On July 25, 2017, the Securities and Exchange Commission (“SEC”) released groundbreaking materials relating to blockchain tokens. These materials provide significant and welcome insight to the SEC’s and its staff’s thinking in this area, although they leave a number of important questions unanswered.

The SEC released a detailed investigative report under Section 21(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) and accompanying staff statement concluding that the 2016 token sale by The DAO, a Swiss organization, was an unregistered securities offering (the “DAO Report” and “DAO Statement,” available here and here, respectively).  The SEC’s Office of Investor Education and Advocacy also released a general investor bulletin on “Initial Coin Offerings” (the “Investor Bulletin,” available here).

This update provides key observations on the findings in the DAO Report and then discusses in more detail the factual background and provides guidance for market participants.

A. Summary of Key Findings in the DAO Report

What significant conclusions did the SEC reach in the DAO Report? The SEC made the following findings:

• DAO Tokens (as defined below) were investment contracts within the definition of “security” under the Securities Act of 1933 (“Securities Act”) and the Exchange Act.
• The DAO was the “issuer” of the securities, even though it was an autonomous organization embodied in computer code and executed on a blockchain.
• The DAO should have registered its offering of DAO Tokens with the SEC or conducted the offering in compliance with an exemption under the Securities Act.
• Platforms over which DAO Tokens are traded were “exchanges” for purposes of the Exchange Act, and should have either registered with the SEC or complied with the exemption for Alternative Trading Systems (“ATS”).
• Implementation of The DAO’s plan to fund projects would have raised questions over its status as an “investment company” under the Investment Company Act of 1940 (the “Investment Company Act”) and the status of its associates as “investment advisers” under the Investment Advisers Act of 1940 (the “Advisers Act”)

Are there other implications of the DAO Report? Although not addressed directly in the DAO Report, the following are likely corollaries to the SEC findings:

• Those who assisted in the initial offering of DAO Tokens or who bought DAO Tokens with a view to later distribution could be treated as “underwriters.” The securities laws broadly define underwriter to capture any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates, or has a direct or indirect participation in any such undertaking.
• Those who participated in effecting secondary market trades in DAO Tokens over the Platforms could be treated as brokers or dealers required to register with the SEC.
• The DAO, its associates and those who participated in offering or trading DAO Tokens would also be subject to the securities laws of various states.

B. The DAO – Factual Background

The DAO was created and released in May 2016. “DAO” stands for “Decentralized Autonomous Organization,” which the DAO Report characterized as a “virtual” organization embodied in computer code and executed on a blockchain.  A German company named Slock.it and its founders created The DAO to operate as a for-profit entity that would raise funds by selling DAO tokens (“DAO Tokens,” a digital means of transferring value and rights) to investors, and then use those assets to fund certain projects.

Individuals could propose projects to be funded with The DAO’s assets, and “Curators” selected by Slock.it were responsible for evaluating and screening such projects before DAO Token holders could vote on them.  In addition to their rights to vote on projects, DAO Token holders would also share in the contemplated revenues from these projects, and could realize their investment in DAO Tokens by re-selling DAO Tokens on a secondary exchanges that listed DAO Tokens.

On June 17, 2016, after the sale of approximately 1.15 billion DAO Tokens, a hacker exploited a flaw in The DAO’s code and misappropriated roughly one-third of The DAO’s sale proceeds (which were in the form of Ether, a digital currency).  Slock.it’s co-founders, in coordination with others in the Ethereum ecosystem, addressed this incident by “hard forking” (changing part of the underlying code of) the Ethereum blockchain which had the effect of transferring all of the diverted Ether back to a recovery address.  All purchasers of DAO Tokens who adopted the hard fork were allowed to exchange their DAO Tokens for Ether and avoid any loss of the Ether they invested.  As the DAO Report found, The DAO never commenced its business operations of funding projects.

C. The SEC’s DAO Materials and Investor Bulletin

The SEC conducted an investigation into whether The DAO, its co-founders and intermediaries had violated the federal securities laws.  Based on its investigation, the SEC concluded that the DAO Tokens were securities under the Securities Act and the Exchange Act, the offer and sale of which was required to have been registered with the SEC or exempt from the registration requirements.

The DAO Report includes a lengthy analysis of the basis for concluding that the DAO Tokens were securities, the salient points of which are summarized in the DAO Statement, including: (1) “The DAO sold tokens representing interests in its enterprise to investors in exchange for payment with virtual currency” and (2) “[i]nvestors could hold these tokens as an investment with certain voting and ownership rights or could sell them on web-based secondary market platforms.”  Although we summarize key takeaways from the DAO Report below, we strongly recommend market participants to read the report in full.  It provides a clear road map to the industry with respect to how the SEC and its staff will analyze token sales in the future.

Along with the release of the DAO Statement and DAO Report, the SEC’s Office of Investor Education and Advocacy also issued an Investor Bulletin.  The Investor Bulletin is aimed at helping the general public understand the basics of blockchain technology, blockchain tokens, and risks and other relevant considerations in purchasing such tokens.  Consistent with the SEC’s investor protection mandate, a substantial part of the document focuses on risks and red flags relating to investment fraud—including deals that sound too good to be true, promises of high returns without risk, and high pressure sales tactics.  Although the Investor Bulletin is purchaser-facing, all sellers of blockchain tokens should read it to understand the risks that are of principal concern to the SEC.

D. Key Takeaways for Market Participants

1. Why The DAO, and Why Now? By the time of The DAO’s spectacular crash in 2016, many legal observers (see here, for instance) had already concluded The DAO was likely to be a security and that the SEC would likely investigate given the substantial amount of money raised. Now that the SEC has confirmed as much in the DAO Report, the next obvious question is: why did the SEC not also bring an enforcement action?  While it is still possible for the SEC to do so, several practical reasons for not doing so might include:

Speed:  A Section 21(a) report like the DAO Report can be issued without delay.  A legal action or settlement would surely take time.

Certainty:  Any legal action carries a risk that a party may not achieve its goals, whether for substantive or procedural reasons.  By publishing a Section 21(a) report, the SEC could be sure to get its message out.

Clarity:  A legal action could muddy the waters, depending on factual discovery and legal strategies.  The Section 21(a) report allowed the SEC to make its public statement without negotiation or other input from an adversary.

Thus, the SEC leveraged its investigative work on The DAO, set forth the relevant legal analysis for determining whether a token is a security, expressed its views on activities of exchanges and promptly made a clear statement putting the industry on notice that the federal securities laws apply to “emerging technologies and new investor interfaces.”

2. Blockchain Token Sellers Are Subject to the Federal Securities Laws. Although not surprising to a number of market participants and legal counsel, the DAO Report dispels any argument that blockchain token sellers may be exempt from federal securities laws on the basis that a token sale (that would otherwise be a securities offering) is conducted on an autonomous or pre-programmed basis.  An argument that a “smart contract,” once deployed, operates on an autonomous basis and thus does not involve an “issuer” is not likely to be persuasive to the SEC.  (See our whitepaper here for more information on smart contracts).  The DAO Report notes that an “unincorporated organization” is a “person” that can fall within the relevant definition of “issuer,” and leaves no doubt that the SEC will identify an issuer if it finds that a token is a security.
3. Any “Participants” in a Securities Sale May Be Subject to the Federal Securities Laws. The SEC also made clear that any “participant” in an unregistered sale of a token that is determined to be a security may face liabilities and remedies under federal securities laws. Based on case law cited in the DAO Report, the SEC would appear to construe “participants” to include any person with a “necessary role” in the transaction, at a minimum.  The necessary participant test essentially asks whether, but for the participation, the sale transaction would not have taken place—in other words, whether the acts were a substantial factor in the sales transaction.  Persons who advise or consult on the sale of a security token, create the applicable code that executes a security token sale, who receive or manage sale proceeds, or who help find investors or broker token purchases, among others, should carefully consider their status when a security token may be involved.  It should also be noted that violations of Section 5 of the Securities Act (the offer or sale of an unregistered security) are strict liability offenses that do not require proof of scienter.
4. Some Tokens Are Not Securities, and Others Are – It Depends on the Facts and Circumstances. The SEC stressed the importance of a “facts and circumstances” evaluation of each token sale to determine if the sale was a securities offering.  The SEC did not express the view that all blockchain tokens are securities – some tokens may be securities, and others may not be.  Elevating economic reality (and substance) over technological form, the SEC will apply the longstanding investment contract test set forth in SEC v. W.J. Howey Co. (“Howey”) where appropriate to determine if the sale was a securities offering:  was there an investment of money, in a common enterprise, with expectation of profits from the managerial efforts of others?  In the DAO Report, notably, the SEC put significant thought into the “managerial efforts of others” prong to illustrate that decentralized, blockchain-based ecosystems such as The DAO may satisfy that prong.  The detail and sophistication of the SEC’s analysis makes clear that they have worked hard to understand blockchain technology, and presumably won’t shy from investigations or enforcement on the basis of technological complexity.
5. The SEC Staff Welcomes Blockchain and Other Emerging Technologies as a Means of Capital Formation. The SEC’s Division of Corporate Finance and Enforcement staff, in the DAO Statement, stated that:

Distributed ledger and other emerging technologies have the potential to influence and improve the capital markets and the financial services industry. Interest in and funding for these technologies appears to be growing at a rapid pace. We welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities. We are particularly hopeful that innovation in this area will facilitate fair and efficient capital raisings for small businesses. We are also mindful of our obligation to protect investors and recognize that new technologies can offer opportunities for misconduct and abuse.

For the companies that are considering blockchain tokens for securities offerings, whether exempt or registered, this is welcome news.  It suggests that the Divisions of Corporate Finance and Enforcement would not broadly view blockchain-based models as disfavored means of raising capital.  Given the transparency, security and efficiency benefits of using blockchain technology, this recognition of the value of the technology from the SEC staff sets the tone and will hopefully help spur broader adoption and use by a variety of market participants.  Perkins Coie has advised clients on SEC-registered digital securities issued and trading via blockchain technology on an ATS, as well as privately placed unregistered securities issued using blockchain technology with ownership represented on the private company’s shareholder ledger.

6. Avoiding “Investment” Messaging Is Critical for “Non-Security” Tokens. For persons selling a blockchain token that is not a security, it is essential to craft communications in a way that will not mistakenly create the expectation of profit through the seller’s effort.  The SEC meticulously analyzed the communications that The DAO’s principals made in concluding that investors bought DAO Tokens with investment expectations, specifically referencing that “the various promotional materials disseminated by Slock.it and its co-founders informed investors that The DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment.”  In this regard, it is essential to recall that any communications (including private emails) made to a purchaser are fair game in the “security” analysis.
7. Token Utility Still Matters for “Non-Security” Tokens. In the Investor Bulletin, the SEC Office of Investor Education and Advocacy noted that token sellers may structure and market tokens to access a platform, use software, or otherwise participate in a project made available by the token seller.  Taken with the DAO Report’s careful emphasis that a “facts and circumstances” analysis is required under Howey before finding that a blockchain token is a security, it remains the case that a token whose primary purpose is utility may, depending on the facts and circumstances, be created and sold without constituting an unregistered securities offering.  In other words, other tokens may—in contrast to the DAO Token—provide sufficient access, utility, or other features to their purchasers and users that they should not be viewed to correspond to the promises, rights, and expectations that cause a token to rise to the level of a security.  Perkins Coie has extensive experience in U.S. regulatory counseling on blockchain utility tokens of various kinds.  See here for a compilation of public materials addressing this topic generally.
8. Exchanges, Advisers and Investors Should Carefully Re-Evaluate Token Activities. At the end of the DAO Report, the SEC pivoted from The DAO itself to the exchanges that facilitated the trading of DAO Tokens, as well as other entities that purchase, sell, invest in, or provide advice with respect to DAO Tokens.  We address the implications for these entities in turn:

Exchanges.  Citing the Exchange Act’s definition of “exchange” (which are entities subject to substantial SEC regulation), the SEC observed that platforms that traded DAO Tokens “provided  users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.” Because of these characteristics, and because no exemptions applied, the SEC explained that such a platform is required to register with the SEC as an exchange or, under an exemption, as an ATS.  As a result, platforms currently facilitating the trade of tokens that are securities (such as a token materially similar to The DAO) should consider their status.

Advisers.  Similarly, the DAO Statement provides that any person providing advice about an investment in a token that is a security (which could include valuation analysis) could be acting as an investment adviser that may be subject to registration requirements under the Advisers Act.

Investors.  The DAO Report also noted the potential application of Investment Company Act to the funding of projects with the proceeds from a token sale.  Accordingly, investment company regulation could potentially apply to any investment company that holds security tokens.

Other Secondary Purchasers and Sellers.  Finally, although not explicitly stated in the DAO materials, an important implication is that anyone who purchases an unregistered security and subsequently sells it is still subject to Section 5 of the Securities Act.  Therefore, investors who purchased DAO Tokens and subsequently sold them without an applicable exemption or registration may have violated Section 5.

9. Consultation with Counsel and Division Staff Is Encouraged. The DAO Statement explained that the federal securities laws “have a principles based framework that can readily adapt to new types of technologies for creating and distributing securities.” In other words, there are not any bright line rules in how the Howey test applies to blockchain tokens, and no such rules will likely be forthcoming.  It is thus unsurprising that DAO Statement expressly encouraged market participants to “consult with securities counsel to aid in their analysis of these issues” and to “contact [SEC] staff, as needed.”  From our substantial experience in this field, we would underscore the importance of tailored legal analyses of blockchain token sales and ecosystems, given the “facts and circumstances” nature of the Howey test, the variety of considerations that can affect whether a token is a security, and the potentially severe consequences of violating federal and state securities laws.

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