Blockchain and Digital Token Update: SEC Releases Investigative Report and Investor Bulletin

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.”

  1. 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.
  2. 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.
  3. 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.
  4. 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.

  1. 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.
  2. 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.
  3. 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.

  1. 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 the 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.

Please contact the authors of this blog post, or your usual contact in Perkins Coie’s Blockchain Technology and Digital Currency group, if you have questions about how the Investor Bulletin, DAO Statement or DAO Report might apply to you or your business.

Blockchain Week in Review – July 14, 2017

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments

     Regulatory

IRS Tailors Request for Coinbase Transactions
After launching an investigation of Coinbase customer accounts, the IRS filed a Notice in California District Court on July 6, limiting the scope of the investigation to only the accounts that issued Continue Reading

SEC and U.S. Attorney’s Office Bring Action Against Promoter of Bitcoin Store, Inc.

On June 30, 2017, the SEC and the U.S. Attorney brought parallel civil and criminal fraud charges against Renwick Haddow, the owner of an unregistered broker-dealer entity named In Crowd Equity Inc., and two corporate entities named Bitcoin Store, Inc. and Bar Works, Inc. (SEC Litigation Release, US Attorney Press Release) In addition to filing the civil complaint, the SEC sought and obtained an emergency asset freeze against Haddow, Bitcoin Store, and Bar Works.

According to the SEC, Haddow, a citizen of the United Kingdom living in New York, used an unregistered broker-dealer—In Crowd Equity Inc.—to solicit potential investors to purchase securities of Bitcoin Store and Bar Works. In connection with raising over $37 million, Haddow and other employees of InCrowd allegedly made numerous false statements concerning the companies’ operations and the existence and qualifications of certain senior executives.  For example, according to the SEC’s complaint, Haddow set up Bitcoin Store to be a purported “Bitcoin trading platform.”  The investor materials that were sent to prospective investors claimed that Bitcoin Store had gross sales of over $7 million and that the proceeds from the stock issues would be put toward Bitcoin Store’s working capital and development.  In addition, the investor materials allegedly contained an introductory letter signed by Bitcoin Store’s “Chief Executive, Gordon Phillips.” The materials described Mr. Phillips as a former “Global Head of Currency and Options trading” at HSBC.  They also claimed that he held an MSc in finance from Yale.  In reality, according to the SEC, Mr. Phillips never obtained any degree from Yale, never worked for HSBC, and was a fictitious person.  The SEC also claims that Bitcoin Store had no operations and never generated the gross sales claimed in the offering materials, and was a complete sham.

The SEC alleges that Haddow diverted more than eighty percent of the funds raised for Bitcoin Store and transferred more than $5 million from Bar Works’ bank accounts to accounts in Mauritius and Morocco.

This case demonstrates that the SEC and the Department of Justice are keenly watching companies that raise funds and tout information relating to bitcoin.

 

 

Blockchain Week in Review – June 16, 2017

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments

Regulatory Updates

Illinois Regulators Determine that Digital Currencies Are Not Considered Money
In new guidance provided and finalized by the Illinois Department of Financial and Professional Regulation (“IDFPR”), the agency has taken the stance that decentralized digital currencies are not money because they are not “authorized or Continue Reading

Blockchain Week in Review – June 9, 2017

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments

SEC Obtains Judgment Against Bitcoin Mining Companies The SEC obtained final judgment this week against GAW Miners, LLC and ZenMiner, LLC. – two virtual currency mining companies who, along with their principal, Homero “Josh” Garza – have been the subject of ongoing investigation and litigation since the SEC filed a complaint against them in December 2015. The two mining companies were accused Continue Reading

Resources on Crypto-Tokens and Securities Law

Recently, there has been growing interest in whether, and in what circumstances, crypto-tokens may constitute “investment contracts” under the U.S. Supreme Court’s Howey test, rendering them securities subject to regulation in the United States.  The following resources take a deep dive into that issue, exploring the structural, marketing and other key considerations that may make crypto-tokens more or less likely to be securities under Howey.  As these resources demonstrate, the Howey test is highly fact-dependent, indicating that certain crypto-tokens may be securities under Howey whereas others – if properly designed – may not.

Continue Reading

Blockchain Week in Review – May 26, 2017

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments

Regulatory Updates

Vermont Law Recognizes Digital Currency as a Permissible Investment
Earlier this month, Vermont Governor Phil Scott signed Continue Reading

Guilt by Association: Bitcoin and the WannaCry Ransomware Attack

The recent so-called “WannaCry” ransomware cyber-extortion attack has thrust bitcoin as a means of payment back into the debate surrounding illegal online activity. Much in the way that the internet, in its early days, was seen as a tool useful only for crime, pornography, and other socially unacceptable activities, so too are bitcoin and other cryptocurrencies seen by some as only useful for bad actors. This of course ignores the substantial investment in bitcoin and other cryptocurrencies by legitimate and well-known businesses, financial institutions, and even governments all around the world. Still, in some corners the stereotype persists. But much in the way that the internet continued to grow and evolve, so too will the bitcoin and cryptocurrency ecosystem grow and evolve, and its use by bad actors will continue to diminish. Continue Reading

Two New White Papers Exploring Use Cases and Legal Issues of Distributed Ledger Technology-Based Smart Contracts and Self-Sovereign Identity Systems

We are pleased to release two in-depth white papers discussing cutting-edge legal and technology issues applicable to smart contracts and self-sovereign identity systems.

In the smart contracts white paper, Dax Hansen, Partner and Chair of the Blockchain and Digital Currency Industry Group, and Carla Reyes, Visiting Assistant Professor of Law at the Stetson University College of Law, define and demystify DLT-based smart contracts with a review of the current academic and industry literature, describe five actual use cases for smart contracts and analyze the novel legal issues surrounding smart contracts. This is the first comprehensive treatment of the full range of legal issues related to smart contract applications – going beyond the narrow discussion of contract law issues that predominate the existing literature.

Hansen and Reyes describe the state of the art of smart contracts in digital asset sales and capital markets, supply chain management, smart government records and smart cities, real estate land registries, and self-sovereign identity systems. The paper consists of four sections:

  • A brief introduction to DLT-based smart contracts;
  • A review of current academic and industry literature on smart contracts;
  • An exploration of the legal issues in emerging use cases of smart contracts; and
  • An initial risk mitigation checklist for businesses developing applications using smart contracts.

Following an overview of the legal risks involved in the use cases of this nascent and quickly-evolving technology, the authors conclude that companies in all industries should determine how this significant technology will impact them, that companies can benefit from the use of this significant technology, and that industry participants can address relevant legal issues with careful planning and collaboration.

In the self-sovereign identity white paper, Joe Cutler, Dax Hansen, and Charlyn Ho discuss the development of self-sovereign identity as a DLT-based technology, the various industry leaders offering DLT-based identity solutions, and the key legal issues self-sovereign identity solutions will face as the technology goes mainstream. The paper addresses:

  • The background and state of digital identity
  • Distributed ledger technology and self-sovereign identity
  • A sampling of companies or foundations working on DLT-based identity solutions
  • Self-sovereign identity and the law

While tracing the evolution of self-sovereign identity, the authors describe the many ways DLT can be leveraged to create applications that allow users to control their digital identity in a way that is both secure and portable across multiple platforms. Entities building out such solutions that are profiled in the white paper include Sovrin, Uport, Civic, R3, and Mooti.

Finally, Hansen, Cutler, and Ho discuss the most pressing legal considerations facing this promising technology, including:

  • Privacy Laws;
  • Anti-Money Laundering Laws;
  • Biometrics Laws;
  • Laws Governing Online Identities and Death;
  • Trust Frameworks and
  • Practical Considerations for Governments Using SSI.

As self-sovereign identity and other DLT-based technologies grow in popularity and adoption, they will have an ever increasing disruptive impact across all industries. The authors conclude that these advances will demand that legal practitioners, lawmakers, and technologists harmonize their approaches with applicable law.

Follow the links below to download the White Papers:

Perkins Coie LLP Legal Aspects of Smart Contracts Applications

Perkins Coie Self-Sovereign Identity and Distributed Ledger Technology_Framing the Legal Issues

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