Initial coin offerings (ICOs) are a way of crowdfunding using cryptocurrency, where the coin offered in the sale represents the right of ownership or royalties related to the specific project. Until recently ICOs have not been regulated and as a result the SEC, the U.S. Securities and Exchange Commission, conducted an investigation in order to issue its official announcement on ICO and DAO Tokens regulations on July 25, 2017.
Among other things the SEC investigation was conducted because of the many questions raised as a consequence of the DAO Tokens case, when the lack of KYC procedures and a major bug in the system led to the hacking of the platform in May 2016. As a result from the cyber attack 50 million in Ether were stolen and the whole industry was shaken. The SEC investigation therefore aimed to find out whether the offer and sale of DAO Tokens should be regulated by the U.S. federal securities laws, including resolving the issue whether DAO Tokens should be defined as securities. Thus the main issue – to protect the rights of the people buying the DAO Tokens had to be resolved under the conventional regulatory framework.
“Based on the investigation, and under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The Commission deems it appropriate and in the public interest to issue this report of investigation (“Report”) pursuant to Section 21(a) of the Exchange Act2 to advise those who would use a Decentralized Autonomous Organization (“DAO Entity”), or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws. All securities offered and sold in the United States must be registered with the Commission or must qualify for an exemption from the registration requirements. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration.” (SEC, Investigation Report 34-81207)
In its investigative report the SEC states further that issuers of securities, based on blockchain technology, must register every offer and sale unless a valid exemption applies. In case an unregistered offering occurs, it might risk violating the securities’ laws.
As a result of its investigative report, SEC issued an official press release on July 25, 2017 discussing the matter of sales and offerings of digital assets by a virtual organization, aka “The DAO” and defines them as securities, subject to federal securities laws.
“Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as "Initial Coin Offerings" or "Token Sales." 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.” (SEC, Press Release 2017-131)
As Jay Clayton, SEC Chairman, stated: "The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us.” (Finextra, July 26, 2017) According to Clayton, SEC not only follows with the industry developments in order to put into place the necessary protection mechanisms for the people involved but also strives not to discourage any innovative or beneficial ways for organizations to rise capital.
Being a highly unregulated sector, market analysts have anticipated that a stricter and more defined regulation should be on the way for virtual currencies and DAO Tokens. The question about ICO regulations or the lack of them thereof has been raised by Valerie Szczepanik, the head of the SEC's distributed ledger group in May this year. Her comment on the issue during a panel discussion at the Consensus blockchain conference in New York was that: “Whether or not you are regulated by the SEC, you still have fiduciary duties to your investors. If you want this industry to flourish, protection of investors should be at the forefront”. (Reuters, May 24, 2017)
Another expert opinion on the matter belongs to Angela Walch, associate professor at St. Mary’s University School of Law commented that it’s been a long time and, quote, “it is a big deal”. This is the most detailed the SEC has been about how digital currencies and the exchanges where they trade fit into financial markets, she said. “It’s a reminder that basic consumer protection principles still apply” in the digital asset world, she added.
The SEC was asked to decide if the DAO token sales “violated federal securities laws with unregistered offers and sales of DAO Tokens in exchange for ‘Ether,” according to the SEC report. The agency has decided not to bring charges in the DAO token sale case.
The concept of the report was “to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.” (Bloomberg, July 25, 2017)
What happened in the DAO case and why SEC got involved?
DAO is a digital decentralized autonomous organization which serves as an investor-directed venture capital fund with an open-source code. It was built onto the Ethereum blockchain with the concept to present a new business model for the organization of both commercial and non-profit enterprises.
The DAO platform was created with the idea to be transparent and secure. Unfortunately, the lack of KYC procedures and a major bug in the system were the main reasons that led to the hacking of the platform in May 2016, when 50 million in Ether were stolen. The cyber-attack, of course, shook the entire industry, and this was the reason why the SEC began its investigation.
Whether already completed ICOs will be liable to the newly implied rules, is still unclear. Nevertheless, many experts within the cryptocurrency sector are giving a warm welcome to SECs’ decision. They believe the new regulation will bring more clarity and as a result will make users’ and investors’ ventures based on virtual currencies more secure.
Read More:
SEC, Investigation Report 34-81207
SEC, Press Release 2017-131, July 25, 2017
Reuters, May 24, 2017: U.S. SEC official urges companies issuing tokens to protect investors
Finextra, July 26, 2017: SEC deems DAO tokens and ICOs as securities
Bloomberg, July 25, 2017: U.S. Signals Clampdown on Red-Hot Digital Coin Offerings
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