Securities Law

The SEC States The Obvious: DAO Tokens Are Securities

If citrus groves can be securities, cryptocurrencies can be securities.

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If you were reading the financial news on Tuesday, you may be under the impression the Crypto-sky is falling. You probably read stories with titles such as “SEC Report May Put An End To ICO Boom,” “The SEC Just Crashed the ICO Party,” and my personal favorite, “Oh Shit, the SEC Just Ruled that Ethereum ICO Tokens Are Securities.”

Yep, the SEC did just rule that Ethereum digital tokens are securities, at least the Ethereum-based DAO tokens that were offered by a German blockchain startup named Slock.it. (I don’t know what their tag line was, but wouldn’t it be great if it was “Slock it to me!”) The SEC’s two-page press release caused all the initial fuss, but if you have the time and are so inclined, I recommend reading the entire 18-page report, which is available here.

So what exactly did the SEC do?

First, let’s be clear on what the SEC did not do. The SEC did not say “no more coin offerings.” The SEC didn’t even say “digital tokens are securities.” The SEC simply said, “digital tokens can be securities.” Before Tuesday’s release, 99% of securities lawyers would have told you that digital tokens could be considered a security. After Tuesday’s release, 99% of securities lawyers will tell you that digital tokens can be considered a security (there’s always a 1% that have donated their brain to science before they’re done with it). So all the SEC effectively did was confirm what most of us suspected. If citrus groves can be securities, cryptocurrencies can be securities.

Let’s back up. Ethereum is a cryptocurrency system based on the Blockchain, which is a decentralized network of records called blocks. Ethereum went live only two years ago, and was an instant hit due to its as-yet-unparalleled ability to facilitate “smart” contracts, which are best thought of as self-executing computer programs. For example, one day in the not-too-distant future, if you are leasing your car pursuant to a smart contract, if you’re late on a payment you might automatically be locked out of (or in!) your car.

In April 2016, Slock.it launched something called the Distributed Autonomous Organization (DAO). The DAO was a for-profit enterprise and was Ethereum’s largest smart contract, pursuant to which DAO tokens were sold to investors, with the proceeds of the sale used to fund certain projects. Tokenholders would vote on which projects were to be funded, though the DAO’s “curators” actually had control of which projects tokenholders could vote on. These projects were going to generate profits, hopefully, so tokenholders could receive a return on their investments. Tokenholders also had the option of selling their DAO tokens on a number of secondary trading platforms.

Remember my column a couple of months ago on “what is a security?” The Howey Test? The Howey court defined “investment contract” as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”  Remind you of anything you may have just read? Like, one paragraph ago?

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It reminded the SEC of something, because it followed the Howey Test in concluding that DAO tokenholders (i) invested money, (ii) with a reasonable expectation of profits, (iii) derived from the managerial efforts of others. For the latter, the SEC said sure, DAO tokenholders had the ability to vote, but the voting was limited, so it was really the Curators who were running the show. (At that point, they were going to rule the tokens were securities regardless, so every fact was going to be interpreted as supporting their conclusion. Kind of like when you’re having a disagreement with your spouse.)

Yep, if DAO tokens weren’t going to be securities, then not only was every other cryptocurrency not going to be considered a security, but people would start trying to fashion regular ‘ole securities to be cryptocurrencies, and the market would be flooded even more than it already is with crypto tokens. So the SEC’s report was not a surprising development.

However, the SEC made clear that it was not finding that every single cryptocurrency is a security. On the contrary, it stated that whether a particular virtual currency would be deemed a security would always be a fact-specific determination, hinging on the outcome of the Howey Test above. For example, if people are buying tokens released by a certain company, such as a non-profit, and for some reason the token-buyers do not have any expectation of profits, then the situation starts looking much more like donation crowdfunding, which is fine and doesn’t violate any securities laws (though you’re still not allowed to perpetuate a fraud).

The SEC also had a little message for the people running the platforms where the DAO tokens were traded: We will look for you, we will find you, and we will kill you. But they worded it a little differently, instead couching it as a reminder that “a system that meets the definition of an exchange must register as a national securities exchange” or have an exemption therefrom, regardless of whether it’s facilitating the buying/selling of virtual or “fiat” currency.

The moral of the story is, it’s not a simple process to get around the law, particularly the securities laws. If some newfangled thing comes along that’s convinced a lot of people that the securities laws don’t apply even though it looks like a security, swims like a security, and quacks like a security, it’s probably not a duck. It just might be a security.

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Disclaimer:  I’m a lawyer!  My family and friends back home are still in a state of disbelief.  But I’m (probably) not your lawyer, so please note that no attorney/client relationship is established by your reading this column (or any of my other columns), though I do appreciate your time and hope you got something out of it.

Gary J. Ross is a partner at Ross & Shulga PLLC, which he co-founded in 2017 after running his own firm for four years and after several years in Biglaw and the federal government. Gary handles corporate and securities law matters for venture capital funds, startups, and other large and small businesses, as well as investors in each. You can reach Gary by email at Gary@RSglobal.law.

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