With the advent of Initial Coin Offerings (“ICO”), the question of whether they are securities continues to plague the industry. If an ICO interest is a security, then it is subject to all of the regulations around the buying and selling of securities, in particular the requirement that the securities be registered or offered under a valid exemption. As this question remains open, companies thinking about pursuing an ICO should take great care in whether they treat them as a security.
US Law defines “security” in section 2 of the Securities Act of 1933 and section 3 of the Securities and Exchange Act of 1934. As one would expect, the definition includes stocks, bonds, futures, swaps, puts, calls, etc. Since the passage of these acts, the courts have expanded these definitions over time and developed tests to determine whether an instrument or device is a security. Courts and the SEC particularly focus on the definition of an investment contract as laid out in the Supreme Court case SEC v. W.J. Howey. This case, which was concerned with real estate contracts for citrus groves in Florida, created the “Howey test.” The Howey test states that an instrument is an investment contract if it is an investment of money into a common enterprise with the reasonable expectation of profits dependent solely on the efforts of another. Over time this test has been expanded to include instruments where the investment is not money and the profits do not arise solely from the efforts of another.
So do ICOs meet the definition of an investment contract in Howey? At this time, no case has made it to a US court for determination, but the Securities and Exchange Commission has issued multiple statements indicating its belief that some ICOs, if not most, meet the definition of a security. In July 2017, the SEC released an Investor Bulletin concerning ICOs simultaneously with publishing a Report of Investigation under Section 21(a) of the Securities and Exchange Act, describing a SEC investigation of The DAO, a virtual organization’s use of block-chain technology to facilitate the offer and sale of DAO Tokens to raise capital. The SEC applied the Howey test and determined that DAO Tokens are investment contracts and therefore securities under the Securities Act. The SEC based this determination on the following facts:
- The investors provided The DAO Ether, a virtual currency in exchange for the DAO Tokens.
- The investors invested in a common enterprise, as all their funds were pooled and available for use by The DAO.
- The investors stood to share in potential profits from the contracts that The DAO took.
- These profits were to be derived from the efforts of Slock.it, its co-founders, and The DAO’s curators for the idea of The DAO, the infrastructure behind it, and determining which projects to vote on and when to vote on them. Additionally, the DAO token holder’s voting rights were limited to voting on proposals, which were set by the curators.
This report served as a shot across the bow of the ICO industry, and since then the SEC has continued to focus on the unregistered sale of securities in the ICO market. At the end of September, the SEC charged Maksim Zaslavskiy and two of his companies (REcoin Group Foundation and DRC World) with selling unregistered securities and defrauding investors. This was quickly followed by a remark from SEC Chairman Jay Clayton, who was quoted as saying, “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” The ICO market should not take these actions lightly. If the SEC has determined that ICOs, especially where investors are given tokens, are securities offerings, it will not be long before more and more ICO issuers end up in legal trouble for unregistered securities offerings.
It is important to highlight that, at this point, only the SEC has made the determination that the DAO Tokens were securities, but, in light of the increased attention ICOs are receiving, ICO issuers should be wary of trying to run an ICO without registering the interests or operating under a valid exemption.
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