SEC Finds That Internet Sales of Tokens and Virtual Coins Are Subject To Federal Securities Laws
August 1, 2017
On July 25, 2017 the United States Securities and Exchange Commission (“SEC”) released a report on its investigation of an organization involved in selling digital assets (so-called virtual coins or tokens). Its findings serve as a warning to individuals and businesses who have recently relied, with increasing frequency, upon the sale of internet tokens to effect “initial coin offerings” or “ICOs” as a means of investing in and raising capital for companies. The SEC determined that the offering of such coins or tokens may constitute the offering and sale of securities, depending on the circumstances. The offering and sale of securities triggers registration and exemption issues under both federal and state law which, in turn, results in some complex and expensive legal compliance matters that these ICO offerors had surely hoped to avoid. The ICO offerors were attempting a unique and complicated way to form equity capital, a process that has historically been challenging and expensive for companies, particularly so for start-ups and smaller ones, and remains so despite recent efforts by Congress and the SEC to ease that burden through the implementation of “crowdfunding” and other means.
The SEC had investigated one of the more popular entities among the so-called decentralized autonomous organizations. One of such entities known as “The DAO” was found to have likely violated the federal securities laws. These are virtual entities, run by way of a series of rules encoded within software known as smart contracts. There is no actual company or legal entity involved, but the principals of a German start-up named Slock.it were involved in The DAO. Just like other similar entities, the activity conducted by The DAO was maintained on something known as a “blockchain.” Even though the SEC elected not to pursue enforcement action against The DAO, its findings will surely have a chilling effect on the use of this procedure as a method of raising capital. The SEC’s position was based on well-established law, primarily a 70-year-old U.S. Supreme Court case involving the determination of what constitutes a security.
As part of its efforts to educate the public on this matter, the SEC issued an investor bulletin explaining the new and complex area of virtual coins and tokens. Interestingly, and importantly, the SEC noted that these offerings may provide fair and lawful investment opportunities. That signals a possible increase in the use of this method, presumably so long as the methods used by The DAO are not employed. A brief summary recap of the SEC’s bulletin follows:
- What is a blockchain? It is an electronic ledger used to process transactions using cryptography. (Bitcoin and Ethereum are two well-known examples, the latter having been used by The DAO.)
- What is a virtual currency or virtual token or coin? It is a digital representation of value that can function as a medium of exchange or be digitally traded.
- Who issues virtual tokens or coins? Typically, a virtual organization or other capital-raising entity. A virtual organization typically consists of computer code and is executed through a distributed ledger or blockchain.
While the area of virtual coins and tokens is relatively new and complex, the SEC believes that persons considering participating in same should consider a number of factors before doing so, including:
In short, the participation in ICOs for the purposes of investing and/or raising capital, should probably not be casually undertaken. Because of the manner in which these transactions are conducted, investors’ ability to recover money invested in a fraudulent ICO is severely limited.
- Has the ICO been registered with the SEC?
- If the ICO promotor declares that the ICO is exempt from registration, potential investors will likely need to be accredited investors (meaning that net income or net worth requirements will apply).
- If the ICO is referred to as a “crowdfunding offering,” people wishing to participate in such offering should try to ensure that it is structured according to the SEC’s requirements for such offerings, which requirements are fairly lengthy and detailed.
 The DAO, a fledgling shadowy entity was launched last year with a $150 million crowdfunding and almost immediately thereafter was hacked and drained of $50 million of cryptocurrency. Shortly thereafter, the hack was unwound and the funds restored through the use of a procedure known as a hard fork of the blockchain.
 SEC v W. J. Howey Co., 328 U.S. 293 (1946)
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