Loyola University Chicago School of Law, JD 2019
The Securities and Exchange Commission, which has been notably quiet on the subject, is beginning to show an interest in the cryptocurrency craze. It published a report last July concluding that initial coin offerings (ICOs) are subject to securities laws and that one ICO which raised nearly $150 million worth of cryptocurrency violated securities law.
What does all of this mean?
In a basic sense, a security is a tradable asset issued by companies and other entities and can represent ownership interest and debt amongst other instruments. The SEC regulates the securities industry, proposes securities rules, and enforces the federal securities laws. Cryptocurrencies are digital currencies designed to use blockchain technology, essentially digital cryptography, to ensure secure online transactions. An ICO is a new cryptocurrency being offered for sale to the public, just like an initial public offering (IPO) in the stock market. The subject of the SEC report was an ICO called the decentralized autonomous organization (DAO). The DAO was intended to be a completely decentralized cryptocurrency venture capital fund. It would raise money in the form of a cryptocurrency called Ethereum and issue DAO tokens to its investors in return. Then it would allocate its funds to various business ventures through voting by the DAO token holders. The DAO raised around $150 million worth of Ethereum, but hackers syphoned $53 million worth of the cryptocurrency from the fund, subsequently closing the DAO.
Where does the issue arise?
ICO’s have long been a controversial means of crowdfunding; they can be completely unregulated sources of capital for startup companies. Many ICOs have raised large amounts of money without the regulatory constraints of traditional IPOs and other capital-raising strategies. The SEC has taken notice of this fundraising tool in the wake of the DAO cyberattack. The report it published was not focused on identifying the culprit of the attack, but on determining whether the DAO tokens constituted a security and should be regulated under securities laws.
The SEC’s Findings
The SEC concluded that the DAO tokens were securities that were required to be registered with the SEC. Since they were not registered, they had been in violation of federal securities laws. The report specified that not all tokens constituted securities, but rather, depending on the specific facts and circumstances, might be subject to regulation.
The SEC reached its conclusion based on the 1946 Supreme Court decision SEC v. Howey Co., which created a test known as the Howey Test as a means of determining whether a transaction qualifies as an “investment contract.” According to the test, a business transaction should be characterized as an investment contract and be treated as a security if it involves 1) the investment of money or some tangible or quantifiable consideration, 2) in a common entity with a reasonable expectation of earning a profit, 3) derived from the managerial efforts of others.
The SEC classified the DAO as an issuer, despite the fact that purchasing DAO tokens was not exactly like purchasing stock in a corporation in a traditional sense and that the DAO, decentralized as emphasized by its name, was not an entity formed under state law like a traditional corporation. The DAO met the first two prongs of the three-pronged Howey Test because 1) the purchase of DAO tokens using Etherium was an investment and 2) its investors were promised a share of the profits earned from the business ventures it invested in, satisfying the common entity and reasonable expectation of profit prong.
The difficult aspect of the SEC’s analysis was whether the DAO’s profits would have been derived from the managerial efforts of others as to satisfy the third prong of the test. Autonomous is in the DAO’s name, suggesting that it did not delegate managerial efforts to anyone. The SEC determined that the DAO nonetheless did require managerial efforts of other because the people who created the DAO marketed the fund through a website, selected “Curators” that proposed investment opportunities before they were voted on by the token holders, and monitored and maintained the funds overall operations. Therefore, the DAO had satisfied the three-prongs of the Howey Test. The SEC concluded in its report that because the DAO had failed to register with the SEC as an issuer or securities, it violated section 5 of the Securities Act of 1933.
Will the SEC Retaliate?
The report was purely cautionary to the industry and its participants. The SEC stated there and in a subsequent press release that they would not be taking action against those responsible for the creation of the DAO. It is also likely that existing cryptocurrencies will be exempt from SEC regulation for the time being. The primary objective of the SEC will be to monitor newcomers to the cryptocurrency market and evaluate them under the Howey Test to determine whether they govern their activities.
Since its release, the SEC’s report hasn’t had any noticeable impact on the overall cryptocurrency market in the United States. Regardless, how the SEC defines and treats cryptocurrencies in the future can have serious implications on their market in this country. It can affect their value and overall performance in US jurisdiction. When cryptocurrencies to begin to fall under SEC governance, US investors should be aware of what they are purchasing and if they are complicit with federal law. As for the global market, there is some speculation that more international ICOs will come to existence that specifically prohibit US investors because most people don’t opt for being constrained by US regulations when they can evade them.