A common sense dissection of the SEC filing on Blockchain technology
I spend my days digesting regulation and working with financial institutions to implement it in the most efficient/least painful way possible. I have most recently worked on implementing the Investor Protection regulation in MiFID II. I am not a Lawyer, this is not advice and all views are my own.
So, who has actually read the SEC filing? Many people have read the Coinbase review and opinions on twitter, but have you actually read the SEC filling?
No? Okay, lets break it down.
The report, titled Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO , sets the scene by describing The DOA corporate structure and the sale of DAO tokens.
Observation 1) I have seen several twitter posts proclaiming “This paper is about the DAO it does not apply to other organisations/tokens/ICO’s”
Nope, they’re referring to the structure in general.
The DAO is one example of a Decentralized Autonomous Organization, which is a term used to describe a “virtual” organization embodied in computer code and executed on a distributed ledger or blockchain.
Observation 2) The SEC are going broad. really broad.
This Report reiterates these fundamental principles of the U.S. federal securities laws and describes their applicability to a new paradigm — virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities. The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws.
This Report also serves to stress the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces.
Observation 3) They have cited some pretty punchy and wide reaching legal cases as precedent
SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943) “[T]he reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security’.”)
Reves v. Ernst & Young, 494 U.S. 56, 61 (1990) (“Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”).
Observation 4) They have chosen not to prosecute. They’re naming and shaming. This is a warning shot to the community.
The Commission has determined not to pursue an enforcement action in this matter…
The concept of a DAO Entity is memorialized in a document (the “White Paper”), authored by Christoph Jentzsch, the Chief Technology Officer of Slock.it, a “Blockchain and IoT [(internet-of-things)] solution company,” incorporated in Germany and co-founded by Christoph Jentzsch, Simon Jentzsch (Christoph Jentzsch’s brother), and Stephan Tual (“Tual”).
Observation 5) WARNING: The SEC may not appreciate…
5.1) Telling investors they will make a profit
According to promotional materials, The DAO would earn profits by funding projects that would provide DAO Token holders a return on investment.
5.2) Allowing people to invest anonymously
Investments in The DAO were made “pseudonymously”
5.3) Allowing people to invest who do not hold the expertise to understand the underlying risks
There were no limitations placed on the number of DAO Tokens offered for sale, the number of purchasers of DAO Tokens, or the level of sophistication of such purchasers.
5.4) Allowing token holders to sell DAO on a secondary market
DAO Token holders were not restricted from re-selling DAO Tokens acquired in the offering, and DAO Token holders could sell their DAO Tokens in a variety of ways in the secondary market and thereby monetize their investment
5.5) Investors not having meaningful control
…diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.
Now tell me what makes a token a security?
It’s worth pointing out that this regulation is a “…flexible rather than a static principle…”. That means the SEC can contort the text to make it comply to situations as it pleases. Thus they have declared:
Foundational Principles of the Securities Laws Apply to Virtual Organizations or Capital Raising Entities Making Use of Distributed Ledger Technology
The SEC have used the Howey Test to determine if the DAO is a security. The Howey Test determines whether an instrument is an investment contract, and thus a security under the Securities Exchange Act of 1933. It consists of 4 principles: an investment contract is defined as (1) investment of money into a (2) common enterprise (3) with the expectation of profits (4) solely from the efforts of the promoter or a third party.
So, ask yourself if these principles apply to that token you are planning to issue through that flashy ICO?
Are your Investors going to invest money (and money doesn’t mean cash!) (Howey test principle 1)
[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.
Are you a common enterprise? (The SEC filling paper skips over this in relation to the DAO but heres a the legal definition)
a “common enterprise” is defined as an enterprise in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those offering or selling the investment or of third parties.
Do your investors expect to profit? (…why else would they invest?!)
Investors who purchased DAO Tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise…
The various promotional materials disseminated by Slock.it and its cofounders informed investors that The DAO was a for-profit entity whose objective was to fund 12 projects in exchange for a return on investment.
Is the profitability of the business reliant on you, the founder / business proposition? (eg the “Managerial efforts of others”)
Investors’ profits were to be derived from the managerial efforts of others — specifically, Slock.it and its co-founders, and The DAO’s Curators. The 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.” The DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it and its co-founders, and The DAO’s Curators, to manage The DAO and put forth project proposals that could generate profits for The DAO’s investors.
The registration requirements are designed to provide investors with procedural protections and material information necessary to make informed investment decisions. These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.
That seems pretty all encompassing, to me. I’m sure the SEC will add more clarity to this filling over the coming months. Maybe we will even get guidance on what a token which isn’t a security looks like!
In my opinion, this is a warning shot and is meant to curb the ICO craze. The next time the SEC weigh in it will be at point blank range to make an example to the industry. You better hope they don’t target you.