On July 25, 2017, the U.S. Securities Exchange Commission ("SEC") issued an Investigative Report and Investor Bulletin (collectively, "Reports") detailing the SEC's investigation of a specific Initial Coin Offering ("ICO") of "The DAO," a decentralized autonomous organization ("DAO"). The DAO is an entity created by Slock.it that offered "DAO Tokens" to investors in exchange for Ether, a virtual currency used on the Ethereum blockchain, through an ICO. In the Reports, the SEC concludes that the offer and sale of The DAO Tokens were securities and subject to the U.S. Securities Law.
Market participants and investors should know the key conclusions in the Reports.
- The Reports acknowledge the use of ICOs as an acceptable form of raising capital and how the SEC plans to determine their applicability to federal securities laws.
- Offers and sales of digital assets by "virtual" organizations such as an ICO or token sale could likely be subject to the requirements of the federal securities laws.
- The SEC is classifying these digital assets as “investment contracts” and will use a facts and circumstances test to determine if the offering should conform to federal securities laws. Expect that this determination will rely more on function over form and the economics of the transaction, regardless of the terminology used.
- Issuers of distributed ledger or Blockchain technology-based securities that meet the facts and circumstances test must register offers and sales of such securities. Those participating in unregistered offerings also may be liable for violations of the securities laws.
- Exchanges that facilitated the trading of The DAO tokens could likely have been required to register as national securities exchanges under the Securities Exchange Act of 1934. Exchanges will likely be more careful in the future, when evaluating which tokens they allow to trade on their exchanges.
- Exchanges providing for trading in these securities will likely need to register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors' protection.
- The DAO has been described as a "crowdfunding contract" but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.
- Issuers of ICOs should be cautious when drafting promotional materials, whitepapers, and making public statements, as the SEC looked carefully at the publicly available information for The DAO when assessing if it was characterized like a security offering.
In closing, the SEC has decided not to bring charges in this instance, or make findings of violations in the Reports, but rather to caution the industry and market participants that the federal securities laws could be applicable. It disregards whether the issuing entity is a traditional company or a DAO, whether those securities are purchased using U.S. dollars or virtual currencies, and whether they are distributed in certificated form or through distributed ledger technology.
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