Businesses are increasingly relying on initial coin offerings (ICOs) to raise capital. However, as with many other new high-tech financial transactions, the law has largely failed to keep pace.

[caption id="attachment_21861" align="aligncenter" width="550"] Photo courtesy of Jimi Filipovski ([/caption]

As we have discussed previously, virtual coins are created and disseminated using distributed ledger or blockchain technology. In an initial coin offering, buyers may use fiat U.S. dollars or virtual currencies to purchase virtual coins or tokens. The capital raised from the sales may be used to fund the development of a digital platform, software, or other projects. In addition, investors may use the virtual tokens or coins to access the platform, use the software, or otherwise participate in the project. After they are issued, the virtual coins or tokens may also be resold to others in a secondary market on virtual currency exchanges or other platforms. 

SEC Report on Initial Coin Offerings

This summer, the Securities and Exchange Commission (SEC) provided its first guidance on ICOs. The agency’s Report of Investigation under Section 21(a) of the Securities Exchange Act of 1934 outlined its investigation of The DAO, a virtual organization, and its use of distributed ledger or blockchain technology to facilitate the offer and sale of DAO Tokens to raise capital.

DAO sold tokens (DAO Tokens) to investors, which would then be used to fund “projects.” The holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investment in DAO Tokens. In addition, DAO Token holders could monetize their investments in DAO Tokens by re-selling DAO Tokens on a number of web-based platforms that supported secondary trading in the DAO Tokens.

In determining that DAO Tokens were securities, the SEC applied traditional federal securities laws to the novel capital-raising tool. The SEC also emphasized that businesses that offer and sell securities in the U.S. are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology. The agency also published an Investor Bulletin regarding the potential risks associated with ICOs.

Is a Virtual Coin Offering an Investment Contract?

In an initial coin offering, the virtual coins or tokens may constitute investment contracts. If they are, the offer and sale of these virtual coins or tokens in an ICO must comply with federal securities laws.

So how do businesses and investors make that determination?

The basic definitions of what is a security are set forth in Section 2(a)(1) of the Securities Act, and in Section 3(a)(10) of the Exchange Act. The securities regulations list several types of financial instruments that constitute securities, including notes, bonds, debentures, stock, and investment contracts. In interpreting the provisions, the U.S. Supreme Court has consistently held that they should be interpreted broadly.

In SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), the Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others. As explained by the Court, this definition embodies a “flexible rather than a static principle, 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.”

The SEC applied the Howey test to the DAO Tokens. It readily concluded that investors who purchased DAO Tokens were investing in a common enterprise and that they reasonably expected to earn profits through that enterprise when they sent virtual currency to The DAO’s Ethereum Blockchain address in exchange for  DAO Tokens. In support of that conclusion, the agency cited various promotional materials that informed investors that The DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment.

With regard to the third prong of the test, the SEC concluded that the “DAO’s investors relied on the managerial and entrepreneurial efforts of and its co-founders, and The DAO’s Curators, to manage The DAO and put forth project proposals that could generate profits for The DAO’s investors.” It specifically noted that and its co-founders determined which projects would be voted on by DAO Token holders, monitored the operation of The DAO, and held themselves out as experts on the blockchain technology underlying the platform. The SEC also highlighted 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.”

Consequences of Failing to Register a Security

Pursuant to Section 5(a) of the Securities Act, unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities in interstate commerce. As emphasized by the SEC in the DAO report, “These requirements 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.”

For businesses interested in conducting an ICO, the SEC’s report provides a roadmap for structuring token sales so that they are exempt from U.S. securities registration requirements. Recent reports include that in some offerings new investors have been told that they are investing in “Software Pre-sales” where payments are received not for an equitable share in the enterprise but instead for a license to run the software.   These are efforts to follow the crowdfunding model instead of an initial public offering model. As highlighted above, one of the key issues is the rights, expectations, and participation of token holders. For detailed guidance, it is always advisable to consult with an experienced attorney.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.