SEC Determines That Certain Virtual Tokens Are Securities
July 26, 2017
Yesterday, the Securities and Exchange Commission (SEC) issued an investigative report concluding that certain tokens (or coins) offered and sold by The DAO, a virtual organization, were securities under the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act).1 The DAO offered and sold its tokens in exchange for Ether, a virtual currency, and the tokens were distributed through distributed ledger technology (sometimes referred to as "blockchain").
The DAO intended to invest the proceeds of its token offerings in certain projects intended to generate additional Ether as income, which The DAO would then, subject to the vote of the token holders, distribute to the holders or re-invest in another project. The DAO would only submit projects for a vote of token holders if the proposed projects had been reviewed and approved by one or more expert "curators," who were handpicked by The DAO's creator.
In the report, the SEC took the position that the tokens were securities because, among other things, the token holders could share in the potential profits from a project in which The DAO invested, and those profits were to be derived from the managerial and entrepreneurial efforts of The DAO's creator, the creator's co-founders, and the curators.
The SEC concluded that because the tokens were securities, their offer and sale should have been registered under the 1933 Act, unless an exemption existed. Further, the web-based platforms that supported secondary trading of the tokens should have been registered as a national securities exchange under the 1934 Act or operated pursuant to an exemption.
WSGR's fintech practice recently issued a WSGR Alert regarding the regulatory considerations of initial coin (or token) offerings and warned, among other things, that such offerings may constitute offerings of securities to which the securities laws would apply. The report echoes this sentiment. WSGR's fintech practice believes that the report also provides the following lessons:
- Whether a token is a security depends upon the characteristics of the token and should be analyzed under the traditional tests for determining whether an instrument is a security.
- Tokens that offer holders a share of profits, revenue, dividends, or similar gains from the issuer or a related party often will be securities.
- Tokens that have a current utility (e.g., they may be used to operate a website or an application), and that do not have traditional characteristics of securities, generally should not be securities, although issuers should analyze this on a case-by-case basis.
- Tokens that may have utility in the future, but do not have utility at the time of sale, may be securities, at least until the time they have utility.
- Tokens that are securities that are offered and sold in the U.S. either must be registered under the 1933 Act or they must be sold pursuant to an exemption, such as sales to accredited investors in a private placement pursuant to Regulation D under the 1933 Act.
- Resales of tokens that are securities must also be made pursuant to an exemption from registration, such as the resale safe harbor provided in Section 4(a)(7) of the 1933 Act. This safe harbor requires, among other things, initial purchasers to be subject to a 90-day hold period, secondary purchasers to be accredited investors, and certain information to be made available to potential purchasers.
- If the tokens are securities, a person or entity that receives a portion of the tokens or other compensation in connection with the token sale may need to register as a broker-dealer, and a person or entity that provides any advice regarding the purchase of the tokens may need to register as an investment adviser.
- If the tokens are securities, any secondary trading market may need to register as a broker-dealer, exchange, or alternative trading system, depending on how it is structured.
- If the tokens are securities, a fund or other entity that holds a significant amount of tokens may need to register as an investment company, unless it is privately offered and has either no more than 100 beneficial owners or is limited to accepting investors only if they are individuals with at least $5 million in investments or entities with at least $25 million in investments.2
- Tokens that are securities and that are sold outside of the U.S. may be subject to prohibitions on resale in the U.S., as provided in Regulation S under the 1933 Act, and need to be offered and sold in compliance with applicable local laws.
- Instruments such as Simple Agreements for Future Tokens, or SAFTs, may also be securities (or in some cases swap agreements, which may be the case if, for example, those instruments are cash settled).
For more information about the report or any related matter, please contact Robert H. Rosenblum (202-973-8808, firstname.lastname@example.org); Susan Gault-Brown (202-973-8809, email@example.com); or any member of the fintech regulatory practice at Wilson Sonsini Goodrich & Rosati.