Securities Law Blog

The SEC’s Latest Investigative Report Concludes that DAO Tokens Are Digital Securities in an Initial Coin Offering

U.S. federal securities laws apply to offers, sales and trading of digital securities in virtual organizations the same as in everyday stock sales.

On Tuesday, July 25, the Securities and Exchange Commission issued an investigative report cautioning market participants that offers and sales of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. Offers and sales conducted by organizations using distributed ledger or blockchain software technology have been referred to as “initial coin offerings” or “token sales.” According to the SEC, 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 (i.e., whether the digital asset is the functional equivalent of a share of stock in that it offers investors the potential for a return on their investment). The SEC’s Report reflects a mild statement of what many securities and capital markets lawyers have been recently telling their clients.

The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” last summer were securities and, therefore, were subject to the federal securities laws.  The Report confirmed that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of these securities unless a valid exemption applies. Officers and directors of issuers, as well as financial intermediaries, participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities markets and other proprietary trading platforms providing for trading in these securities must register unless they are exempt. As discussed in the Report, the purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors’ protection.

The SEC’s Report resulted from an inquiry that the SEC’s Enforcement Division launched into whether The DAO and associated entities and individuals violated federal securities laws with unregistered offers and sales of DAO tokens in exchange for “ether,” a popular cryptocurrency. The DAO has been described as a “crowdfunding contract,” but it would not have met the requirements of the Regulation Crowdfunding exemption because it was not a retail broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.

The SEC determined not to bring charges in this case, or make findings of violations in the Report, but rather to caution the industry and market participants that the federal securities laws apply to those who offer and sell securities in the United States, regardless of whether (i) the issuing entity is a traditional company or a decentralized autonomous organization, (ii) the securities are purchased using U.S. dollars or virtual currencies, or (iii) the securities are distributed in certificated form or recorded in a public-distributed ledger.

The SEC’s Office of Investor Education and Advocacy also issued an investor bulletin educating investors about initial coin offerings. The bulletin reminds investors of red flags of investment fraud, and that new technologies may be used to perpetrate investment schemes that may not comply with federal securities laws.