On Tuesday, July 25, 2017, the Securities and Exchange Commission (“SEC”) issued a Report of Investigation (the “Report”) finding for the first time that an offer and sale of virtual currency, often called an Initial Coin Offering (abbreviated “ICO”) or “Token Sale”, can be subject to U.S. federal securities laws. While the SEC decided not to pursue an enforcement action in this particular instance, the SEC did find that that the ICO that was the subject of the Report involved an offering of securities subject to U.S. federal securities laws.
ICOs and Token Sales are an innovative means by which many organizations use distributed ledger or blockchain technology to raise capital. Such sales have been subject to significant regulatory uncertainty. The Report serves as a warning to the industry and market participants that virtual tokens and coins can be considered securities “regardless of the terminology or technology used”, in which case issuers must register offers and sales unless an exemption to registration applies. Similarly, platforms for trading tokens and coins may also be subject to federal securities laws regulating securities exchanges.
The Report arose as a result of the SEC’s inquiry into an ICO made by a virtually existing entity, called The DAO, for the sale of its virtual DAO Tokens, the proceeds of which would be used to fund “projects” in exchange for a return on investment. The SEC began its investigation after hackers stole approximately one-third of The DAO’s assets after the tokens were sold to investors.
In its Press Release announcing the Report, the SEC emphasized that the Report confirms “that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption [to registration] applies.” However, in the Report and in an Investor Bulletin released concurrently with the Report, the SEC noted that whether particular virtual coins or tokens are securities will depend on the facts and circumstances of each ICO, including underlying economic realities of a particular transaction. In the case of The DAO, the SEC found that the DAO Tokens were securities regardless of the fact that (a) the tokens were only purchasable with “Ether,” a virtual currency, (b) the DAO itself was not a traditional corporate entity, but rather a decentralized autonomous organization existing only virtually, and (c) the tokens were only distributable through blockchain ledger technology.
While SEC Chairman Clayton noted that the SEC is studying the effects of distributed ledger and other related technologies and encourages market actors to interact with the SEC on these matters, the Director of the Division of Corporation Finance, William Hinman, and the Co-Director of Enforcement, Steven Peikin, warned that market participants must remain cognizant of the application of the federal securities laws and that investors must be given essential facts behind any investment opportunity and as to how compliance with such laws may be achieved.
In summary, issuers, potential investors, transaction facilitating platforms and other market participants should take care to consider whether U.S. and state securities laws apply to offerings and sales of innovative financial products and technologies.
Special thanks to Sean O'Neill in Los Angeles and Nicolas Dumont in New York for their summary of the Report.