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SEC Investigates the DAO on its Initial Coin Offering on Blockchain

By Alexandra Levin Kramer, Esq., CKR Law Chair, Blockchain Technology and Digital Currency

What is Blockchain1?

Blockchain is an emerging and revolutionary technology which allows data to be stored securely using cryptography on distributed, non-centralized electronic ledgers. Each specific “block” of data is linked to the next related block of data, which is verified by multiple participants across a network of hundreds or thousands of computers, thus creating a “chain” of “blocks”, which can be private or public and in effect removes the need for a third party or central authority. The most commonly known applications of Blockchain are cryptocurrencies known as bitcoin (created in 2009), litecoin (2011) and ethereum (2015). Another example of Blockchain technology is a “smart contract”, i.e. a self-executing and self-enforcing arrangement among two or more parties created by computer coding.

What has been the commercial use of Blockchain?

The early designers of cryptocurrencies may have had utopian visions of creating a “decentralized system of money” to remove barriers to entry to financial markets and industry.2 However, like in most transformative technologies, e.g., the internet, some early users of cryptocurrency and Blockchain took advantage of the anonymity and lack of regulation at the time to commit fraud, money laundering and other crimes. The U.S. Securities and Exchange Commission (the “SEC”) has issued Investor Alerts warning investors about the use of bitcoin in Ponzi schemes3 and other investments4, as did the Financial Industry Regulatory Authority (“FINRA”)5.

However, the industry has developed rapidly, producing legitimate business and non-profit applications of Blockchain technology in industries including real estate, urban planning, digital commerce, government and NGOs, banking, finance, financial technology, healthcare, transportation, energy, tourism, shipping and online dating. Established consumers have recognized the utility of Blockchain and have invested in applications including efficiencies in financial technologies6 (supported by a consortium of Fortune 500 enterprises, startups and academics7), recording title to real property on Blockchain8, founding of “Blockchain Cities”9 globally, and the creation of digital identities10 utilizing smartphones11 for approximately 2.4 billion12 individuals globally who have no official proof of identity enabling them access to social services13, banking, alternative credit histories, etc.

What are ICOs?

An initial coin (or token) offering (“ICO”) is an innovative capital-raising technique, similar to crowdfunding, for startups particularly in the Blockchain technology space. In an ICO, the startup sells its own virtual coin or token in exchange for fiat currency (dollars, euros, etc.) or other cryptocurrency, often through the use of a smart contract. Since the start of 2017, US$1.27 billion has been raised globally through 56 ICOs, compared with US$222 million in 2016 and US$14 million in 201514. Historically, ICOs, whether launched within the United States or abroad, have not limited purchasers to accredited or sophisticated investors. That is about to change.

How are ICOs currently viewed under U.S. securities laws?

The SEC had been silent on whether the coins or tokens issued in ICOs are securities which must be registered with the SEC, or qualify for an exemption therefrom, until the SEC completed its investigation of The DAO on July 25, 2017.

The DAO (a decentralized autonomous organization) was an unincorporated virtual entity created by Slock.it, a German corporation, which in 2016 used Blockchain to raise approximately US$150 million through its issuance of “DAO Tokens” in an ICO. Unfortunately, soon thereafter a hacker manipulated a software error resulting in the loss of about US$55 million, leading to the demise of The DAO and piquing the interest of the SEC.

On July 25, 2017, the SEC released a highly anticipated report of investigation15 (the “SEC Report”) as well as an investor bulletin16 to make it clear to the public that requirements under the U.S. Securities Act of 1933 (the “Securities Act”) and Section 3(a)(10) of the U.S. Securities Exchange Act of 1934 (the “Exchange Act”) “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.”17

The SEC found, in this specific case, that DAO Tokens were investment contracts and thus securities under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act. The SEC stated that the DAO Tokens passed the Howey test, determining that “an investment contract is an (a) investment of money (b) in a common enterprise (c) with a reasonable expectation of profits (d) to be derived from the entrepreneurial or managerial efforts of others.”18

How does this affect the launch of ICOs in the future?

The SEC Report was very careful not to broadly declare all ICO coins or tokens to be securities under U.S. federal law19. Each ICO must be analyzed on a case by case basis. ICOs that permit sales of coins or tokens to U.S. investors will need to apply the four following factors of the Howey test:

  1. Are coin/token purchasers investing money (which can take the form of fiat currency, virtual currency20, goods and services or some other exchange of value21)?
  2. Is the investment in a common enterprise (i.e., is the ICO taking place before the deployment of code on Blockchain or will all coin/token holders receive pro rata or equal returns on their investment without requiring any additional action by the coin/token holders)?
  3. Will the coins/tokens give its holders rights similar to shareholder rights (e.g. profit/loss share, legal interest in the entity itself, etc.)?
  4. Does the value of the coins/tokens rely on the efforts or actions of third parties (i.e. ““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.”22)?

If all four factors above are answered in the affirmative, then it is highly likely that the SEC will consider the coin or token a security, and therefore require either registration of the ICO with the SEC or qualification under an exemption from registration, most commonly Regulation D or, if the ICO is launched outside the United States, Regulation S.

What about the platforms that trade coins and tokens sold in ICOs?

On March 10, 2017, the SEC rejected proposed rule changes to permit Winklevoss Bitcoin Trust (COIN), a bitcoin exchange-traded fund led by Cameron and Tyler Winklevoss, to list and trade its shares, due mainly to the lack of regulation of bitcoin markets.23

In the SEC Report, the SEC confirmed that the platforms that traded DAO Tokens met the criteria of an “exchange” under Section 3(a)(1) of the Exchange Act as they “provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods” and did not qualify for an exemption24.  Therefore, these platforms were found to violate the Exchange Act as well.

Conclusion

The SEC chose not to take enforcement action against The DAO, Slock.it or its cofounders, likely in order to prevent a quick exodus of innovators out of the United States, however, it has sent a clear message to the Blockchain industry – while we encourage creativity and innovation, you are no longer flying under the radar and you are on notice that the SEC’s mandate of investor protection and market transparency will be enforced.

Soon after the SEC Report was released, the Monetary Authority of Singapore, a popular jurisdiction for Blockchain startups, released its own report on August 1, 2017, mirroring the SEC’s opinion, stating that the issue or offer of coins/tokens in Singapore may be subject to regulation if they meet the criteria set by the Securities and Futures Act of Singapore25.

Switzerland, in particular the canton of Zug (which recently offered all its residents a Blockchain-based digital identity26), has been the premier jurisdiction for the registration of Blockchain startups and ICOs outside the United States, and its regulator has yet to restrict ICOs so as to not discourage the growth of the Blockchain industry. In a press release by the Swiss Federal Council on July 5, 2017 announcing the adoption of an amendment of the Swiss Banking Ordinance, the regulator concluded that it “will continue to closely follow further developments in the areas of digitalisation and fintech, and examine further regulatory measures. The corresponding work, i.e. on clarifying the legal qualification of virtual currencies, has been taken over and is to be swiftly pursued.”27

However, while the world was focused on the SEC Report, few noticed that the U.S. State of Delaware quietly passed amendments on July 21, 2017 allowing Blockchain to be used for corporate recordkeeping purposes (by entities registered in Delaware) beginning August 1, 2017.28 Given the importance of this jurisdiction for U.S. corporations, this news comes at a great time to confirm that the while Blockchain cannot escape the law, it will be supported by pioneering regulatory regimes29 within the United States.

 



1For a free primer on Blockchain, see CoinDesk’s “Blockchain 101”, https://www.coindesk.com/information/ and McLain, Cameron. “A Brief History of Blockchain: An Investor’s Perspective.” Medium July 8, 2017, https://medium.com/indian-thoughts/a-brief-history-of-blockchain-an-investors-perspective-387c440ad11c.

2Jeffries, Daniel. “Why Everyone Missed the Most Mind-Blowing Feature of Cryptocurrency.” Hacker Noon July 31, 2017, https://hackernoon.com/why-everyone-missed-the-most-mind-blowing-feature-of-cryptocurrency-860c3f25f1fb.

3“Investor Alert: Ponzi schemes Using Virtual Currencies.” SEC July 23, 2013, https://www.sec.gov/investor/alerts/ia_virtualcurrencies.pdf.

4“Investor Alert: Bitcoin and Other Virtual Currency-Related Investments.” SEC May 7, 2014, https://investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-alert-bitcoin-other-virtual-currency.

5“Investor Alerts: Bitcoin: More than a Bit Risky.” Financial Industry Regulatory Authority May 7, 2014 (updated), http://www.finra.org/investors/alerts/bitcoin-more-bit-risky.

6Tapscott, Alex and Tapscott, Don. “How Blockchain Is Changing Finance.” Harvard Business Review March 1, 2017, https://hbr.org/2017/03/how-Blockchain-is-changing-finance.

7del Castillo, Michael. “Big Corporates Unite for Launch of Enterprise Ethereum Alliance.” coindesk.com February 28, 2017, https://www.coindesk.com/big-corporates-unite-for-launch-of-enterprise-ethereum-alliance.

8“Blockchain offers an open source, universal protocol for property buying, conveyancing, recording, escrow, crowdfunding, and more. It can reduce costs, stamp out fraud, speed up transactions, increase financial privacy, internationalize markets, and make real estate a liquid asset,” Ragnar Lifthrasir (www.ibtcrea.org). Specific examples include Brazil (www.coindesk.com/blockchain-land-registry-tech-gets-test-brazil/), the Republic of Georgia (https://medium.com/@BitFuryGroup/the-bitfury-group-and-government-of-republic-of-georgia-expand-historic-blockchain-land-titling-4c507a073f6b), Honduras (http://in.reuters.com/article/usa-honduras-technology-idINKBN0O01V720150515), Sweden (http://nordic.businessinsider.com/sweden-is-pioneering-a-blockchain-run-land-registry---which-could-save-taxpayers-$100-million-2017-4/), the United Kingdom (https://publicappointments.cabinetoffice.gov.uk/appointment/land-registry-3-x-non-executive-board-members/) and Cook County in the United States (http://cookrecorder.com/blockchain/).

9As one element of the City of Dubai “Smart Dubai” initiative to digitize by 2020, in March 2017 the Dubai Blockchain Strategy was launched in partnership with IBM and ConsenSys to become the first Blockchain powered government and to support Blockchain startups and service providers. See www.smartdubai.ae/dubai_blockchain.php.

10ID2020 (id2020.org) is a non-profit “public-private partnership dedicated to solving the challenges of identity for these people through technology,” which was founded in 2016.  The ID2020 Alliance includes governments, NGOs and the private sector, e.g. Accenture, Microsoft, Rockefeller Foundation and the United Nations High Commissioner for Refugees. Citizens of the city of Zug in Switzerland will also soon be able to receive digital identities (https://cryptovalley.swiss/swiss-city-zug-offer-blockchain-based-digital-identity-residents/).

11“Up to 97% of homeless people [in New York City] have smartphones,” Mayor Bill de Blassio, Julie Menin, New York City Mobile Services Study (November 2015); New York City Department of Consumer Affairs. Supplemental Nutrition assistance program. Tate Activity Report (2015).

12“The Identity Target in the Post-2015 Development Agenda.” The World Bank September 17, 2015, http://www.worldbank.org/en/topic/ict/brief/the-identity-target-in-the-post-2015-development-agenda-connections-note-19.

13One such example in New York City is the Blockchain visual and digital identity and payments startup FUMMi (www.Blockchainforchange.org), which is expanding its pilot program in Q1 2018 to enable authorized payments, access to benefits, alternative credit histories and financial inclusion of 3,000 homeless, with the ultimate goal of reaching 127,000 people living in New York City shelters.

14Arnold, Martin. “Tech Start-Ups Raise $1.3bn This Year from Initial Coin Offerings.” Financial Times July 18, 2017, https://www.ft.com/content/1a164d6c-6b12-11e7-bfeb-33fe0c5b7eaa.

15“Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.” SEC July 25, 2017, https://www.sec.gov/litigation/investreport/34-81207.pdf.

16“Investor Bulletin: Initial Coin Offerings” SEC July 25, 2017, https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings.

17Ibid. 13

18SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), as further developed in United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) and SEC v. Edwards, 540 U.S. 389, 393 (2004).

19Note that “blue sky” (individual U.S. state) securities law may apply as well.

20SEC v. Shavers, No. 4:13-CV-416, 2014 WL 4652121, at *1 (E.D. Tex. Sept. 18, 2014).

21Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 574 (10th Cir. 1991).

22SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973).

23“Self-Regulatory Organizations; Bats BZX Exchange, Inc.; Order Disapproving a Proposed Rule Change, as Modified by Amendments No. 1 and 2, to BZX Rule 14.11(e)(4), Commodity-Based Trust Shares, to List and Trade Shares Issued by the Winklevoss Bitcoin Trust.” SEC March 10, 2017, https://www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf.

24Ibid. 13

25“MAS Clarifies Regulatory Position on the Offer of Digital Tokens in Singapore.” Monetary Authority of Singapore August 1, 2017, http://www.mas.gov.sg/News-and-Publications/Media-Releases/2017/MAS-clarifies-regulatory-position-on-the-offer-of-digital-tokens-in-Singapore.aspx

26“Swiss City of Zug to Offer Blockchain-Based Digital Identity to Residents.” Crypto Valley Association July 11, 2017, https://cryptovalley.swiss/swiss-city-zug-offer-blockchain-based-digital-identity-residents/

27“Federal Council Puts New Fintech Rules into Force.” The Federal Council of the Swiss Government July 5, 2017, https://www.admin.ch/gov/en/start/documentation/media-releases.msg-id-67436.html.

28Long, Caitlin. “Blockchain Crosses the Delaware: Smart Securities to Disrupt Corporate Finance - Historic Amendments Pave the Way for Blockchain to Transform Securities Processes.” MarketsMedia.com  July 31, 2017, https://marketsmedia.com/blockchain-crosses-delaware/.

29Other states in the United States which support the development of the Blockchain industry include Arizona (https://www.coindesk.com/arizona-governor-signs-blockchain-bill-law/) and Vermont (https://www.coindesk.com/vermont-lawmakers-jobs-tax-revenue-blockchain/).