I posted this elsewhere but think it more properly belongs here:
An analysis of the SEC Report, released on July 25, 2017, By a non-lawyer community member.
On, July 25, 2017, the United States Securities and Exchange Commission (SEC)released their investigative report regarding “The DAO” initial coin offering (ICO)which was launched in April, 2016, and was subsequently hacked during the ICO sale. The most attention grabbing assertion in this report is that DAO Tokens were defined as securities, and are therefore subject to the laws and regulations of the SEC. Furthermore, the report states that ICO issuers as well as investors are required to register with the SEC, unless an exemption applies.
What does this mean? Should we all start dumping our ETH tokens on the nearest exchange and wipe our hard drives? No, probably not. It is important during these fast moving and ever changing times to keep a clear head and examine the real world impact that this report will have on the average user and token issuer. I will attempt to break down each section of the SEC’s report and provide you with a summary of their assertions and conclusions. I am not an attorney, I am not a financial adviser, I am not giving anyone advice in relation to anything. My purpose is to increase community awareness and assist those who have trouble understanding the convoluted legal jargon.
First, please understand that this is an investigative report, nothing more. This is not a law nor is it a proposed law. This is a legal opinion offered by a government agency. While it may be very influential in developing future legal arguments and regulation enforcement in the United States, it is simply an opinion at this point. Further clarification and modification through legal challenges will most certainly follow in the months and years to come.
A .pdf of the SEC Investigation Report can be found here:
https://www.sec.gov/litigation/investreport/34-81207.pdfIn section I, paragraph four, the SEC states as follows:
“The investigation raised questions regarding the application of the U.S. federal securities laws to the offer and sale of DAO Tokens, including the threshold question whether DAO Tokens are securities. Based on the investigation, and under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933.”
The SEC is basing its determination that DAO tokens are securities on the following factors which I have listed numerically for ease of reference:
1. Foundational Principles of the Securities Laws Apply to Virtual Organizations or Capital Raising Entities Making Use of Distributed Ledger Technology
2. Those who Invested Money in The DAO
3. With a Reasonable Expectation of Profits
4. Derived from the Managerial Efforts of Others
a. The Efforts of Slock.it, Slock.it’s Co-Founders, and The DAO’s Curators Were Essential to the Enterprise
b. DAO Token Holders’ Voting Rights Were Limited
The first factor asserts that SEC laws apply to blockchain technology and virtual organizations because under the Securities and Exchange Act a security includes “an investment contract.” This argument certainly works for some currencies and assets as they are openly based on ‘smart contracts’ among other similar configurations. Whether or not this would apply to all cryptocurrencies is debatable. The SEC acknowledges in other areas of their report that these determinations should be taken on a case by case basis and include multiple factors.
The SEC’s second argument is that members of the DAO invested money. In order to perfect an investment contract, there must be an exchange of money from investors. They assert that the ‘term’ money does not have to mean cash. The SEC cites several cases where it was held that virtual currency, namely bitcoin, can be used to create an investment contract. Conversely,it has not been established that simply investing in, or contributing to, a community project would be subject to this section. There is room for argument on this premise that a specific cryptocurrency project may not fall under this section.
The third factor for determining whether a token or currency meets the definition of a security is that investors have a reasonable expectation of profits. In the case of the DAO, there were numerous marketing campaigns, whitepapers, and forum posts promising continual returns on investment. Not all crypto currencies are launched in this way and not all promise a return from monetary gains. Based on this,community members may be able to tailor their projects in certain ways to negate this factor.
Finally, the SEC asserts that securities are investment gains derived from the managerial efforts of others. This is where things can get really interesting and tricky for other cryptocurrency projects. The DAO was set up in a very centralized way. As the SEC pointed out, the founders and ‘curators’ of the DAO were essential to its’ enterprise. The voting rights of investors were limited at best, and just for show at worst. When the DAO hack occurred, investors had no control or legal standing to resolve the issue themselves and had to turn to the founders and curators for a solution. In this way, the DAO was certainly managing the enterprise with little to no input from investors. Projects that are truly decentralized, where voting and new implementations are community based or automated, could potentially avoid meeting this factor.
In summary as to whether a crypto project is or is not a security, this report simply outlines the criteria they used to determine whether or not the DAO should be considered a security. It offers guidelines for future actions and regulation but does not change existing law. While there are likely to be upcoming challenges on this issue,the courts of law may not accept the SEC’s argument in its entirety. For now, it is best to seek the advice of an attorney specializing in virtual assets and/or securities trading in regard to how this report may affect you and our projects in the future.
I hope you found this information helpful. I will be following up with an analysis of the exemptions allowed under the Securities and Exchanges Act and how those may or may not apply to cryptocurrency projects.
Dated: July 25, 2017
