Digital Tokens as Securities: The SEC Weighs in on the Debate

Fintech Alert

Orrick's global Blockchain Working Group is in the camp that believes the blockchain and associated token or appcoin innovations are here to stay and have the potential to be a significant disruptive force, but we will be happy to see a more predictable system of regulation in place.  The volatility of crypto currencies, the hacking theft of millions of dollars of value and the gold rush nature of the market have obscured some of the truly revolutionary long-term potential of this technology. Orrick's Blockchain Working Group has closely monitored token sales and is actively working on advising clients with respect to the various complex issues which tokens sales entail, including issues relating to federal and state securities laws, the Commodity Exchange Act, federal and state money transmitter laws, federal, state and foreign tax laws, consumer protection laws, commercial transactions and securities litigation, among others.

As anyone interested in blockchain and cryptocurrencies probably already knows, the SEC issued a formal Report of Investigation on July 25, relating to a token offering by The DAO, a decentralized autonomous organization that used distributed ledger or blockchain technology to operate and raise money as a virtual entity. The SEC's take on this particular token sale did not surprise anyone, especially securities lawyers, as the SEC affirmed that tokens in many cases are in fact securities, subject to regulation under US securities laws.

Over the past three years, and especially over the past year or so, a substantial number of entities and companies have issued various crypto-currencies, known as tokens, in so-called initial coin offerings, or ICO's, to raise often substantial amounts of money for the stated purpose of funding the development of new services such as communications or networking technology or other electronic goods and services.  These token sales have been appealing to companies because they are perceived as a non-dilutive source of financing and have been conducted without the normal complexities and compliance requirements of the securities laws, allowing companies to reach a broad investing audience quickly at minimal cost.  With little more than an 8-10 page whitepaper describing a proposed project, issuers have raised tens or hundreds of millions of dollars over a period of only hours or days from participants across the world. There has been concern, however, whether the free lunch of quickly raising money from many people without worrying about regulation can possibly be as easy as ICO proponents hope.

The SEC has reminded the industry that there is in fact no free lunch, as it declared in its Report that tokens can be and often likely are, in fact, securities under U.S. law.  According to the Report, The DAO sold tokens representing interests in its enterprise to investors in exchange for payment with a virtual currency.  Based upon all of the facts and circumstances presented, including its finding that investors could hold these tokens as an investment with certain voting and ownership rights or could sell them on web-based secondary market platforms, the SEC determined that the DAO Tokens are securities under the Securities Act of 1933 and the Securities Exchange Act of 1934. While the Report and its conclusion that the DAO Tokens are securities is not at all surprising, it still has had an immediate and substantial chilling effect on the entire blockchain and cryptocurrency market, as participants struggle with its implications.

Notably, despite its finding that The DAO, its co-founders and intermediaries may have violated the federal securities laws, the SEC determined not to pursue an enforcement action in this matter "based upon the conduct and activities known to the [SEC] at this time."

Because the investigation determined that many market participants questioned the application of the U.S. federal securities laws to the offer and sale of DAO Tokens, the SEC issued the Report "to advise those who use a Decentralized Autonomous Organization . . . or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws."  The SEC very plainly stated that no matter whether it is called a token, a crypt-currency, a smart contract or a duck, there are clear guidelines under U.S. law on what constitutes a security, and that digital tokens need to be analyzed under existing securities laws to determine their regulatory status.

The Report concluded by listing, for additional guidance, SEC enforcement actions involving virtual currencies and investor alerts.[1]

The DAO Tokens at issue in the Report were obviously securities – we think that anyone who knows much about the securities laws would agree after giving it some thought.  However, there are many more interesting cases – for instance appcoins or utility tokens for use on an existing network – that pose more difficult questions.  While there is an argument that utility tokens issued in connection with an already functioning network are outside the scope of the securities laws, we think that the jury is still out and those wishing to make a public sale of tokens whether pre or post network launch should proceed very cautiously, and possibly first consult with the SEC, as the SEC will examine the economic realities underlying a transaction. 

In a companion Public Statement by the SEC Divisions of Corporation Finance and Enforcement on the Report, the Divisions "encouraged" market participants who are employing new technologies to form investment vehicles or distribute investment opportunities to "contact our staff, as needed, for assistance in analyzing the application of the federal securities laws." We imagine that there will be a number of such consultations in the days ahead as market participants try to better understand how to navigate the evolving regulatory environment.

In addition, the SEC stated bluntly that any entity or person engaging in the activities of an exchange, "such as bringing together the orders for securities of multiple buyers and sellers using established non-discretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration."  Of course, the exchanges and trading portals have been one of the main motivating factors behind the surge of coin offerings, allowing early purchasers of tokens to get an investment return on their original purchase.  The proliferation of portal trading in tokens serves to highlight the aspects of tokens (even of app coins meant to purchase services) that make them appear most like securities.  It also should be noted that the SEC pointed out in passing that other issues were presented as to whether The Dao was an "investment company," as defined under the Investment Company Act of 1940, and whether anyone associated with The Dao was an "investment adviser," as defined under the Investment Advisers Act of 1940.[2]

Lastly, emphasizing its focus on ICO's, the SEC also issued an Investor Bulletin on ICO's cautioning prospective investors that "new technologies and financial products, such as those associated with ICO's, can be used improperly to entice investors with promise of high returns in a new investment space."

For additional information regarding the Report, token sales and other blockchain-related questions, please do not hesitate to contact Daniel Kim, Edward Eisert or your usual Orrick advisor.

The other SEC enforcement actions involving virtual currencies are as follows:

[1] Links to those other enforcement actions are at the end of this alert.

[2] N.B.: The Report did not address these issues in detail, in part, because The Dao never commenced its business operations funding projects. The Report also did not address the reporting obligations of issuers under the Securities Exchange Act of 1934 to file periodic and current reports with respect to each class of their equity securities if certain conditions are met.