On Tuesday evening the SEC issued a significant report for cryptocurrency fund managers, announcing its determination that blockchain tokens offered and sold by an organization called The DAO were securities, subject to federal regulation. In its report, the SEC analyzed whether The DAO, Slock.it UG (a German corporation), Slock.it UG’s co-founders, and any intermediaries that brokered transactions violated federal securities laws through the issuance of DAO Tokens. Although the SEC ultimately elected not to bring charges or make specific findings regarding the transactions in connection with the issuance of DAO tokens, the SEC provided a cautionary report to all individuals and entities involved with future and past Initial Coin Offerings (ICOs), including cryptocurrency fund managers. Below is a brief background of the emergence of cryptocurrencies and ICOs, a securities analysis framework for ICOs moving forward, and finally our guidance regarding how certain virtual currency participants—particularly cryptocurrency fund managers—should proceed in light of the SEC’s report.
Understanding the terms
Blockchain: Blockchain is an emerging piece of technology that generally serves as a distributed electronic ledger—similar to a database of stored information—that is spread out and maintained by multiple individuals in a network of computers. Blockchain networks utilize cryptography and encryption methods to secure, process, and verify transactions that occur on the blockchain network. Virtual currencies (such as Bitcoin, Ethereum, and Litecoin) utilize blockchain technology to create and verify transactions that occur between users of the virtual currency.
Virtual Currencies (also labeled cryptocurrencies): Virtual currency is a digital representation of value that is issued and controlled by its developers, and used and accepted among the members of a specific (virtual) community. Unlike regular money, it is not issued by a central bank or other banking authority and is therefore called unregulated, decentralized and relying on a system of trust; this trust is typically accomplished through the use of cryptographic methods in blockchain technology. Many virtual currencies are convertible and can be exchanged to “real” money like the US Dollars.
Virtual Tokens or Coins: Virtual tokens or coins are typically units of value for virtual currencies. While virtual tokens or coins may represent other rights such as the right to utilize a product, virtual tokens or coins can often represent a financial interest in an entity or product; the latter potentially constituting a security.
Understanding the ICO
In an ICO, a company or other entity creates specialized virtual coins or tokens that it later distributes using blockchain technology. Individuals and entities that purchase these virtual coins or tokens typically exchange virtual currencies such as Bitcoin or Ether for the ICO company’s virtual coins or tokens. The capital raised in an ICO may go towards funding of a digital program, software, or other project. The virtual tokens or coins issued in an ICO can potentially be utilized by purchasers to access the digital platform, software, or contribute to the project in some capacity.
Where promoters and cryptocurrency fund managers may run afoul of federal securities laws is in situations where the ICO involves a return on investment or an interest in the company. For example, a startup company could potentially raise capital through an ICO; in lieu of issuing stock to investors, it could conduct an ICO and distribute virtual coins or tokens to investors, promising a share of future profits. Investors–including cryptocurrency fund managers–could then sell and purchase the virtual tokens or coins of the ICO for virtual currency or fiat currency (U.S. dollars) via virtual currency exchanges, thus creating a secondary market for the virtual coins or tokens of the ICO.
After the SECs release, the virtual coins or tokens that the company distributed would likely be considered securities subject to federal regulation. In addition, cryptocurrency fund managers purchasing such coins or tokens would need to comply with relevant Investment Adviser Act and Investment Company Act provisions and the virtual currency exchanges would likely be required to register as broker-dealers to avoid violation of federal securities laws.
In the SEC’s report, the SEC refrained from laying down concrete rules regarding whether any given ICO constitutes a securities offering. Instead, the Commission stated “[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.” If the facts and circumstances of an ICO constitute the offer and sale of a security, the issuers and promoters of the ICO “must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws.”
While the facts and circumstances standard does not provide a concrete test, entities looking to conduct an ICO may utilize the securities analysis provided by Coinbase, the first regulated Bitcoin exchange in the United States, to obtain a preliminary understanding of whether a particular ICO may constitute the offer or sale of securities. Based on the Howey Test for whether an arrangement involves an investment contract, the securities analysis can be distilled to the following:
Blockchain tokens with one or more of the following rights are not likely to meet the definition of a security:
1. Rights to program, develop or create features for the system or to “mine” coins or tokens that are embedded in the system;
2. Rights to access or license the system;
3. Rights to charge a toll for such access or license;
4. Rights to contribute labor or effort to the system;
5. Rights to use the system and its outputs;
6. Rights to sell the products of the system; and
7. Rights to vote on additions to or deletions from the system in terms of features and functionality
Conversely, blockchain tokens that provide one or more of the following rights are likely to constitute a security:
1. Ownership interest in a legal entity, including a general partnership;
2. Equity interest;
3. Share of profits and/or losses, or assets and/or liabilities;
4. Status as a creditor or lender;
5. Claim in bankruptcy as equity interest holder or creditor;
6. Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token; and
7. A feature allowing the holder to convert a non-security Blockchain Token into a Blockchain Token or instrument with one or more investment interests, or granting the holder an option to purchase one or more investment interests
While the SEC elected to not pursue charges against any individuals or entities that participated in The DAO ICO, this latest development signifies the SEC’s intent to assert its authority to regulate the digital asset and ICO market. Issuers intending on conducting an ICO and exchanges intending on brokering transactions involving virtual coins or tokens will need to consult qualified legal counsel prior to doing so. In addition, U.S. purchasers–including cryptocurrency fund managers–will need to consult qualified legal counsel concerning possible securities implications prior to doing so, including whether to register as an investment adviser and compliance with the Investment Company Act if planning on allocating investor funds toward ICOs and/or other virtual coin or token tractions.
We will continue to update you on further developments concerning blockchain networks, virtual currencies and ICOs. Given that the SEC has determined that an ICO’s status as a security will be decided on a case-by-case basis depending on the underlying facts and circumstances, we advise cryptocurrency fund managers to seek counsel before venturing into the virtual currency space. Please feel free to reach out to us if you have any additional questions about virtual currencies or the SEC’s report.