On July 25, 2017, the Securities and Exchange Commission (the “SEC”) weighed in on Initial Coin Offerings (“ICOs”) by issuing a Report of Investigation under Section 21(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Report describes the SEC investigation of the ICO of tokens (the “DAO Tokens”) to raise capital by The DAO, an unincorporated organization, Slock.it UG, a German corporation (“Slock.it“), the co-founders of Slock.it and certain intermediaries, and its findings that the DAO Tokens ICO violated U.S. securities laws (the “DAO Report”).¹ The SEC also released an investor bulletin to educate potential investors about ICOs.²

ICOs may have been around since 2013, but have rocketed to prominence recently with almost daily news reports of new ICOs that raise IPO-level money.³ The “coins” or “tokens” offered in these offerings are virtual currency, digital value tokens using distributed ledger or blockchain technology, that permit owners to access services offered on or through a platform created by the issuer of the coins or one of its affiliates. The virtual coins or tokens offered or sold may be securities, depending on the facts and circumstances of each individual ICO; therefore, the offer and sale of virtual coins or tokens in an ICO may be subject to the federal securities laws. Most of the coins or tokens offered can only be used on the issuer’s system, though they can be traded on the secondary market if and when one develops. Many of the issuers use the proceeds from the ICO to fund developing and setting up the platform.⁴

Offer and Sale of DAO Tokens was Unregistered Offer and Sale of Securities

The DAO Report concluded that the offering of DAO Tokens was an unregistered offering of securities. This was based on a finding that, based on the facts and circumstances of the offering, a DAO Token is a security because it is an “investment contract.” An investment contract⁵ is a scheme that “involves an investment of money⁶ in a common enterprise with profits to come solely from the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). The SEC concluded that in the offering of DAO Tokens, investors delivered Ether (a popular, existing cryptocurrency) valued at approximately $150 million while investing in a common enterprise and reasonably expected to earn profits through The DAO⁷ based on the efforts of Slock.it, its co-founders and the curators of The DAO.⁸ Thus, the DAO Tokens were investment contracts and the offering of DAO Tokens was an unregistered offering of securities.

The SEC ultimately determined that based on the conduct and activities known to the SEC at this time by the relevant parties, the SEC would not bring an enforcement action in the DAO case. It is important to note that this does not mean that the SEC would not bring an enforcement action if a similar situation occurs after the release of the DAO Report.

The SEC’s Approach to This Issue Is in Line With Precedent

The DAO Report has created significant stir in the virtual and cryptocurrency community and may have sent the trading values of a number of cryptocurrencies down. The SEC’s analysis of this new “paradigm”⁹ follows its established method of evaluating new technologies through the existing framework of securities laws and regulations. For instance, in June 2011, the SEC issued a cease and desist order to two individuals engaged in an online solicitation of pledges (through the use of websites and other online portals) to purchase “crowdsourced certificates of ownership” with the intention of purchasing a brewery.¹⁰ The SEC found that individuals (whose vision predated the JOBS Act by a few years) had made an offer to sell an unregistered security, in violation of the Securities Act of 1933, as amended (the “Securities Act”).¹¹

Similarly, the SEC has applied the securities laws and regulations to activities involving virtual currencies. In one case, the SEC found that an individual had violated the Securities Act by offering unregistered shares of two separate businesses in exchange for virtual currency.¹² In a separate case, the respondent operated two online, virtual currency-denominated securities exchanges and broker-dealers and offered interests in a Bitcoin mining business and a Bitcoin-denominated securities exchange.¹³ Although the transactions were in virtual currency, the SEC found that the respondent had issued unregistered securities in violation of the Securities Act, operated an unregistered exchange in violation of the Exchange Act of 1934, as amended (the “Exchange Act”), and acted as an unregistered broker-dealer in violation of the Exchange Act.¹⁴

If an ICO Is an Offering of Securities, What Are the Consequences?¹⁵

• The offer and sale of the tokens/coins must either be registered with the SEC or fit under an exemption from the registration requirements.
• The issuer and anyone in the chain of distribution have liability under the Securities Act and the Exchange Act.
• Sellers or promoters of tokens/coins may need to register as brokers or dealers under the Exchange Act.
• Under certain circumstances, the issuer may need to comply with the reporting requirements of the Exchange Act.
• Transactions in coins or tokens during the offering period by the issuer and distribution participants may need to comply with Regulation M.
• Anyone acting as an exchange for the tokens/coins or acting as a marketplace for the offer and sale of the tokens/coins may need to register as a securities exchange under the Exchange Act.
• Under certain circumstances, the issuer of the tokens/coins may be deemed to be an investment company under the Investment Company Act of 1940, as amended (the “ICA”), and thus must either register under the ICA or operate pursuant to an exemption from the registration requirements of the ICA.
• Anyone promoting or providing investment advice regarding virtual currency may need to register as an investment adviser under the Investment Advisers Act of 1940.

It is important to note that not every ICO necessarily involves the offering of a security. The analysis of whether something is an investment contract (and therefore a security) is based on the fact and circumstances of the particular ICO. In light of the DAO Report and the SEC focus on similar types of offering, it is very important to work with legal counsel to analyze contemplated ICOs to determine whether such offering must be conducted as a securities offering or, alternatively, whether it can be structured to so as not to constitute a security.

Other Regulatory Pronouncements and Requirements

The Commodity Futures Trading Commission (“CFTC”) first exercised its authority to regulate derivatives on bitcoin and other virtual currencies as commodity interests under the Commodity Exchange Act in 2015.¹⁶ The CFTC has since been actively engaged in the regulation and enforcement of conduct surrounding virtual currency. Certain activities involving commodity interests, including derivatives on virtual currencies, such as operating a commodity pool or providing advice and services related to trading commodity interests, may require registration with the CFTC as a CPO or CTA, as applicable.

The Internal Revenue Service treats virtual currency as property (rather than currency) for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency.¹⁷

The U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) does not regulate users of virtual currency, but administrators and exchangers must register as money transmitters and Money Services Businesses (“MSB”s).¹⁸ Designation as an MSB will trigger the registration, reporting and recordkeeping requirements of the Bank Secrecy Act.¹⁹ The Treasury Department has further reporting requirements for certain foreign entities.²⁰

State regulators vary greatly in their treatment of virtual currency. Several states now offer permissive exemptions from money transmitter laws for virtual currency transactors while other states may require a license to sell or store virtual currency.²¹State legislation has become increasingly frequent in this space and continues to grow as virtual currency and blockchain ledgers become more mainstream.

If you have any questions regarding ICOs or other issues in connection with virtual or cryptocurrencies, please speak with your Seward & Kissel contact attorney.

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¹   Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Securities Act Release No. 81207 (July 25, 2017).  https://www.sec.gov/litigation/investreport/34-81207.pdf.

² Investor Bulletin: Initial Coin Offerings, Investor.gov (July 25, 2017),  https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings.

³ Paul Vigna, Forget an IPO,Coin Offerings Are New Road to Startup Riches, Wall Street Journal (July 7, 2017), https://www.wsj.com/articles/forget-an-ipo-coin-offerings-are-new-road-to-startup-riches-1499425200.

⁴ For many of the ICOs, the only information available about the issuer and/or the platform on which the coins can be used is a “white paper” that describes the platform, the coins, and the expected uses and benefits of either or both.

⁵ It does not matter whether the underlying investment is participation in orange groves (as in Howey), a distributed ledger or blockchain token, or something in between or beyond those two.  “[E]mphasis should be on economic realities underlying a transaction, and not in the name appended hereto.”  United Housing Found., Inc. v. Forman, 421 U.S. 837, 849 (1975).

⁶ The word “money” in this definition is a substitute for “something of value” and does not refer solely to cash.  While DAO Tokens could only be purchased with another cryptocurrency, Ether, that Ether had value.

⁷ The DAO Report found that a reasonable investor would have been motivated, at least in part, by the prospect of profits on their investment in The DAO because any profits from projects funded by the DAO could be distributed to holders of DAO Tokens.  DAO Report p. 12.  However, it could be argued that the expectation of profits could arise just from an anticipated increase in the value of DAO Tokens, and therefore the absence of an ability to receive some of the profits from the enterprise alone may not be dispositive that a different token or coin is not an investment contract.

⁸ One of the threshold questions in this context is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973).   The SEC found such efforts present in the managerial efforts of Slock.it, it’s co-founders and the DAO curators which have the responsibility of whitelisting projects for The DAO to fund.  The DAO code was deployed before the sale of DAO Tokes commenced.  DAO Report p. 5. In some ICOs, the platform on which the coins or tokens sold in the ICO will be used do not yet exist; it could be argued that in such a situation the very creation of the platform after the sale of the coins or tokens  is enough to meet the “efforts of others” test, since without the platform, the coins or tokens are largely worthless.

⁹ “This Report reiterates the fundamental principles of the U.S. federal securities laws and describes their applicability to a new paradigm-virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facility capital raising and/or investment and the related offer and sale of securities.” DAO Report p. 2.

¹⁰ See In the Matter of Michael Migliozzi II and Brian William Flatow, Securities Act Release No. 9216 (June 8, 2011). https://www.sec.gov/litigation/admin/2011/33-9216.pdf.

¹¹ Id.

¹² See In the Matter of Erik T. Voorhees, Securities Act Release No. 9592 (June 3, 2014).  https://www.sec.gov/litigation/admin/2014/33-9592.pdf.

¹³ See In the Matter of BTC Trading, Corp. and Ethan Burnside, Securities Act Release No. 9685 (December 8, 2014). https://www.sec.gov/litigation/admin/2014/33-9685.pdf.

¹⁴ Through other releases, the SEC has demonstrated its concerns about virtual currencies, warning investors about the possibility of fraudulent investment schemes involving Bitcoin or other virtual currencies.   These concerns have not been unfounded, as the SEC has succeeded in several enforcement actions against individuals running fraudulent Ponzi schemes using cryptocurrencies. See, e.g., SEC v. Trendon T. Shavers and Bitcoin Savings & Trust, Civil Action No. 4.12-CV-416 (Sept. 22, 2014), https://www.sec.gov/litigation/complaints/2013/comp-pr2013-132.pdf and Ponzi Schemes Using Virtual Currencies, SEC Pub. No. 153 (July 2013). https://www.sec.gov/investor/alerts/ia_virtualcurrencies.pdf.

¹⁵ This section only addresses federal securities law issues.  There may be additional state laws that need to be complied with.

¹⁶ See In re Coinflip, Inc., CTFC No. 15-29, 2015 WL 5535736 (Sept. 17, 2015); see also 7 U.S.C. § 1(a)(9) (2012) (“[A]ll services, rights, and interests… in which contracts for future delivery are presently or in the future dealt in.”).

¹⁷ IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply, IR-2014-36, March. 25, 2014, https://www.irs.gov/uac/newsroom/irs-virtual-currency-guidance; Notice 2014-21, https://www.irs.gov/pub/irs-drop/n-14-21.pdf.

¹⁸ Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001, March 18, 2013,  https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf.

¹⁹ See 31 U.S.C. § 5330, 31 C.F.R. § 1022.380 (registration); 31 U.S.C. § 5318(a)(2), (h), 31 C.F.R. § 1022.210 (AML program); and 31 U.S.C. § 5318(g), 31 C.F.R. § 1022.320 (SAR reporting).

²⁰ The Foreign Account Tax Compliance Act (“FATCA”) requires foreign financial institutions (including bitcoin exchanges) to report to the IRS information on financial accounts held by U.S. taxpayers, or by foreign entities controlled by U.S. taxpayers. In addition, individuals with at least $50,000 in foreign financial assets must file Form 8938, Statement of Specified Foreign Financial Assets.  FinCEN Form 114, Report of Foreign Bank and Financial Accounts (“FBAR”), must be filed by U.S. persons with an interest in foreign accounts with an aggregate value of more than $10,000. A business that transfers virtual currencies or that exchanges virtual currencies for real currencies is a money transmitter and a financial institution for FBAR purposes.

²¹ See State of Regulation 2017, Bitcoin and Blockchain Regulation in the United States,  http://news.dinbits.com/2017/01/state-of-regulation-2017-bitcoin-and.html (current as of Jan. 2017).