Graphics by Anna Gray.
A German company used virtual currency to fund a Decentralized Autonomous Organization (DAO), which then exchanged its own tokens to provide ownership and control of the DAO. In a 2017 report of investigation, the SEC concluded that the Slock.it DAO tokens were securities irrespective of their form and that the platform on which they were traded was a securities exchange. Slock.it allegedly violated U.S. securities laws by offering, selling, and facilitating the trade of DAO tokens to U.S. investors in the United States because it did not register or file with the SEC.
The SEC offered Slock.it as an example of a company that, in the agency’s opinion, violated U.S. securities laws and regulations with an Initial Coin Offering (ICO) and a corporate structure based on blockchain, distributed ledgers, and virtual currency technology. So how does a virtual currency become a security, a trading platform become an exchange, and what must be done to comply with the SEC?
What is a Digital Autonomous Organizations (DAO)?
A DAO is a completely digital form of investor-directed venture capital fund. Its purpose is to provide a decentralized business model for organizing commercial or non-profit endeavors. This is accomplished by means of a virtual currency exchange. Virtual currency tokens are exchanged for tokens representing ownership of and investment in the DAO entity.
The distributed ledger technology underlying the DAO tokens is also the means by which investors exercise some control over the DAO. They do so by voting on proposed business ideas as well as the performance of contractual obligations in proportion to their token ownership. Corporate governance and management are handled exclusively through smart contracts, which also rely on blockchain and distributed ledgers. Profits from sound projects are paid back as dividends or rewards to the investors based on their token ownership. In this way, a DAO should be able to replace traditional mechanisms of corporate governance.
Slock.it Offered, Sold, and Exchanged DAO Tokens for 12 Million Ether in Two Months
German company Slock.it created a DAO to fund third party business proposals with the capital raised from its ICO (much like a venture capital firm would do with traditional currency). It offered and sold roughly 1.15 billion DAO tokens, for which 12 million units of virtual currency, called Ether, were traded on the Ethereum Blockchain. This massive ICO was complete after only two months: from April 30 to May 28, 2016.
Promotions for DAO Tokens were Online, Reaching U.S. Investors
Prior to the ICO, Slock.it created a website, blog, and posted on third-party finTech forums. It propagated the DAO concept in a White Paper, the founders attended conferences, like the 2015 Ethereum Developer Conference in London, and promoted the DAO’s initial coin offering. All this raised awareness and primed investors to buy, including some in the United States.
The DAO Tokens Were Initially Part of the Ethereum Blockchain
Potential investors identified themselves to Slock.it only with their Ethereum virtual currency account at first. They then purchased Ethereum with “fiat” currency (such as U.S. dollars) to open an account. Those Ether were then exchanged for DAO Tokens on the Ethereum platform during the offering period. The subsequent selling or exchange of DAO tokens was not restricted by Slock.it or Ethereum.
Contractors Submitted Business Proposals to the DAO Entity, which Voted on Funding
The business purpose of the Slock.it DAO was to pursue projects token owners believed would yield profit. This was initiated by token holders writing a smart contract and publishing it on the Ethereum blockchain. The founders and curators of the DAO would then decide about whether to post the contract on their website for voting and ensure the rules for proposals were followed. Some of those rules were that contractors had to own at least one DAO token and pay a deposit of a larger amount, in Ether, that would be forfeit if the DAO voted “no.” A “yes” vote would trigger funding from the DAO to the contractor, again, in the form of Ether, to perform the terms of the contract. Smart contracts measure performance and dole out payment with blockchain technology.
Theft of Ether from the DAO Prompted a Response from Curators, Demonstrating Their Autonomy
The DAO curators demonstrated the extent of their independent control over the DAO code by implementing security updates and successfully recovering lost value after a successful attack. Prior to the end of the ICO, security concerns began to be identified and discussed. In response, the curators stopped DAO trading and patched the code. Thereafter, trading resumed, but the fix was not enough. An attacker managed to hijack 3.6 million Ether. The curators responded by changing the Ethereum protocol with a “hard fork” in the distributed ledger. This successfully restored investors’ lost Etherium. This activity was strong proof of the curators’ independence and control – a necessary element of the legal definition of a security called “an investment contract.”
DAO Tokens were Also Traded on “the Platforms”
Following the ICO, investors tended to trade their DAO tokens for virtual and fiat currency on an exchange called “the Platforms.” This exchange allowed for anonymous transactions in DAO tokens, virtual currency, and other cash and property. Much like a stock market, the Platforms publicly displayed all DAO token quotes, trades, and daily trading volume online.
The Law: Ignorance of the Securities Act of 1934 Is No Excuse for the SEC
Unless a registration statement has been filed, it is unlawful for any person, directly or indirectly, to offer or sell securities in interstate commerce. 15 U.S.C. Sections 77e(a) and (c). A registration statement consists of a public prospectus and a separate section of exhibits and more sensitive information for filing directly with the SEC. The prospectus must describe important information about the business’ operations, financial condition, results of operations, risk factors, management, and audited financial statements. Any information required to prevent these filings from being misleading must also be disclosed. Violations of this law, by failing to file a prospectus, additional disclosures, and the appropriate SEC forms, do not require knowledge of the legal duty to register or an intent to violate the law.
SEC Laws & Principles Are Adequate to Conclude DAO Tokens and Many ICOs Are Securities
A flexible application of classic SEC statutes and cases is enough to reach virtual currency that acts like a security. More specifically, a security includes an investment contract, which is an investment of money in a common enterprise with reasonable expectation that profit will be derived from the entrepreneurial efforts of others. 15 U.S.C. Sections 77b-77c; SEC v. W.J. Howey Co. Emphasizing economic realities instead of the names applied to the underlying instruments, the SEC believes it makes no difference whether a security is called a stock and tracked with spreadsheets or if it’s called a token and tracked with distributed ledgers. This analysis, however, was conducted without opposition from an advocate for investors. Such help is essential to making sure the SEC is not overly ambitions in its application of somewhat antiquated laws.
Owners of Ether Used Those Tokens to Buy DAO Tokens, Equivalent to Purchasing with Money
Several SEC cases hold that purchases can be made with anything of value, not just cash money and that virtual currency can be used to make a purchase. E.g. Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991). The investors in this case used a type of virtual currency called “Ether,” and that was sufficient to meet the investment of “money” requirement under Howey.
DAO Investments were Made with a Reasonable Expectation of Profits
The “profits” investors expect to earn include dividends, periodic payments, or any increase in value in their investment. SEC v. Edwards, 540 U.S. 389, 394 (2004). Slock.it’s advertising materials allegedly made clear that it was motivated by profit, which would be satisfied by investing the pooled Ether to fund contracts the DAO coin holders voted on. The hope was that this newer, smarter business model would increase the likelihood that funded projects became profitable. Note that DAOs may also be formed for non-profit purposes.
Profits are Allegedly Derived from the Managerial Efforts of Slock.it, Its Founders & DAO Curators
One issue on which the SEC’s analysis turns is, “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973). Founding a company such as Slock.it, publishing a White Paper about the business concept on the company website, hosting and interacting with a forum for commentary, “curating” DAO tokens (vetting contractors, deciding when to submit proposals for votes, determining order and frequency of proposals, managing security, etc.), and managing what projects would be put to DAO investors for a vote are sufficient efforts of someone other than the investor to meet this portion of the Howey test. However, the SEC’s emphasis on DAO curators’ response to a malicious attack leaves open the possibility that a DAO could be structured such that investors derive profit through their own efforts, effectively removing the organization from the SEC’s jurisdiction.
DAO Token Holders’ Voting Rights Did Not Equate to Managerial Control
There’s a fine line between owning and controlling part of a company in proportion to that ownership and investing in and influencing the business decisions of the company’s management. Limited control via voting power is important for showing profits are derived from the efforts of others like corporate shareholders. Steinhardt Group, Inc. v. Citicorp., 126 F.3d 144, 152 (3rd. Cir. 1997). Based on the alleged Slock.it facts, the SEC’s position is that the DAO curators limited information and control to an extent that token holders voting rights were limited. In addition, the relative anonymity of the DAO token holders from one another and their geographic dispersion would prevent the Slock.it token holders from independently joining forces to usurp power if the investors collectively disagreed with a managerial decision.
“Issuers” Must Register ICOs & Sales of Securities Unless They Have an Exemption
An “issuer” under the SEC laws and regulations includes anyone “who issues or proposes to issue” a security, including “unincorporated organizations.” 15 USC Section 77b(a)(4). Securities must be registered with the SEC. 15 USC Section 77f. Much like other important concepts in this analysis, that of an “issuer” is construed flexibly. So even though the Slock.it DAO sold equity investments in the company in the form of tokens (which were securities) for Ethereum tokens exclusively online, it was still required to register as an issuer with the SEC.
Note that there are exceptions to this registration requirement, however, determination of whether an exception may apply is something where a registrant would be best advised to obtain the opinion of a legal professional.
An Exchange Must Register Unless it Has Secured an Exemption from Doing So
An exchange is defined as any organization association, or group of persons which provides a marketplace in which securities buyers and sellers can do the things normally performed by a stock exchange. 15 USC Section 78c(a)(1). An exchange cannot directly or indirectly transact in securities, or even report these transactions, unless it is registered as a national securities exchange. 15 USC Section 78e. The two-prong test is whether the purported exchange: (1) Brings together orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods by which the orders interact with one another and the buyers and sellers entering the orders agree to the terms of the trade. Exchange Act Rule 3b-16(a). Once the flashy details of virtual currency, online exchanges, block chain, and distributed ledger technology are abstracted away, the Slock.it market, and any DAO market, meets this test by definition.
The SEC concluded this point of its investigation with the opinion that The Platforms clearly met these threshold requirements. Again, this analysis was conducted without an advocate for the investors or the company. Although it should not be ignored, the advocacy of a firm like Alliance Law Firm International is necessary to structure a DAO or ICO and defend it from overzealous regulation. Note that there are also exemptions to the registration requirements for exchanges.
In short, the same SEC laws and regulations apply to those who offer and sell securities in the U.S. irrespective of a company’s use of new or non-traditional technology like blockchain, virtual currency, ICOs, smart contracts, distributed ledgers, and the like. Solid planning and zealous advocacy can help your DAO or ICO comply with the law and avoid SEC overreach.
Existing SEC Laws & Regulations Require Many ICOs to File with the SEC
Virtual currency companies planning an ICO like that of Slock.it or any DAO must file forms and disclosures with the SEC, register offers and sales of securities (or secure an exemption), and register an exchange of such securities (or secure an exemption) to comply with SEC laws and regulations. There are over 158 different forms of registration and registration-related actions alone. Companies experimenting with virtual currency must still comply with the law, make the appropriate filings, secure available exemptions, and avoid civil and criminal SEC liability.