Are Initial Coin Offerings the Offer of Securities?

July 27, 2017

The SEC Applies Securities Laws to Blockchain-Based Initial Coin Offerings in Investigative Report

The stratospheric rise in valuations of cryptocurrencies, such as Bitcoin and Ethereum, and emerging applications for blockchain across the financial landscape have captured headlines and cover pages in 2017.  In the area of capital-raising, blockchain-based financing events known as token sales or initial coin offerings (ICOs) have shattered fundraising records and emerged as a viable alternative for funding the development of new products and services.  ICOs have grown in popularity despite uncertainties as to whether, and under what conditions, these offerings may be viewed by the US Securities and Exchange Commission (SEC) as constituting the offer or sale of “securities.”

A trio of releases issued by the SEC on July 26 provide the clearest window to date into the SEC’s views on initial coin offerings and its regulatory mandate in the cryptocurrency space.  Most prominently, the SEC published an investigation concluding that the particular tokens offered and sold in a 2016 token sale by “the DAO” were securities, and therefore subject to federal securities laws.  The DAO had issued tokens to purchasers, providing them the right to vote on contract proposals to be funded by the assets collected by the DAO and receive earnings from the projects.  In the report and accompanying press release, the SEC confirmed that issuers of distributed ledger or blockchain-technology based securities must register offers and sales of these securities, unless a valid exemption applies.  The SEC did not recommend enforcement at this time, but used the investigative report as an opportunity to caution the industry and market participants.  The SEC also concurrently issued an investor bulletin on ICOs to alert investors on potential risks associated with ICOs.

Under US federal securities statutes and case law, the definition of a security is interpreted expansively, and includes, among other things, “investment contracts” defined under what is commonly referred to as the “Howey Test” from a 1946 case, SEC v. W. J. Howey Co., 328 U.S. 293.  Howey and its attendant case law define the “touchstone” of an investment contract as “the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975). The investigation report on the DAO’s token offering illustrates how the SEC applied this test to the particular facts it considered.

In the report, the SEC detailed its view that purchasers of DAO tokens reasonably expected to earn profits, noting that various promotional materials informed purchasers that the DAO was a for-profit entity whose purpose was to fund projects in exchange for a return on investment.  Depending on the terms of a contract for a particular project, token holders could share in potential profits from the contracts.  The SEC found that the fact that the projects could include services and goods for use by token holders didn’t change the “core analysis” that investors purchased tokens with the expectation of earning profits from the efforts of others.  The SEC also noted the ability of token holders to monetize their tokens by re-selling them on a number of web-based platforms that supported secondary trading in the tokens.  In addressing whether such profits derived from the managerial efforts of others, the SEC found profits from the platform were derived substantially from the efforts and expertise of the founders and curators, and that voting rights afforded to token holders were not sufficient to offset those essential managerial efforts.

The SEC also flagged the absence of any limitation on the sophistication of investors and resale restrictions.  Additionally, they raised the specter of potential Investment Company Act and Investment Advisers Act considerations, as well as potential requirements for exchanges transacting in digital assets deemed securities to register as a national securities exchange under the Securities Exchange Act of 1934.

Notably, the SEC did not make a determination that all ICOs constitute an offer of securities.  The SEC indicated that whether a particular transaction involves the offer or sale of a security—regardless of the terminology or technology used—will depend upon the facts and circumstances, including the realities of the transaction.  Many ICOs and token sales today are intended to be characterized more like presales providing discounted access to services or products that the issuing company does or will provide, rather than an offer and sale of securities.  Companies evaluating potential ICOs will want to consider the views expressed by the SEC, and the particular facts and circumstances relating to a proposed ICO in assessing the risk that their ICOs may be viewed as an offering of securities.  In light of potential risks arising from legal uncertainties, some companies may also wish to consider alternative approaches to ICOs, which may include structuring an ICO to comply with securities law-based exemptions tied to limiting participation to accredited investors and non-US persons or crowdfunding.  There may even be specific circumstances where consideration of the benefits and disadvantages of registering an ICO under the Securities Act of 1933 is appropriate.

The SEC report and the attendant investor bulletin on ICOs are the clearest signals yet of the SEC’s approach to the flurry of activity in the crypto space.  Furthermore, they serve as a harbinger of potential future scrutiny by the SEC, as blockchain continues to be applied in new and innovative ways.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Eric Sibbitt, an O'Melveny partner licensed to practice law in California and New York, Robert Plesnarski, an O'Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, Kiran Raj, an O'Melveny partner licensed to practice law in the District of Columbia and Georgia, and Jake Leraul, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted. 

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