SEC Report on Virtual Token Offerings and ICOs

On July 25, 2017, the Securities and Exchange Commission (the “SEC”) Division of Enforcement released a Report of Investigation (the “Report”) and a press release on the securities law analysis of an offer of DAO virtual tokens (“DAO Tokens”).  (Such an offer is sometimes called an Initial Coin Offering, or “ICO”.)  The Report may be the first of this type of report on an offer of such tokens, not just by the SEC but to the best of our knowledge other regulators as well, and as such is likely to be carefully reviewed by the virtual token and investor communities.  The Report focuses on an offer by The DAO, a virtual entity, of a token created by UG (a German corporation), executed on a distributed ledger or blockchain (basically, a virtual ledger) in exchange for a virtual currency called the Ether.  The proceeds of the DAO Token offering were intended to fund “projects”.  The SEC does not decide the question of what type of entity The DAO may be, but it is described as a “decentralized autonomous organization” in that it exists only in computer code and its founders say that they have little or no control over it.  Projects would be contracts proposed by contractors – and approved by a “curator” of The DAO – that exist in the Ethereum Blockchain, and the DAO Token holders would be able to vote on any project with the votes handled by the software and not by a person.  Investors in DAO Tokens were to receive income from the projects, and could monetize their investment by selling the DAO Tokens.

Unfortunately, a hacker or hackers stole about a third of the Ether received by The DAO.  The SEC decided not to charge anyone involved in the DAO Token offer.  The SEC was, however, clear that under the facts, DAO Tokens are securities for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934.  The SEC applied the tests developed in SEC v. Edwards, 540 U.S. 389 (2004) and SEC v. W.J. Howey Co., 328 U.S. 293 (1946) to one form of security, the “investment contract”: “an investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial effort of others.”  It is not possible to go into detail in this note, but it is clear that a determination whether a virtual token is a security or not (for example, it is perhaps merely a kind of commodity or a currency) is a question of the particular facts and circumstances.  That said, the Report indicates that at least at this stage, the SEC is looking broadly at any virtual token offering or ICO, particularly where the investor expects a return on their investment due to third party entrepreneurial or managerial efforts (even where the efforts are not directly controlled by the person that first issues the tokens).  In addition, the SEC did not decide whether The DAO was an “investment company” under the Investment Company Act of 1940 because it did not begin funding projects, but merely noted that such an analysis would be required as well.