to those token holders. However, the SEC determined that, notwithstanding this token holder voting power, the actual power and oversight of the platform, and control over returns, was reposed with theDao’s co-founders, who were expected to monitor and control the platform, and with the Curators, who were expected to vet parties who offered proposals of revenue-driving investment targets, determine when proposals were up for vote, and control aspects of voting, including the removal of themselves as Curators.
The SEC looked at the voting power of token holders as “limited” and found that the token holders were substantially reliant upon the co-founders and curators.
Even if an investor’s efforts help to make an enterprise profitable, those efforts do not necessarily equate with a promoter’s significant managerial efforts or control over the enterprise. See, e.g., Glenn W. Turner, w (finding that a multi-level marketing scheme was an investment contract and that investors relied on the promoter’s managerial efforts, despite the fact that investors put forth the majority of the labor that made the enterprise profitable, because the promoter dictated the terms and controlled the scheme itself); Long v. Shultz, 881 F.2d 129, 137 (5th Cir. 1989) (“An investor may authorize the assumption of particular risks that would create the possibility of greater profits or losses but still depend on a third party for all of the essential managerial efforts without which the risk could not pay off.”). See also generally SEC v. Merchant Capital, LLC, 483 F.3d 747 (11th Cir. 2007) (finding an investment contract even where voting rights were provided to purported general partners, noting that the voting process provided limited information for investors to make informed decisions, and the purported general partners lacked control over the information in the ballots).
The SEC then concludes that
The voting rights afforded DAO Token holders did not provide them with meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote for contracts was a largely perfunctory one; and (2) DAO Token holders were widely dispersed and limited in their ability to communicate with one another.
The SEC argues here that because the Curators limited what could be voted upon, and because the token holders were psuedoanonymous and widely geographically distributed, the token holder voting right was not tantamount to control, but instead, more like shareholder’s rights.
Those facts, combined with the sheer number of DAO Token holders, potentially made the forums of limited use if investors hoped to consolidate their votes into blocs powerful enough to assert actual control. This was later demonstrated through the fact that DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others. The DAO Token holders’ pseudonymity and dispersion diluted their control over The DAO. See Merchant Capital, 483 F.3d at 758 (finding geographic dispersion of investors weighing against investor control).
… Steinhardt Group, Inc. v. Citicorp., 126 F.3d 144, 152 (3d Cir. 1997) (“It must be emphasized that the assignment of nominal or limited responsibilities to the participant does not negate the existence of an investment contract; where the duties assigned are so narrowly circumscribed as to involve little real choice of action … a security may be found to exist … . [The] emphasis must be placed on economic reality.”) (citing SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 n. 14 (5th Cir. 1974).
If the inquiry is simply whether token holders relied on the managerial efforts of others to maintain theDao, then the analysis appears correct.
If the analysis instead focuses on relying on third parties for the expectation of a return of profit, it is closer to equipoise between token holders and curators because the voters themselves would determine into what proposal investment capital was to be contributed, or determine if any investment was made at all. (Ironically, the best use of the investment corpus aggregated by theDao, for theDao token holders, may have been to sit on the aggregated ether holdings, trade Dao Tokens, and fund no proposals at all to avoid blockage discounts and flash crashes when funded proposals tried to liquidate large chunks of ether).
As demonstrated by the lengthy analysis included in the investigative report, this is a fact sensitive inquiry, and will vary across platforms. The analysis included, however, should be useful to designers of systems involving collective action, whether using a blockchain, smart contract, or otherwise.
4. Exemptions exist and apply to ICOs.
“The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.”
This paragraph supports the use of exemptions that would apply to securities would also apply to qualifying ICOs as well. Ladies and gentlemen, please welcome Reg D and Reg S.
5. Potential exposure for trading platforms
The closest thing to a surprise in the SEC’s statements may be the sharp critique of virtual currency exchanges that allow for trades of cryptoassets. The SEC clearly and repeatedly criticizes exchanges and secondary market makers, suggesting they should register or qualify for an exemption:
Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.
Section 5 of the Exchange Act makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange under Section 6 of the Exchange Act, or is exempted from such registration. See 15 U.S.C. §78e. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood … .” 15 U.S.C. § 78c(a)(1).
An organization is an exchange under Exchange Act Rule 3b-16(a), if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. A qualifying organization must register with the SEC or operate pursuant to an exemption. The SEC points out that these exchanges may qualify for an Alternative Trading System (ATS) exemption.
If you’re operating a crypto-exchange site, it’s time to consult with qualified counsel.
6. Will this push ICO’s off-shore?
I personally do not view the SEC’s statements today as a surprise. Most responsible ICO ventures know they need to work within the confines of the law, and get qualified counsel, who, may advise them to proceed under an exemption, or otherwise make efforts by structuring their businesses and using foreign jurisdictions to protect themselves. Subject to analysis of your particular ICO concept and business model, exemptions may allow the offer of an ICO without entirely abandoning the US market.
If the statements today encourage potential ICO issuers to seek qualified counsel, make real disclosures, and take securities laws seriously, then today is a huge win for consumers, and the entire ecosystem.
As always, seek qualified counsel.
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