Does your company’s ICO need to be registered with the SEC as a securities offering?
By Vela Wood
If a blockchain technology company is considering conducting an initial coin offering (“ICO”) or token sale, the question the company needs to answer is whether it needs to register the token sale with the SEC? The answer depends on whether the SEC classifies the token as a security. Thankfully for us, the SEC recently provided some much-needed clarity on this topic with a Report of Investigation regarding a recent ICO. This article analyzes that report and touches on what makes tangible or intangible property or other agreements a security (and regulated by the SEC), or a non-security property that can be properly sold outside of SEC regulations.
WHAT IS A SECURITY, AND WHY IS THAT IMPORTANT?
The SEC determines whether an agreement is a security based upon the facts and circumstances of its execution. In doing so, the SEC looks past formulaic descriptions of the agreement and instead concentrates on the substance of the transaction to conclude whether it is a security under the Security Act of 1933. In performing this analysis, the SEC applies the established Howey Test derived from the U.S. Supreme Court case of SEC v. W.J. Howey Co.
Within the context of analyzing blockchain companies, there are three necessary elements that make the sale of property an investment contract under the Howey Test: (i) Was there an investment of money (or other property) into a common enterprise, (ii) with an expectation of profit, and (iii) predominately from the efforts of others? If the SEC answers all three of these questions affirmatively, then the agreement is a security. And, to protect investors, all persons who offer the sale of securities must either (a) register the offering with the SEC in order to provide necessary disclosures to potential investors, or (b) qualify for an exemption to registration. In its recent Report of Investigation addressing this topic, the SEC applied the Howey Test to the facts and circumstances of the DAO’S ICO.
THE FACTS AND CIRCUMSTANCES SURROUNDING THE DAO’S ICO HEAVILY SUGGESTED THE DAO TOKENS WERE SUBSTANTIVELY EQUITY DESPITE THEIR TOKEN FORM, AND THE SEC DETERMINED THE ICO MET ALL THREE ELEMENTS OF THE HOWEY TEST.
Slock.it, a German blockchain technology company, in an effort to eliminate disputes regarding what a company’s corporate governance rules meant, wrote code to theoretically replace corporate governance rules with self-executing “smart contracts.” Their code included what would be one central smart contract called the “DAO” that would create a Decentralized Autonomous Organization that allows other smart contracts to perform functions within the rules of the DAO. The co-founders of Slock.it designed the DAO to be independent of Slock.it with the idea that thousands of “founders,” who would offer products and services through the DAO, would be owners. But before this dispersed structure could take form, Slock.it needed to deploy the DAO.
The co-founders of Slock.it deployed the DAO by selling DAO tokens to purchasers for ether (Ethereum’s currency) to allow the DOA to fund and manage projects submitted by contractors (with the DAO submitting the first proposed project). Under the terms of the smart contract, when a project is successful, the DAO receives profits and the token holders vote to either fund additional projects or to receive the leftover profits as a distribution. And select members of the DAO, called curators, had the authority to determine which projects received a vote, and ultimately, whether the project was selected for funding.
In analyzing the structure of the ICO, the SEC determined that the token holders invested money in the form of ether in a common enterprise, expecting to receive profits from the successful projects as advertised by the DAO marketing materials that Slock.it’s co-founders created, and that the profits the token holders received would be generated by Slock.it, Slock.it’s co-founders, and the DAO curators that determined which projects to fund, placing heavy emphasis on the third element. Because the token holders could exert little to no meaningful effort in generating the potential profits, the SEC was not swayed by the voting rights granted by the tokens. While token holders could in theory vote, in practice the curators’ decisions pre-empted those votes. Moreover, the token holders could not collectively make informed decisions regarding potential proposals because of the “pseudonymity and dispersion” of the many token holders. Thus, these facts prevented the token holders from exercising meaningful control over the DAO’s actions and profits.
As a result, the SEC held in its report that the ICO violated federal securities law because the coins were offered in a manner similar to traditional securities offerings, and the DAO did not register the sale of the virtual coins and the ICO did not qualify for a registration exemption.
DOES THE DAO REPORT MEAN THAT ALL ICOS ARE SECURITIES OFFERINGS THAT MUST BE REGISTERED WITH THE SEC?
While the SEC report regarding the DAO ICO determined the tokens were securities, this does not mean that all ICOs are now subject to SEC regulations. Indeed, the report, by applying the Howey Test, made clear that it will use the unique facts and substance of each ICO to determine whether the offering is legal or not.
If a company’s ICO advertisements tout the potential profits for investing in its blockchain technology managed and controlled by the company and its founders, the tokens sold are most likely a security. However, if a company structures an ICO such that it is similar to someone purchasing gold, then there are strong arguments that the ICOs may not be a securities offering.
Furthermore, companies wanting to sell tokens outside of SEC regulations must avoid giving token purchasers any indication that they will receive some right, benefit, profit, or other expected return from the company’s efforts. Additionally, it is crucial for the company to establish that the tokens they are selling have a utility outside of their mere possession; they should provide the holder a service, or benefit unrelated to a direct monetary reward.
For example, a blockchain company may sell tokens that grant the holder access to storage, SaaS platforms, decentralized computing power, or the ability to contribute to and build on the services offered by the company. And, it can also be helpful to stop using the term ICO altogether. The term itself connotes a security offering through an IPO and implies a security is being offered.
In conclusion, if a company plans to undergo an ICO (or pre-sell tokens), it must either recognize its ICO as a securities offering and comply with SEC and state securities laws, or structure its ICO in such a way that differentiates it from the DAO offering.