When bitcoin emerged from the ether in 2008, it revealed a new technological frontier seemingly outside of the scope of our current financial institutions—and our law books. In this Wild West of finance, there is both an uncapped potential for growth and an unknown amount of risk at play.
Technologists entering the space may feel like they are in the right place at the right time but they should understand and appreciate the legal and regulatory risks of their ventures. Admittedly, this is easier said than done: there is no statute and very limited case law that describes the legal rights and obligations associated with bitcoin and other cryptocurrencies.
So, how can you know where you and your venture stand?
The following is for general education purposes. This is just my opinion and what US regulators could be wont to believe. I highly recommend speaking with counsel in your jurisdiction before making any offerings.
Why and how would US regulators classify crypto-token crowdsales as securities?
As often happens, the technology has emerged at a faster rate than the legislation regulating its use. In this climate, lawyers (including those who work in Enforcement at the SEC/DOJ) are apt to interpret statutes in a way that makes sense to them within the current regulatory framework.
So, let’s see what regulators will be looking at. Under the Securities Act of 1933 (“’33 Act’), the term “security” is defined as:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
This definition doesn’t really make the legal notion of a security easier for any of us to understand.
But wait, there’s more! In 1982, the US Supreme Court stated that the definition of security is “quite broad” and is intended to include “the many types of instruments that, in our commercial world, fall within the ordinary concept of a security . . . [including] stocks and bonds, along with the countless and variable schemes by those who seek the use of the money of others on the promise of profits.” Marine Bank v. Weaver, 455 U.S. 551, (1982).
In other words, US Federal Courts give regulators considerable latitude in determining what is and what is not a security.¹
Given this relative carte-blanche, technologists should organize their businesses with the expectation that regulators are apt to be overly inclusive with the instruments they deem securities rather than under-inclusive.
So what?! Federal Courts interpret the definition of securities broadly. I don’t see DAO tokens, Augur REP or any other token in that list.
Okay. The seminal test for determining whether a particular instrument is an “investment contract” (and thus considered a security under the ‘33 Act) is the Howey Test.
What in the wild wild world of sports is the Howey Test?
Way back in 1946, the W.J. Howey Co. was offering the sale of small tracts of land where purchasers could lease the land (via a service contract), back to Howey, who would then keep the purchasers’ land looking majestic AF. Individual purchasers of these tracts had no right of entry or any right to market the crop, but were promised a share of the profits of the citrus fruits grown on the land.
Now this little scheme was going great for good ole W.J. even though some folks did not take W.J. up on his offer to service their property. That is, until the SEC stepped in and effectively said, “Slow yo motherfuckin’ roll fella. You can’t just go around selling investment contracts (securities!) without checking with us first” (registering said securities). The SEC brought an action to enjoin the sale of citrus grove interests but had a problem because the interests in question did not constitute any of the specific, traditionally enumerated securities listed in the definition above. So the SEC got a little creative. They argued that the citrus fruit interests were investment contracts which had yet to be defined by Congress. The Justices of the Supreme Court, being the Wise Gs that they were, determined that in the instances where the instrument is novel, they will always disregard the form of a transaction and instead focus on the economic reality of the transaction.²
If the form of a transaction is inconsequential, what constitutes an investment contract?
SCOTUS explained that an investment contract requires:
- The investment of money (or anything of value);
- In a common enterprise (Some courts require vertical³ and horizontal commonality⁴);
- Where investors are led to expect profit$;
- Solely (which later was held to mean predominantly⁵) from the efforts of others.
Applying this framework to Howey, the Court determined that the contracts in issue met all four prongs of this test and W. J. could be held liable for violating § 5 of the Securities Act of ‘33.
Importantly, the fact that some investors didn’t enter into the service contract was irrelevant because the ’33 Act PROHIBITS THE OFFER as well as the sale of unregistered securities.
This case and its progeny remind us that the world of securities regulation is complex and that those things which we may not initially consider “securities” can be regulated as such.
Now let’s consider this in the context of a recent occurrence many of us are familiar with.
TheDAO Token Crowdsale Case
The spectacular debacle that was The DAO (“TheDAO”) provides us with an all too recent instance of a crowdsale token issuance that US regulators would likely classify as a security.
TheDAO was billed as the first decentralized autonomous organization on the Ethereum blockchain. The folks at Slock.it developed a piece of software that gave token holders a voting interest in the kinds of projects that TheDAO would invest in as well as a share of the profits from those investments. There was no management to speak of, no directors, no physical address and no legal entity⁶⁷. Investors in TheDAO simply sent their Ethereum(ETH) to TheDAO at which point it was exchanged into DAO tokens.
Could the above fall under the legal definition of an investment contract? Let’s run it through the Howey Test.
1. Was there an investment of money made on behalf of TheDAO token holders?
Yes, emphatically yes. Any consideration that has value is likely to be classified as “money” for a Howey analysis.⁸ ETH or any other token that is highly fungible, divisible, and has some value, is likely to satisfy the investment of money prong of Howey.
2. Was there a common enterprise?
Yes. TheDAO’s pooling of token holders’ ETH, pro rata profit sharing, and its proportional dispensation of voting rights are important indicators of common enterprise. The latter properties, in particular, are hallmarks of traditional stock ownership (aka Securities with a capital “$”). These similarities would be difficult for courts/regulators to ignore, irrespective of the commonality test used.⁹
3. Did investors in TheDAO expect to make a profit?
Yes. Slock.it placed a reward mechanism within TheDAO wherein token holders would have received profit (had TheDAO not been vulnerable to attack) in the form of reward tokens commensurate with the portion of TheDAO they owned. On paper, these reward tokens look a hell of a lot like dividends. Investors in TheDAO clearly expected to receive reward tokens from TheDAO’s successful projects.
4. Did token holders rely on the efforts of others for their (expected) profits?
Yes. The touchstone of this prong is whether an investment in a common venture is “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”¹⁰ The value of TheDAO tokens and the prospective value of reward tokens had their value pegged to the overall success of the contractors hired through TheDAO’s proposal mechanism. In other words, the success of TheDAO was heavily dependent on the business savvy and success of its contractors to make a profit for themselves and in turn, TheDAO token holders. Had TheDAO not suffered a significant security breach which undermined the entire project, it is very likely that the hiring of contractors would be sufficient to satisfy the fourth prong of Howey’s investment contract analysis.
A big part of the answer to the question, are crypto-token crowdsales considered securities? comes to us in the legal precedent Howey provides: in instances where an instrument is novel, the law will disregard the form and instead focus on the economic reality of the transaction.
If ever the term “novel instruments” applied, it would be now, in our treatment of blockchain and crypto-token ventures. It is my belief that these instruments, which have not been considered by many as traditional securities/investment contracts, may yet fall within the regulatory grasp of the SEC. I hope that it gives anyone contemplating a crowdsale some food for thought.
The ethos behind the ‘33 Act was to protect consumers from “betting the farm” on risky, unproven businesses. The disruption of financial markets and traditional fundraising mechanisms via distributed ledger technology opens the door for non-accredited investors to make incredibly risky and speculative investments. These are exactly the types of ventures that the ’33 Act attempts to regulate.
Determining whether a given token sale/offering of securities is complex and fact-specific so I’ll leave you here with some questions technologists in this space should be asking themselves before “going public” with their projects.
- How am I going to scale considering the risk of selling unregistered securities?
- Are any of my marketing efforts directed at US investors?
- Are my marketing materials compliant with US securities laws?
- Am I receiving anything of value from US investors in my crowdsale or am I going to exclusively focus on non-US markets?
- How do I plan to conduct KYC and AML on my potential investors?
- Will I use Slack, blogs, and message boards to promote my crowdsale?
- Am I prepared to act as fiduciary on behalf of my investors?
- Do crowdsale purchasers expect to receive any sorts of dividends or expect to share in the profits of the platform and/or business?
- Have I considered fundraising through private placements or funding portals?
: See SEC v. Edwards, 540 U.S. 393 (2004); see Reves v. Ernst & Young, 494 U.S. 56, 60-61 (1990) (“Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits,’ and determined that the best way to achieve its goal of protecting investors was to define the term ‘security’ in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.'”)
: “The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Although courts place more or less emphasis on different prongs of the Howey test, it is the seminal framework for determining whether a particular novel instrument will be considered an investment contract and thus, a security.
: There is a well acknowledged Federal Circuit split over what types of vertical commonality are sufficient find that a particular instrument is a security. The first is the “narrow vertical” approach wherein the test is satisfied if the risk and profit motives of the promoter and investor are aligned. See SEC v. Eurobond Exchange, Ltd., 13 F.3d 1334, 1339 (9th Cir., 1994). The second being the “broad vertical” approach wherein a common enterprise is one in which “ the success of an investor depends on a promoter’s expertise” and requires only that “investors are dependent upon the expertise or efforts of [the] promoter for their returns” SEC v. ETS Payphones, Inc., 300 F.3d 1281, 1284 (11th Cir., 2002).
: “[A] common enterprise . . . [is] satisfied where a movant shows ‘horizontal commonality,’ that is the ‘pooling’ of investors’ funds as a result of which  investors share all the risks and benefits of the business enterprise.” See SEC v. ETS Payphones, Inc., at 1284; “Pool” is defined as “[a]n association of individuals or entities who share resources and funds to promote their joint undertaking; esp., an association of persons engaged in buying or selling commodities.” Black’s Law Dictionary, 7th ed., 1180.
: See SEC v. Koscot Interplanetary, 497 F.2d 473, 483 (1974) (noting that an investment contract constitutes a security if the efforts made by those other than the investor are the undeniably significant ones . . . which affect the failure or success of an enterprise.”) quoting SEC v. Glenn W. Turner Enterprises, 474 F.2d 476, 483 (9th Cir.)
: Although TheDAO’s legal status remains in flux for lack of guidance, there was a rush to define TheDAO in crypto terms. It’s a equity token! No, no, no, it’s a token for a distributed collaborative organization token! Notwithstanding these claims, there’s a strong argument to be made that it was a venture capital fund. It was pooled investment vehicle that looked to invest in and receive dividends or ownership interests in high growth projects on the ethereum blockchain. Unlike a venture capital fund however, they did not limit their solicitation to accredited investors. A big no-no. The slock.it team built TheDAO contract, actively promoted its use and sale, facilitated with the exchange of ethereum to DAO tokens and solicited proposals to TheDAO likely violating the prohibition on generally soliciting unregistered securities.
: State v. Gopher Tire & Rubber Co., 177 N.W. 937 (Minn. 1920).
: See supra, notes 3 and 4.
: United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975)(stating that the “touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”)