Authors: Herbert F. Kozlov
The Report offers insight into the SEC’s interpretation of the Howey test in the context of pseudonymously held digital assets and corporate structures with “decentralized” ownership and control. Moreover, it highlights the specific facts that led the SEC to determine that this particular ICO fell within the ambit of the securities laws. Notably, the SEC Investor Bulletin warns market participants of the potential risks attendant to investing in ICOs involving both securities and non-jurisdictional products.
The DAO is a for-profit entity created by Slock.it and Slock.it’s co-founders. Through an ICO, The DAO offered “DAO Tokens” to investors in exchange for ether, a digital currency connected to the Ethereum blockchain. Each DAO Token granted the holder voting rights and an entitlement to “rewards” in exchange for their investment. The investors remained “pseudonymous,” meaning that the investor’s Ethereum blockchain address functions as their only identifying information. Following the ICO, persons could buy or sell DAO Tokens on the secondary market through digital asset exchanges. The DAO’s primary form of business was investing in projects submitted by “Contractors” who received a majority vote from DAO Token holders.3 Generally, only project proposals given the green light by The DAO’s “Curators” were voted on.
The SEC determined that the DAO Tokens offered by The DAO through an ICO are unregistered and non-exempt securities. The SEC applied the Howey test (first articulated in a 1946 Supreme Court decision) to reach a determination on the regulatory status of the tokens. In that case, the Court considered whether the offering of units of a citrus group development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor constitutes an “investment contract,” a form of security. The Court defined an “investment contract” as a contract, transaction or scheme whereby a person:
- Invests his money
- In a common enterprise and
- Is led to expect profits
- Solely from the efforts of others (i.e., a promoter or third party).
The Howey test is very fact specific, and the Report provides insight into how the SEC applied each factor with regard to the DAO Tokens. Although this is the first time that the SEC has offered explicit guidance regarding its Howey analysis with respect to digital assets, its Division of Enforcement has made a similar argument in prior enforcement actions, such as SEC v. Shavers, where the Eastern District of Texas concluded that bitcoin is a form of “money,” satisfying the first prong of the test.4
II. Key Takeaways
Market participants should be cognizant of the following key takeaways from the Report and Investor Bulletin:
A. Legitimacy of ICOs
The Investor Bulletin acknowledges the legality and validity of ICOs that comply with applicable federal laws and regulations, stating that ICOs “may provide fair and lawful investment opportunities.” This is welcome news to market participants interested in issuing novel digital currencies, tokenized assets, and smart contract products through a blockchain.
With the SEC’s blessing, financial institutions may now begin to use the ICO as a lawful alternative to the traditional initial public offering. The SEC and the Financial Industry Regulatory Authority (“FINRA”) have both encouraged market participants to work together with regulators to allow them to better understand the potential risks and opportunities presented by blockchain technologies. Both the Investor Bulletin and the Report offer insight into possible topics of discussion for future engagement with regulators.
B. Function over Form
The Report states that if a digital asset functions as an investment contract, it will be accordingly regulated as a security. The SEC is relying on the prophylactic catchall “investment contract” definition to allow it to cast a broad net that captures as many “[n]ovel, uncommon, or irregular devices” as possible. The Report explains that “[w]hether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction.” The SEC considers the function of the digital asset to be determinative in its analysis.
C. The SEC Views Digital Currencies as a Form of Money
The SEC considers digital currencies to constitute “money” for the purposes of the securities laws. Investors who purchased DAO Tokens using ether therefore satisfied the first prong of the Howey test. The Eastern District of Texas agreed with the SEC when the SEC made this argument in the Shavers case in 2013, finding that bitcoin is a form of money for purposes of the Howey analysis.
This opens the door to a wide range of potential SEC enforcement actions involving both fraudulent investment schemes and otherwise legitimate issuances of tokens that run afoul of the securities laws and involve the solicitation of digital currency investments from investors in lieu of cash. Companies interested in accepting, acquiring or issuing digital currencies must consider the risk that the arrangement may be characterized as an “investment contract” under the Howey test. Similarly, investment companies and other funds that accept digital assets as an investment and/or hold digital assets for the benefit of investors should consider their regulatory and fiduciary obligations accordingly.
D. Distributions and Voting Rights are Red Flags
Digital tokens that entitle the holder to distributions in the form of profits, such as dividends or other periodic payments, indicate a reasonable expectation of profits under the Howey analysis and functionally resemble equities. Persons who purchased DAO Tokens were entitled to share in earnings from the projects that The DAO funded.
Other digital assets, such as bitcoin and ether, do not entitle holders to any form of distribution. While the owner of these products arguably may have an expectation of profits, in the Report, the SEC characterizes ether as a “virtual currency” or a convertible currency, rather than a security, implying that it does not meet certain of the other Howey test factors.
Similarly, digital tokens that allow the holder to exercise voting rights in proportion to the holder’s ownership interest resemble equities under a functional analysis. Holders of DAO Tokens received voting rights with respect to the management of The DAO and the projects that it would fund, which parallels attributes of some securities.
E. Exercise Care when Drafting Promotional Materials
The vast majority of the SEC’s conclusions are directly supported by language in The DAO’s promotional materials. For example, the SEC Report quotes a YouTube video featuring one of the co-founders at a London conference stating that investing in The DAO is like “buying shares in a company and getting . . . dividends.” Companies that offer digital tokens must exercise caution when drafting their promotional materials so as not to characterize their product as a security.
F. Centralized Managerial and Entrepreneurial Control Satisfies “through the Efforts of Others”
Merely decentralizing voting rights and the day-to-day choices of a company are likely not sufficient to avoid satisfaction of the “through the efforts of others” prong of Howey where others continue to perform critical managerial and entrepreneurial functions. The core of the SEC’s legal analysis came down to the “solely through the efforts of others” prong of the Howey analysis in light of the novel nature of the decentralization of ownership and control through digital assets with voting rights.
The DAO was essentially established to be capable of functioning independently from traditional forms of control, such as a Board of Directors. However, the SEC concluded that the efforts of the co-founders and Curators were critical to the operations of The DAO. The Curators played a “critical” role in selecting the projects that investors were eligible to vote on and the co-founders stepped in to resolve network issues, such as responding to a cyber-attack. However, the SEC concluded that the voting rights provided to DAO Token holders were “limited” because they did not provide the holders with meaningful control due to the “perfunctory” nature of the voting on projects, as well as the inability of the holders to communicate with one another due to wide geographic dispersion.
G. Digital Asset Exchanges May Need to Register with the SEC
The Report clarifies the SEC’s position that unless an alternative trading system (“ATS”) exemption is available, trading venues which allow market participants to purchase and sell digital assets, where those assets would qualify as securities, may be required to register with the SEC as national securities exchanges. The major digital asset exchanges, such as Coinbase and Gemini, currently offer products that function as a medium of exchange and likely would not qualify as securities, such as bitcoin, ether and litecoin.
As currently unregulated exchanges and new entrants begin to offer a wider variety of digital assets, they should consider whether SEC registration or exemptive relief under Regulation ATS will be necessary. Likewise, funds that seek to attract investors and manage digital or fiat currency trading and investing must consider the applicable state and federal regulatory issues applicable to their activities.
H. Regulators are Clarifying their Jurisdiction in the Digital Asset Market
It caught many market participants by surprise when the Commodity Futures Trading Commission (“CFTC”) determined that digital currencies are “commodities” subject to its jurisdiction a few years ago and has subsequently brought a handful of enforcement actions involving digital currencies. However, the scope of the CFTC’s jurisdiction over these products is limited to instances of market manipulation and fraud unless futures or swaps are involved. Earlier this year, the SEC, in rejecting the Winklevoss Bitcoin Trust exchange-traded fund, concluded that the “bulk of bitcoin trading occurs on markets where there is little to no regulation governing trading, and thus no meaningful governmental market oversight designed to detect and deter fraudulent and manipulative activity.”5 With the SEC’s broad interpretation of the Howey factors, such that they arguably encompass a broad swath of the digital assets on the market, the SEC is taking a step towards joining the CFTC in exercising its jurisdiction over these products, leading to more “meaningful government market oversight.”
In the past, the SEC has pursued enforcement actions against Ponzi and retail fraud schemes involving digital currencies, but the issuance of the Report and Investor Bulletin marks the first time that it has clearly asserted jurisdiction over a swath of digital assets as securities.
The CFTC continues to exercise jurisdiction over futures and swap transactions with digital asset underliers, such as bitcoin options. On July 24, the CFTC granted LedgerX LLC, a cryptocurrency trading platform, registration as a clearing house for derivative contracts settling in digital currencies. LedgerX is the first federally regulated digital currency options exchange and clearinghouse in the U.S.6 In 2015, the CFTC ordered Derivabit, another cryptocurrency trading platform, to cease trading because the exchange had not complied with CFTC regulatory requirements.7
Although the SEC decided not to pursue an enforcement action against The DAO and related parties at this time, it chose to issue the Report in conjunction with the Investor Bulletin to provide guidance and a clear warning to the fast growing marketplace. The SEC’s Report and Investor Bulletin should be welcomed as positive guidance for the industry, as these documents provide helpful clarity and acknowledge ICOs as an acceptable method for raising capital. While the SEC’s regulatory requirements may limit the population of participants that can offer securities through an ICO, they may nevertheless broaden the scope of products available by providing comfort to investors and driving further demand.
- The Report and Investor Bulletin are available here.
- SEC v. W.J. Howey Co. et al., 328 U.S. 293 (Oct. 14, 1946).
- The SEC considered the ability of the DAO Token holders to vote on corporate matters to be a factor in its Howey analysis, as discussed in detail below.
- SEC v. Trendon T. Shavers and Bitcoin Savings and Trust, Civil Action No. 4:13-CV-416 (E.D. Tex., complaint filed July 23, 2013).
- The Winklevoss order is available here.
- The LedgerX orders are available here.
- The Derivabit order is available here.
Client Alert 2017-178