The Coming Wave of SEC and CFTC Regulation of ICOs

The Coming Wave of SEC and CFTC Regulation of ICOs

With the startling rise in the value of Bitcoin and the proliferation in the number of crypto- or digital currency initial coin offerings (“ICO’s”) — more than 160 thus far in 2017 — government regulators around the world are actively evaluating the risk and utility of these instruments.  Because the currencies are free moving, anonymous, in bearer form (i.e., payable to the holder – no questions asked) and not subject to governmental policies or foreign exchange, regulators see themselves as protecting national interests and financial markets while also seeking to gain some degree of oversight over a medium that, in time, could have a significant impact on their economies, for better or worse.  For those who remember the technology and telecommunications boom of the late 1990s, which made the Internet a destination marketplace, made millionaires and folk heroes out of college drop-outs, and saw hard-working savers empty their 401Ks in order to “ride the light,” as one company famously encouraged, the wave of cryptocurrencies portends an ominous Second Coming.

Recognizing that some number of these new cryptocurrencies will fail to achieve their creators’ vision, whether due to Murphy’s Law or the digital equivalent of natural selection, some also will present opportunities for fraud.  The more eager less-informed investors are to buy-in at any price, the more likely hard-working savers of today may fall victim to a bogus ICO.  Into this breach, the SEC rode in July 2017, when it issued a report analyzing the characteristics of one ICO, tokens of something called a Decentralized Autonomous Organization, or “DAO.” The SEC evaluated DAO tokens through the prism of a longstanding U.S. Supreme Court that case defines a security as the “investment of money, in a common enterprise with a reasonable expectation of profit to be derived solely or primarily from the efforts of others,” SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and determined that DAO tokens were, indeed, securities.  In analyzing the DAO’s business and its impact on coin holders, the SEC noted that “[t]he central issue 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.’”  DAO report, p. 12.

This conclusion meant DAO tokens would either need to be registered with the SEC, bringing them under government regulation, or qualify under one of the established exemptions from registration.  Unfortunately, before it even got off the ground, DAO suffered a major setback when an attacker exploited a flaw in its code and stole approximately a third of its assets.

The SEC’s determination on DAO announced to the world that digital currencies can be securities subject to regulation and that, at least in the U.S., the SEC will evaluate each ICO offered to U.S. investors on a case by case basis to determine its security status.  The Commodities Futures Trading Commission, which in 2015 declared Bitcoin to be a commodity subject to regulation, has said that it, too, will take a case by case approach.  Since these pronouncements, a number of other governments have declared a similar intent to become more engaged with cryptocurrencies and ICOs, either with a case by case approach as the SEC and CFTC have declared (England and Australia), or by warning citizens to be cautious about them (Switzerland and Dubai), or even banning ICOs outright (China, Russia and South Korea).  Russia has gone so far as to prohibit all cryptocurrency transactions, while Japan has openly embraced at least one such currency, Bitcoin.

The SEC’s analysis in DAO was based primarily on its view that ICO token purchasers are participants in an enterprise organized and controlled by others, which reduces token holders to passive investors, like holders of a share of stock, rather than operators of, or participants in an ongoing business.  Because of the many potential uses to which blockchain technology may be put, however, entrepreneurs and business owners who intend to use a particular blockchain platform to facilitate transactions and operations may seek access to one or more through ICOs.  Should they do so, what would be their status and that of the coins they hold?  Would they be investors?  Would the coins be investments/securities or just the means by which to access the platform?

In light of the SEC’s DAO report, it’s more likely regulators would deem the coins to be securities, even where the holder actively uses the blockchain to conduct business.  On one level, buying access to the blockchain increases its computing power through the addition of the subscriber/purchaser’s nodes (i.e., workstations), thus fortifying the platform, making it more robust and dynamic, and increasing its value through wider acceptance, broader recognition and enhanced computing power.  This obviously provides a benefit to everyone with a stake in the platform in the form of increased value of the coins, and would be analogous to a senior executive of a public company benefitting from the increase in his company’s stock price when his efforts help the company performs well.

On another level, unless the blockchain is dedicated exclusively to the business owner’s transactions – in which case it likely would not have other users – his transactions are likely to be only a part, and maybe even just a small fraction, of the activity driving the platform’s acceptance or popularity.  In this way, the business owner’s transactions would not be the sole or primary reason for the token’s increase in value, i.e., would not be significant drivers, or the essential managerial efforts affecting the platform’s growth or success.

Thus, under a DAO analysis, coins held by a business owner who acquires them to gain access to a blockchain platform will likely be found to be a security, requiring registration or an exemption from registration.  As a result, any business owner considering using a blockchain platform to run a business should consider whether it is registered with the SEC and, if not, the potential implications of having the SEC later come along and challenge the sponsor, and possibly disrupt the business.

Ron Wood

Ron Wood

Ron Wood is a partner with Brown White & Osborn LLP. A former Assistant Director in the SEC's Division of Enforcement, Executive Director in the Law Division at Morgan Stanley, and litigation partner with Proskauer LLP, he practices securities law with a focus on regulatory and enforcement matters. He also conducts internal investigations and complex commercial litigation.
Ron Wood