Last week the Securities and Exchange Commission (“SEC”) released a report on the Initial Coin Offering (“ICO”) of the Decentralized Autonomous Organization (the “DAO”), which raised almost $150mn from investors using this new capital raising method (before returning the money). The report explained that the SEC views this ICO as a sale of securities and that the DAO was in violation of securities laws, though no enforcement action was taken.
There has been an industry wide debate on whether or not Initial Coin Offerings constitute the sale of securities. An ICO is a means by which a company in the blockchain space can raise capital from investors using cryptocurrencies and investors receive compensation in return, whether that is a reward, membership, delivery of a product or service, or financial compensation tied to the underlying profits generated by the business.
Companies like the DAO create computer code and tokens using custom based code or existing infrastructure like the Ethereum blockchain. The DAO’s objective was to provide a decentralized business model for venture capital investing, where DAO token investors would receive profits generated by the investments made by the DAO. When they initiated their ICO, the company penned a white paper that explained their solution and business plan.
The DAO executives explained in their white paper that the rewards received by investors were likened to “buying shares in a company and getting …. dividends.” The company clearly stated that their token sale was intended to make money for investors.
The question that arose is whether or not this meant that the company sold securities. In this case, the tokens could appreciate in value and could be sold on the secondary market. As explained in a recent Pepper Hamilton client alert the SEC uses the definition of a security that came out of the 1946 U.S. Supreme decision of SEC v. W. J. Howey Co., which is now referred to as the Howey test. Under Howey, a financial arrangement will be characterized as an “investment contract” and treated as if it were a security if it involves an investment of money with a reasonable expectation of profit. If considered securities then the company would have to enlist a broker dealer and in the United States only accredited investors would be permitted to participate through a private placement transaction. In the case of the DAO, the SEC determined that this was a sale of a security since the investment came with a reasonable expectation of profit through the DAO’s venture investments.
The SEC report was meant to caution the industry and market participants. According to the SEC press release, Steven Peikin, Co-Director of the Enforcement Division stated, “As the evolution of technology continues to influence how businesses operate and raise capital, market participants must remain cognizant of the application of the federal securities laws.”
This is the first guidance of its kind from US regulators for this new trend of raising capital. Chinese regulators have also begun to look at how regulators can play a role in the market as seen in this article“PBoC Official Suggests Several Ways to Regulate ICOs” recently covered on LendIt News and the Monetary Authority of Singapore issued a similar statement yesterday: “MAS clarifies regulatory position on the offer of digital tokens in Singapore”.
The DAO was also the victim of an attack where almost $50mn worth of Ether had been stolen. This was probably the highest profile theft among a string a crypto thefts that have occurred over the past 18 months. We believe this is part of the reason why the SEC has taken a closer look at the ICO market and why they chose the DAO as their first case study.
The larger debate on ICOs is still being discussed among the blockchain community. This feels very reminiscent of the crowdfunding industry, which clearly delineated between “equity-based crowdfunding” and “rewards-based crowdfunding” (ie, AngelList versus Kickstarter). The SEC determined that equity based crowdfunding constituted the sale of a security and, with the help of Congress, they introduced legislation through the JOBS Act, which provided the regulatory framework for the industry. Rewards based crowdfunding, on the other hand, remains largely unregulated. It is quite possible that the ICO market evolves in a similar manner, with two flavors of an ICO, an equity-based ICO and a rewards-based ICO. We are likely to see the SEC provide further guidance on equity-based ICOs but it remains to be seen if rewards-based ICOs become regulated.
Finally, if you want to get a first hand look at the ICO market in action, check out Stox Prediction Market which launches its ICO today with the goal to raise $30 million. When Floyd Mayweather posts to Instagram the following: “I’m gonna make a $hit t$n of money on August 2nd on the Stox.com ICO,” we welcome the SEC’s, Pboc’s and MAS’s interest in regulating the market before it gets totally out of hand.
