09-08-2017
On July 25th, 2017, the Securities and Exchange Commission (the “S.E.C.”) released a report of their investigation into whether or not The DAO, an unincorporated association that conducted an Initial token Offering (“ITO”) in mid-2016, and its related parties violated U.S. securities law by virtue of the tokens issued in this offering (and later traded freely) actually being securities.
The DAO token was, famously, at the center of a major theft of ethereum and the resulting hard fork of the ethereum blockchain.
ITOs have traditionally been structured, with the help of major law firms, to offer tokens for sale via methods that skirt U.S. securities law. This is often done by creating utility tokens, which essentially function as currency for use in connection with a platform (for example, ETH and Ethereum). In this way, projects can raise money claiming to be selling currency, rather than securities, and claim exemptions from U.S. securities law. (The trick here is doing this without recognizing gain on the sale of these currencies, and we will go over the basics of how this is done in a later post) A raise not being characterized as an “offer or sale of securities” means that it is not subject to regulations regarding the number of investors, advertisement of the offering, sophistication requirements for investors, dollar limits on the raise, among others. Perhaps most importantly, this also means that the tokens are freely tradable and not subject to resale restrictions. If the tokens are securities, all these usual regulations come into play.
The S.E.C.’s report analyzed the DAO Tokens through the framework of the Howey Test, the standard for determining whether an instrument is an investment contract, the catch-all category for securities (the SEC has a long list of specific instruments that are securities, "investment contract" is the broader category which potentially covers non-traditional instruments). The test focuses on four factors: (1) has money been invested, (2) in a common enterprise, (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. They quickly came to the conclusion that the first three factors were met. (1) Payment in BTC and ETH for DAO tokens was determined to be an investment of “money.” (2) The pooling of this money into a common fund to promote projects met the “common enterprise” factor. And, (3) because the tokens had the potential to allow token holders to share in the profits, there was a reasonable expectation of profits as well.
Regarding the third factor, it may be important to note that while “reasonable expectation of profits” has been determined to include “increased value of the investment,” here the S.E.C. made the determination of this factor based on the expected sharing of profits which different projects within the DAO could allow. This leaves open the question of whether tokens, whether utility (ETH, XRP, etc…), or otherwise, meet this third prong.
And so in this case, the key factor for determining whether the DAO should be classified as a security became the application of the fourth and final prong of the Howey Test: whether the expectation of profits was driven by the “entrepreneurial or managerial efforts of others.” With regards to the DAO tokens, the S.E.C. decided that the fourth factor was also met as the efforts of The DAO, and its related parties (Slock.it, Slock.it’s Co-Founders, and The DAO’s Curators), would continue to be necessary in managing the tokens and putting forward project proposals. Moreover, while the token holders had the opportunity to vote on proposals, these proposals were first curated by The DAO, there was no guarantee that the token holders had enough information concerning the project to make an informed decision, and the token holders were a dispersed and disorganized group that could not really coordinate to exercise meaningful control.
The S.E.C. determined that all four factors were met and that the DAO Tokens were securities. This meant U.S. securities law governed the offering and trading of the tokens. They were kind enough not to impose fines and penalties on The DAO, and instead simply ordered compliance with U.S. securities laws going forward. Whether this means death for The DAO in the United States remains to be seen.
Unfortunately, this ruling does not provide too much clarity as the DAO was simply low hanging fruit for the SEC.
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