SEC focuses on initial coin offerings: tokens may be securities under federal securities laws

Transcription

1 SEC focuses o iitial coi offerigs: tokes may be securities uder federal securities laws Jeremy I. Sederowicz, K. Susa Grafto, Timothy Spagler, Kristopher D. Brow ad Adrew J. Schaffer Jeremy I. Sederowicz (jeremy.sederowicz@ dechert.com) is a parter at Dechert LLP, New York, New York, USA. K. Susa Grafto (susa. grafto@dechert.com) is a parter at Dechert LLP, Washigto, DC, USA. Timothy Spagler (timothy. spagler@dechert.com) is a parter at Dechert LLP, Costa Mesa, Califoria, USA. Kristopher D. Brow (kristopher.brow@ dechert.com) is a parter ad Adrew J. Schaffer (adrew.schaffer@dechert. com) is a associate, both at Dechert LLP, New York, New York, USA Dechert LLP. Abstract Purpose To explai the recet determiatio by the US Securities ad Exchage Commissio (SEC) with respect to so-called toke sales or iitial coi offerigs (ICOs) that some tokes may be securities uder federal securities laws ad to address other recet actios by the SEC with respect to ICOs. Desig/methodology/approach Reviews the SEC s determiatio that some tokes issued i a ICO may be securities uder federal securities laws as outlied by the SEC s Divisio of Eforcemet i a Report of Ivestigatio Pursuat to Sectio 21(a) of the Securities Exchage Act of 1934: The DAO. Provides overview of SEC Ivestor Alert, Ivestor Bulleti, ad recet commets ad actios of the Staff regardig ivestmet i ICOs ad provides guidace to those iterested i participatig i a ICO as a ivestor or issuer. Fidigs These actios by the SEC make it clear that the SEC is closely moitorig the market for ICOs, ad that it wats potetial ivestors ad issuers to be aware that it is watchig ad may take actio if it believes the securities laws have bee violated. Origiality/value Practical overview of recet developmets ad guidace from experieced securities ad fiacial services lawyers. Keywords Digital assets, US Securities ad Exchage Commissio (SEC), Cryptocurrecy, Iitial coi offerigs (ICOs), Toke sales, Virtual currecy Paper type Techical paper O July 25, 2017, the SEC s Divisio of Eforcemet issued a Report of Ivestigatio Pursuat to Sectio 21(a) of the Securities Exchage Act of 1934: The DAO (DAO Report). This report idicates that The DAO is oe example of a Decetralized Autoomous Orgaizatio, which is a term used to describe a virtual orgaizatio embodied i computer code ad executed o a distributed ledger or blockchai. The DAO Report cocludes that the digital tokes, which were issued for the purpose of raisig fuds for projects, may be deemed to be securities uder the federal securities laws. Accordig to the SEC, such securities must be registered with the Commissio or eligible for a exemptio from the registratio requiremets. The same day, the SEC s Office of Ivestor Educatio ad Advocacy issued a Ivestor Bulleti, addressig the topic of ICOs more geerally. Cocurretly, the SEC s Divisios of Corporatio Fiace ad Eforcemet released a joit statemet supportig the DAO Report ad Ivestor Bulleti. I their statemet, the Divisios oted that the issue of whether a particular ivestmet opportuity ivolves the offer or sale of a security regardless of the termiology or techology used i the trasactio depeds o the facts ad circumstaces, icludig the ecoomic realities ad structure of the eterprise. PAGE 10 j j JOURNAL OF INVESTMENT COMPLIANCE VOL. 19 NO , pp , Emerald Publishig Limited, ISSN DOI /JOIC

2 Ivestor bulleti The Ivestor Bulleti observes that, [d]epedig o the facts ad circumstaces of each idividual ICO, the virtual cois or tokes that are offered or sold may be securities. If they are securities, the offer ad sale of these virtual cois or tokes i a ICO are subject to the federal securities laws. The Ivestor Bulleti also highlights the risks of ICO ivestig ad provides guidace for potetial ivestors. Amog other risks, the Ivestor Bulleti highlights that, due to the ature of virtual currecies ad digital tokes, ivestors may be subject to cybersecurity risk ad loss resultig from hackig. Additioally, while some tokes may afford ivestors with rights uder the federal securities laws, the SEC may have difficulty eforcig these rights o accout of the difficulty i tracig ad freezig assets due to the iteratioal ature ad lack of cetral authority or custodia with respect to virtual currecies ad digital tokes. DAO report I the DAO Report, the SEC aalyzed certai aspects of The DAO, icludig how the etity was created, fuded ad ru. The DAO was formed as a for-profit etity i order to create ad hold assets by sellig tokes (DAO Tokes) to ivestors i exchage for ether (the ative cryptocurrecy of the Ethereum blockchai), with the proceeds of such sales beig used to fud projects iteded to geerate profits. I additio, DAO Toke holders could moetize their ivestmet i DAO Tokes by re-sellig DAO Tokes o a umber of web-based platforms [...] that supported secodary tradig i the DAO Tokes. After the sale of approximately $150 millio i DAO Tokes to ivestors, The DAO suffered a hack ad lost approximately oe third of the ether raised. I determiig whether a violatio of the federal securities laws had occurred, the SEC cosidered as a threshold questio whether DAO Tokes are securities withi the meaig of such laws. This DAO Report otes that [a]ll securities offered ad sold i the USA must be registered with the Commissio or must qualify for a exemptio from the registratio requiremets, ad applies these priciples to a ew paradigm virtual orgaizatios or capital raisig etities that use distributed ledger or blockchai techology to facilitate capital raisig ad/or ivestmet ad the related offer ad sale of securities. The DAO Report goes o to state that [t]he automatio of certai fuctios through this techology, smart cotracts, or computer code, does ot remove coduct from the purview of the USA federal securities laws ad [t]hese requiremets apply to those who offer ad sell securities i the USA, regardless whether the issuig etity is a traditioal compay or a decetralized autoomous orgaizatio, regardless whether those securities are purchased usig USA dollars or virtual currecies, ad regardless whether they are distributed i certificated form or through distributed ledger techology. Accordigly, based o facts ad circumstaces particular to The DAO, as set forth below, the SEC cocluded that the DAO Tokes are securities withi the meaig of the Securities Act of 1933 (Securities Act) ad the Securities Exchage Act of 1934 (Exchage Act)[1]. I reachig this coclusio, the SEC applied the Howey test of a ivestmet cotract i aalyzig the DAO Tokes ature. I SEC v. W.J. Howey Co. ad its progey, the USA Supreme Court defied a ivestmet cotract as a ivestmet of moey i a commo eterprise with profits to come solely from the efforts of others[2]. The SEC used the followig factors of the Howey test to determie that DAO Tokes are securities: Ivestmet of Moey. A ivestmet of moey eed ot take the form of cash[3]. The SEC foud that ivestors made the type of cotributio of value that ca create a ivestmet cotract by usig ether to make their ivestmets, ad DAO Tokes were received i exchage for ether. VOL. 19 NO j JOURNAL OF INVESTMENT COMPLIANCE j PAGE 11

3 Reasoable Expectatio of Profit. The secod prog of the Howey test looks at whether ivestors who purchased a istrumet had a reasoable expectatio of profit from that eterprise. The SEC foud that ivestors reasoably expected a retur o their ivestmets through a share of potetial profits from projects to be udertake by The DAO a commo eterprise give that they were repeatedly iformed i marketig materials that The DAO s objective was to fud projects i exchage for a retur o ivestmet. Derived from the Maagerial Efforts of Others. The third prog of the Howey test examies whether the profits of a istrumet are derived from the maagerial efforts of others. I makig this determiatio, the SEC queried whether the efforts of others were the udeiably sigificat oes, those essetial maagerial efforts which affect the failure or success of the eterprise[4]. The SEC safeguardig ivestor fuds, ad determiig whether proposed cotracts should be put for a vote which i tur led potetial ivestors to believe that they could be relied o to provide the sigificat maagerial effort required to make The DAO a success. The SEC also foud that the maagemet provided active oversight of The DAO i respodig to the hack. Further, the SEC foud that ivestors votig rights did ot provide them with meaigful cotrol over the eterprise because DAO Toke holders ability to vote for cotracts was mostly perfuctory ad DAO Toke holders were widely dispersed ad limited i their ability to commuicate with oe aother. Based o its fidig that the DAO Tokes qualify as securities, the SEC cocluded the followig: The DAO, as issuer, was required to register the offer ad sale of DAO Tokes uder the Securities Act. Abset a valid exemptio, the registratio, disclosure, reportig ad other aspects of the securities laws applied to the offer, sale ad subsequet tradig of such tokes. Ay platform offerig secodary market tradig of DAO Tokes must register with the SEC as a atioal securities exchage uder the Exchage Act (or operate withi a recogized exemptio). Although the coclusio i the DAO Report was the result of a fact-based iquiry, the SEC described its views with respect to ICOs i terms of geeral applicability, idicatig the SEC s itetio to implemet these views broadly i the future. Uder the SEC s aalysis of the Howey test, ot all tokes are securities, ad potetial issuers should cosider the expectatios of potetial ivestors ad the rights afforded i coectio with a ICO uder such test. While the SEC decided ot to pursue eforcemet i the matter of The DAO, the DAO Report is a remider that all offerigs of tokes withi the USA must be coducted i accordace with the federal securities laws or fall withi a exemptio. The DAO Report also raises a serious cocer that, abset a exemptio, platforms that operate as USA exchages to trade such tokes may eed to register as a atioal securities exchage or alterative tradig system. Furthermore, ay perso who receives compesatio from the sale of tokes may eed to register as a broker-dealer, ad ay perso who provides ivestmet advice with respect to a toke sale may eed to register as a ivestmet adviser. Further, the DAO Report wars [t]hose who would use virtual orgaizatios to review their obligatios uder the Ivestmet Compay of 1940 Act. The DAO Report did ot cosider such obligatios i this case because The DAO did ot begi its plaed ivestmet operatios. SEC Wars Ivestors ad Takes Actio Agaist Issuers Ivolved i ad/or Promotig ICOs Ivestor alert O August 28, 2017, the SEC published a Ivestor Alert warig ivestors about potetial scams ivolvig stock of compaies claimig to be related to, or assertig PAGE 12 j j JOURNAL OF INVESTMENT COMPLIANCE VOL. 19 NO

4 they are egagig i, [ICOs]. The Ivestor Alert wars that potetial scammers may use the lure of ew ad ufamiliar techology to covice ivestors to participate i what may be scams, iclud[ig] pump-ad-dump ad market maipulatio schemes i coectio with publicly traded compaies tryig to take advatage of the hype associated with these ew techologies. The Ivestor Alert ackowledges that ICOs themselves may be fair ad lawful ivestmet opportuities, while cautioig that publicly traded compaies may try to use a ICO to affect the price of the compay s commo stock. Accordig to the Ivestor Alert, the SEC recetly halted tradig i the securities of four issuers who made claims regardig their ivestmets i ICOs or touted coi/toke related ews. The Ivestor Alert states that [c]ircumstaces that might lead to a tradig suspesio iclude: A lack of curret, accurate or adequate iformatio about the compay for example, whe a compay has ot filed ay periodic reports for a exteded period; Questios about the accuracy of publicly available iformatio, icludig i compay press releases ad reports, about the compay s curret operatioal status ad fiacial coditio; or Questios about tradig i the stock, icludig tradig by isiders, potetial market maipulatio, ad the ability to clear ad settle trasactios i the stock. I additio to haltig tradig i the securities of issuers, at least oe start-up i the process of raisig moey through a ICO has reported that it was cotacted by the SEC. Accordig to the website for blockchai-based compay Protostarr: the compay was cotacted by the SEC o August 24, 2017, regardig its ogoig ICO to raise moey for a decetralized applicatio; ad after cosultatio with legal cousel, the compay determied to cease further operatios ad refud to the ICO participats all ether that had bee raised (Protostarr.io, 2017). Statemet by eforcemet co-director Sice the publicatio of the Ivestor Alert, Steve Peiki, Co-Director of the SEC s Eforcemet Divisio, reportedly stated, i coectio with ogoig ivestigatios ito potetial fraudulet activities by compaies i the blockchai ad digital currecy space, that some of these compaies are really just tryig to steal people s moey. Mr. Peiki wet o to state: As with ay kid of ewsworthy evet, roaches kid of crawl out of the woodwork ad try to scam moey off ivestors[5]. Coclusio These commets from the SEC staff, as well as the release of the ivestor alert shortly followig the ivestor bulleti ad DAO report, suggests that the SEC is closely moitorig the market for ICOs, ad that it wats potetial ivestors ad issuers to be aware that it is watchig ad may take actio if it believes the securities laws have bee violated[6]. potetial issuers ad ivestors should also take ito accout the implicatios of state securities laws o a state-by-state basis whe cosiderig whether to raise Capital or ivest, respectively, via a ICO. Issuers ad publicly traded compaies should also be aware that the commodity futures tradig commissio has asserted jurisdictio over digital currecies as commodities, ad has ati-fraud ad ati-maipulatio authority over spot ad forward trasactios ivolvig these products, icludig ICOs[7]. VOL. 19 NO j JOURNAL OF INVESTMENT COMPLIANCE j PAGE 13

5 Notes 1. Sectio 2(a)(1) of the Securities Act ad Sectio 3(a)(10) of the Exchage Act iclude ivestmet cotracts withi the defiitio of security. 2. SEC v. W.J. Howey Co., 328 US 293, 301 (1946); see also SEC v. Edwards, 540 US 389, 393 (2004). 3. SEC v. Shavers, No. 4:13-CV-416, 2014 WL at *1 (E.D. Tex. Sept. 18, 2014) (holdig that a ivestmet of a virtual currecy meets the ivestmet of moey compoet of the Howey test) 4. Citig SEC v. Gle W. Turer Eters., Ic., 474 F.2d 476, 482 (9th Cir. 1973). 5. See SEC Chief Says Cyber Crime Risks Are Substatial, Systemic, New York Times (Sept. 5, 2017). 6. Although beyod the scope of this OPoit, various state ad federal agecies have weighed i o the status ad treatmet of virtual currecies. Additioally, foreig jurisdictios icludig Chia, Sigapore, Hog Kog ad Caada have recetly released their ow guidace with respect to how ICOs are treated uder each jurisdictio s respective securities laws. 7. See I the Matter of Coiflip, Ic., et al., Comm. Fut. L. Rep. (CCH) 33,538, (Sep. 17, 2015). Referece Protostarr.io (2017), available at: (accessed 5 September 2017). Correspodig author Jeremy I. Sederowicz ca be cotacted at: jeremy.sederowicz@dechert.com For istructios o how to order reprits of this article, please visit our website: Or cotact us for further details: permissios@emeraldisight.com PAGE 14 j j JOURNAL OF INVESTMENT COMPLIANCE VOL. 19 NO