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On July 25, 2017, in its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (/wp-content/uploads/2018/07/34-81207.pdf), the Securities and Exchange Commission (SEC) concluded that the virtual currency “tokens” sold by The DAO, a distributed ledger/blockchain-enabled organization, are “securities” and therefore subject to regulation under the federal securities laws. As a result of this classification, offerings and sales of these tokens (as well as other tokens that may also be classified as securities) must comply with the laws and rules applicable to securities offerings – including that the offers and sales be registered with the SEC if an exemption from registration is not otherwise available. The SEC also confirmed that the federal securities laws may apply regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization like The DAO.

Token sales like the ones offered by The DAO, also referred to as Initial Coin Offerings (ICOs), have attracted a lot of attention recently as a range of businesses using blockchain technology have sold hundreds of millions of dollars of tokens. Although the SEC found that the DAO tokens were securities, it emphasized that whether or not other tokens are securities must be determined based on the specific facts and circumstances, thereby suggesting that not all token sales may require SEC compliance.

The DAO conducted its approximately $150 million offering of DAO tokens (which were offered in exchange for Ether, a cryptocurrency used on the Ethereum blockchain) in April and May 2016. The DAO is a virtual organization that invests in projects approved by the holders of DAO tokens. In addition to voting on the projects, the holders of DAO tokens may receive a return on their investment based on the success of funded projects.

The SEC analyzed The DAO token offering using the “Howey” test set by the US Supreme Court in the 1946 case SEC v. W.J. Howey Co. Under the Howey test, the SEC concluded that the DAO tokens were securities because they were “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

Much of the SEC’s analysis focused on the managerial efforts of others, noting that DAO token holders were substantially reliant on The DAO’s co-founders and others closely associated with the enterprise. The “reasonable expectation of profits” prong of the test did not receive much attention from the SEC in the Report. The SEC concluded that based on the structure of the DAO token and statements in The DAO’s promotional material, “a reasonable investor would have been at least partially motivated by the prospect of profiting on their investment in the tokens.”

Many questions still remain. Despite the ongoing excitement and optimism surrounding ICOs and the anticipated development of many new blockchain-enabled businesses, industry participants will need to proceed cautiously on future token sales. The SEC noted that the focus should be on the substance and economic realities, rather than the form and labels. While certain ICOs have involved tokens that could be classified as “utility tokens” (i.e. those whose primary function is to allow token holders to exchange tokens for specified services), even these types of tokens may be securities. With investor speculation that tokens will increase in value, issuers have attracted big dollars. Does this expectation suggest that the purchasers are reasonably expecting to profit on their token purchases? How will issuers know whether their tokens are sufficiently different from those offered by The DAO to avoid SEC regulation? When setting the terms of tokens to avoid a securities classification, what impact will these changes have on the success of future ICOs? As issuers seek to limit or remove the ability to profit on token purchases, will these offerings have the broad appeal necessary to attract sufficient capital?

When it released its Report, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin on ICOs to “make investors aware of potential risks of participating in ICOs,” which provides a useful primer on the subject (https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings). Clearly the SEC is taking notice of this relatively new but fast growing area. We should expect future guidance as well as enforcement actions from the SEC.