SEC Weighs in on Initial Coin Offerings (ICOs)

Initial coin offerings (ICOs) have been hailed as a disruptive new business paradigm that allows startups -- most of which are focused on blockchain or distributed ledger technology (DLT)-- to raise operating funds without the regulatory constraints and requirements that are applied to a traditional underwritten IPO. Being positioned safely outside the regulatory framework, ICOs have become a very attractive and flexible fundraising tool. 
The SEC has made it clear, however, that some ICOs are subject to the full reach of the securities laws. ICO market participants must now distinguish those ICOs that may continue without regulatory constraints and those that must now conform to the U.S. securities laws. This treatment is not elective or optional - if the ICO involves the offering of a security, the ICO must be done in accordance with established securities law requirements or proceed under an exemption if available.
In its July 25, 2017 Report, the SEC concluded that the tokens offered and sold by The DAO, a now-defunct virtual organization, and its use of distributed ledger technology to facilitate the offer and sale of "DAO Tokens" to raise capital, were securities that were required to be registered with the SEC. As the $150 million in tokens were not registered, they were issued in violation of the federal securities laws. The Report makes clear that the SEC believes, depending on the specific facts and circumstances, that blockchain tokens can constitute "securities," and, when they are, they are subject to regulation.
The SEC based its finding that DAO Tokens were securities on the "investment contract" model initially used in the 1946 U.S. Supreme decision of SEC v. W. J. Howey Co., which is now referred to as the Howey test. Under Howey, a financial arrangement will be characterized as an "investment contract" and treated as if it were a security if it involves (1) an investment of money, or other tangible or definable consideration in a common enterprise with (2) a reasonable expectation of profit (3) to be derived primarily from the entrepreneurial or managerial efforts of others. The form (whether there is a certificate, voting rights, defined equity participation, etc.) is irrelevant. 
The Report creates a potential roadmap for determining whether an ICO has a "reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others," making it a security and subject to rigorous reporting requirements under the '34 Act. Broadly speaking, in order for an ICO not to constitute a security, there can be no substantial involvement of a promoter, founder or other centralized governing body in the management or ongoing activities of the ICO organization, and managerial control must effectively be exercised by the token holders. If the tokens can be traded and this trading involves an asset that meets the Howey test then SEC jurisdiction is likely. As the Report clearly illustrates, the conclusion is very fact specific and highly dependent on the particular features of technology protocol and the associated coin or token.


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