While ICOs (initial coin offerings) and their legal advisors analyze facts and circumstances to assemble arguments why some token sales do not fall under the definition of a security, there are other securities-related questions that are necessary to address to ensure token offerings are compliant with the federal securities laws.
While it is interesting to discuss the Howey test and explore whether a token (computer code) is currency, a utility, a security, a commodity, or a mixture of the above, the assumption should not be that filing a private placement memorandum and accepting investments only from accredited investors is sufficient for an ICO to comply with the federal securities laws.
The conversation today is focused almost exclusively on whether a token is a security, and more specifically – how can a token be designed so that it is not a security. But the backdrop remains that the current ICO bubble has made significant money for some people, and issuers now see offering tokens as a way to attract investors. Investors, on the other hand, are investing in ICOs that have no infrastructure where the token can be utilized, thus the benefit of the token is largely conceptual and may never be built. And investors appear to be motivated (perhaps primarily) to invest as a bet that a token will increase in value.
In this environment, we need to remain cognizant that the SEC and state securities regulators will be keenly focused on investor protection. Moreover, the SEC analysis in DAO while concentrating on the question whether a token is a security, did not limit the securities law questions to only that question. While whether a token is a security is certainly the first question, if an ICO is to meet all the requirements of the federal securities laws, participants in ICOs need to address other questions that the SEC will soon be asking them.
The DAO is only the beginning of the ICO story
The DAO, a so-called “decentralized autonomous organization” embodied in computer code, was designed not to be your everyday Delaware corporation. It existed (theoretically) only on blockchain, with smart contracts dictating its protocols and corporate governance. Investors who purchased DAO tokens were permitted to vote on projects that the DAO would fund.
The DAO (like a corporation) was designed to make money by funding projects. While the DAO existed only as computer code, it could hold real assets and holders of its tokens had a right to share in its profits. In addition to the securities issue, as investors remained anonymous, serious IRS and money laundering implications were raised. The DAO still raised $150 million. The SEC in its report considered the Howey test where it was stated that a security is an investment of money or value in a business or operation where an investor has a reasonable expectation of profits based on the efforts of others.
The SEC concluded that the DAO token was a security. And as the security was not registered nor fell under an exemption from registration, the DAO’s actions violated the federal securities laws. The SEC, however, famously issued a report rather than bringing a case. If the SEC did bring a case, however, the SEC would not have limited its inquiry to whether the token sold was a security. Rather, the DAO report and precedent amply support that the SEC would have considered other significant securities-related questions. We can expect that the SEC will do so again in its next wave of ICO investigations. These questions include:
1) if a website enabled the tokens to be sold, was that website operating as a securities exchange?
2) was the entity that sold the securities operating as an investment company?
3) was any person (individual or entity) providing advice about an investment in the security, and if so, was that person required to be registered as an investment adviser,
4) was any person who was selling the token acting as an unregistered broker-dealer, and
5) was the securities offering, or the marketing of the securities offering (including celebrity endorsements), fraudulent in any way?
Liability under the federal securities laws for participants in an ICO can come from many different laws. State securities regulators, like the SEC, have broad powers to enforce their own anti-fraud laws. While the question whether a token is a security is an important question that needs to be analyzed closely (and like a court would analyze the Howey test, not by using a flawed point system or other questionable methods circulating today), it is only the first step, but not the only question necessary to address all pertinent securities-related issues.
The information and materials in this article are provided for general informational purposes only and are not intended to be legal advice. The issues discussed include complicated areas of law and legal advice should be obtained from a securities attorney about your specific circumstances.