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When is an Initial Coin Offering a Security?

by   |   July 31, 2017

As discussed in a post from last week, the SEC determined that Initial Coin Offerings can be securities. The finding stems from the SEC’s investigation into The DAO’s offering and sale of DAO Tokens (a form of virtual currency that were at times referred to as “Initial Coin Offerings”). Based on a review of the facts and circumstances and the substance and economic realities of the offering and sale, the SEC determined that DAO Tokens were securities; a type of investment contract under Sections 2(a)(1) of the Securities Act and 3(a)(10) of the Exchange Act.

In its report, the SEC presented facts in support of the following three elements required for establishing an investment contract under the Securities Act (See SEC v. W.J. Howey Co., 328 U.S. 293 (1948)): (i) an investment of money in a common enterprise; (ii) a reasonable expectation of profits; and (iii) profits derived from the managerial efforts of others.

DAO Token holders invested money in a common enterprise:

The first prong of the test requires a showing that investors invested money of some form in a common enterprise. As noted in the report, it is not necessary that money be in the form of cash; contributions other than cash, such as Bitcoins and services, have been consider “money”. In the case of The DAO, participants purchased DAO Tokens using virtual currency (ETH), which the SEC found was sufficient to establish that DAO Token holders invested money.

DAO Token holders had a reasonable expectation of profits:

The second prong requires a showing that investors had a reasonable exception of profits. In the report, the SEC noted that marketing and informational materials promoted The DAO as a for-profit entity with an objective of investing in projects in exchange for a return on its investments. Similar materials also informed potential investors that, as DAO Token holders, they could expect to receive dividends and various forms of “rewards”. Based on the information in these materials, the SEC found that DAO Token holders had a reasonable expectation of profits, regardless of whether the rewards could come in the form of goods and/or services.

DAO Token holder profits were derived from the managerial efforts of others:

Under the last prong, facts must support a showing that managerial efforts, other than from investors, are essential to obtaining profits. Central to the review is whether such efforts will “affect the failure and success of the enterprise.” In the report, the SEC presented facts establishing that i) The DAO founders ( and Curators were essential to The DAO’s operations and success and ii) DAO Token holders could not effectively exercise control over the enterprise. The reported noted that The DAO founders provided expertise and managerial support; actively engaged in The DAO operations, including responding a security breach; appointed Curators who oversaw the DAO Token holder proposal process; and actively monitored and engaged in investor forums. Additionally, the SEC found that DAO Token holders had limited voting rights, which prevented them from effecting meaningful change or control over the enterprise. The SEC specifically identified the voting structure and DAO Token holder numerosity, pseudonymity and dispersion as obstacles to investor influence.

It should be noted that the SEC did not take the position that all coin offerings are securities. The SEC expressly stated that a determination will need to be made based on the facts and circumstances of each case. Based on the facts from the investigation, the SEC decided not to bring charges against The DAO or make findings of violations. The SEC instead cautioned industry and market participants that federal securities laws apply to all those who offer and sell securities in the United States. As The DAO investigation highlighted, such laws extend to traditional companies and decentralized autonomous organizations, securities purchases using standard U.S. currency and virtual currencies, and distributions in certificated form and through ledger technology.