“If the SEC gains regulatory control of ICOs,
then too will the bankers, VCs and their lawyers
who currently lead IPOs.”
SEC warns issuers of Initial Coin Offerings (ICOs) that they may be subject to securities laws.
Whether an ICO is subject to securities laws will depend on the facts and circumstances of the offering.
SEC determines NOT to take action again the ICO of the Decentralized Autonomous Organization (DAO).
Many ICO tokens may not meet the SEC’s definition of a “security”
SEC Says DAO Tokens are Securities, Brings No Action
The U.S. Securities and Exchange Commission (the “SEC”) issued a press release and an investigative report today warning generally that offers and sales of digital assets by “virtual” organizations or initial coin offerings (ICO’s) are subject to the requirements of the federal securities laws. The report noted, however, that “whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.”
The Registration Requirement for Securities
The SEC is the U.S regulatory body that oversees securities offerings. According to the Securities Act of 1933 (the Act), whenever a security is offered, a registration statement containing enumerated disclosures must be filed with the SEC, unless an exemption from registration is available and claimed by the issuer.
The filing of a registration statement is an expensive an arduous task that involves disclosing financial and other material information about the company and the security it intends to sell. The registration statement, which includes a prospectus or offering document, gets reviewed multiple times by the company’s internal and external lawyers, the company’s bankers and the SEC staff. At the end of the process the SEC, if satisfied, declares the registration statement effective and sales of the securities can begin.
If the registration statement contains any untrue statements of material fact or omits to state material facts, the issuer may be liable to the purchasers of securities issued pursuant to the registration statement and the officers and directors of the company subject to crimminal liability.
There are exemptions from the registration requirements of the act. These include forms of “private placements”, or small offerings to qualified instutional investors and/or a limited number of accredited individual (rich) investors. Generally due to potential liability and investor’s ability to demand full disclosure, many private placement documents contain nearly the same information that as a registration statement’s prospectus.
What is a Security?
The definition of a security is found in Section 2(a) of the Act and reads
(1) The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share,investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or
other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
Initial Coin Offerings that involve issuing tokens to participants may not meet the Act’s literal definition of securities. Indeed, when deciding whether purported security falls under the Act’s definition of “security” and therefore subjects the issuer to the registration requirements of the Act, an important factor is whether such investment instrument gives the holder an ownership interest in the company issuing such investment instrument.
In a Supreme Court case, SECURITIES AND EXCHANGE COMMISSION v. W. J. HOWEY CO.the court held in finding that a land sales contract under which the defendant took possession of land suitable for growing oranges sold to investors, farmed it and distributed a portion of the profits to the investors was indeed a security and not a land sales contract, noting “Form was disregarded for substance and emphasis was placed upon economic reality.”
Today’s SEC investigative report took note of Howley and included the language that the economic realities of the transaction would be considered in determining whether an ICO is a securities offering subject to the registration requirements under the Act.
In the SEC’s investigative report it noted that the DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation;it’s co-founders; and intermediaries may have violated the federal securities laws.
The SEC described the DAO as follows
The DAO was created by Slock.it and Slock.it’s co-founders, with the objective of operating as a for-profit entity that would create and hold a corpus of assets through the sale of DAO Tokens to investors, which assets would then be used to fund “projects.” The holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investment in DAO Tokens.”
The SEC also concluded that the DAO tokens WERE securities but decided not to take action. If the SEC determined that the DAO tokens WERE securities and were not registered as required under the ACT and there was no available exemption, it would seem Slock.it DID violate securities, rather than MAY have violated the law.
Perhaps the SEC took this seemingly contradictory point of view because it was not certain that a court would agree with their determination that the DAO tokens were securities.
The issue of deeming DAO’s tokens as securities and therefore subject to the registration requirements of the Act is problematic because in most cases DAOs are not owned by any one entity or group of entities or individuals but rather are software running on a blockchain.
Token holders in ICOs often have no ownership interest in the companies and therefore the tokens may not be properly deemed to be “securities”. Even with the assistance of the language in Howley whereby the economic realities of the transaction are considered, if no ownership interest is granted, it may be difficult to claim a security is being offering in an ICO and therefore subject to SEC purview and the registration requirements of the Act.
ICOs Are a Threat to Silicon Valley and Wall Street
The initial public offering process is a cash cow for Silicon Valley venture capital (VC) firms and Wall Street bankers and lawyers. The VCs and bankers control which companies go public and receive vast amounts of capital in the process, while making great fortunes themselves acting as gatekeepers. Unregulated ICOs are an existential threat to the IPO market as they by pass Silicon Valley and Wall Street completely.
If ICO’s are not subject to SEC oversight, they may continue unabated and the nominal value raised in such offering continue to grow exponentially. Rather then bring an enforcement action, which the SEC declined to do so today, they may ask Congress to give it broader authority to regulate ICOs specifically. If the SEC gains regulatory control of ICOs, then too will the bankers, VCs and their lawyers who currently lead IPOs.
Longer term, such a regulatory structure may bring even more money in to the cryptocurrency space.
Physical gold in one’s hand may still just be the best coin there can be.
Why not buy when it’s on sale?