On July 25, 2017, the SEC issued a report that was meant to “advise those who would use a … distributed ledger or blockchain-enabled means of capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”
This report has come to be known as The DAO Investigation Report, and is a key document to understanding where crypto currency regulations are today, and where they are likely to go in the future.
The DAO Report was issued by the SEC in connection with virtual tokens known as DAO, which raised about 12 million Ether (ETH), or about US$150 million in their ICO.
Certain important facts that the SEC outlined in its report were as follows:
-The DAO was created with the purpose of holding assets through the sale of “DAO Tokens” to investors, and to fund “projects” with those assets;
-The DAO’s White Paper provided that certain “Curators” of The DAO would determine whether proposals would be voted upon by DAO Token holders
-Holders of DAO Tokens stood to share in anticipated earnings;
-Holders of DAO Tokens could monetize their DAO Tokens by re-selling them through various trading platforms
-The DAO “was intended to be ‘autonomous’ in that project proposals were in the form of smart contracts that exist on the Ethereum Blockchain and the votes were administered by the code of The DAO.”
-A hacker was able to divert about 1/3 of the ETH raised by the offering to an Ethereum Blockchain address controlled by the attacker. However, The DAO’s code prevented the ETH from immediately moving to the attacker’s address and, through the implementation of a change in the Ehtereum Blockchain protocol known as a “Hard Fork”, the transfer of the tokens to the attacker was ultimately prevented.
Using what is known as the “Howey test” (a case law based analysis), and applying Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Exchange Act of 1934, the DAO Report makes the determination that the DAO Tokens are securities.
Accordingly, the SEC finds that “…because DAO Tokens were securities, The DAO was required to register the offer and sale of DAO Tokens [under Section 5 of the Securities Act], unless a valid exemption from such registration applied.”
Further and, importantly, the DAO Report addresses the trading platforms that were involved in the trading of DAO Tokens, finding that they “appear to have satisfied” the definition of an “exchange” under section 3(a)(1) of the Exchange Act. Pursuant to Section 5 of the Exchange Act, it is unlawful for any broker, dealer, or exchange, directly or indirectly, to effectuate 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.
Accordingly, the SEC report reminds virtual currency promoters that: “[a]ll 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.”
It is worth nothing that the DAO Report raises the issue, without making a determination, of whether The DAO was an “Investment Company” under the Investment Company Act of 1940. Whereas closely held companies can often be excluded from the definition of an investment company (for example, under 3(c)(1) and/or 3(c)(7) of the Investment Company Act), this footnote in the DAO Report should serve as a stern warning to virtual currency promoters that there is an entire complex world of securities laws and regulations that may apply to their ICO’s.
Finally, the Commission concludes that “[w]hether 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.”
Note: Laws and regulations are constantly changing and evolving. This article provides a summary of a specific Commission Report dated July 25, 2017 and should not be considered legal advice.