Securities Law and Cryptocurrencies
(Editor’s Note: This article was written with the invaluable assistance of Mr. Rane Riley, a third-year law student at Southern Methodist University’s Dedman School of Law, my alma mater.)
Anyone paying attention to world news headlines has witnessed the recent meteoric rise in the value of Bitcoin, a cryptocurrency (or virtual currency) increasing in price per unit from approximately $15 in 2013 to approximately $7,000 per unit as of the writing of this article. It does not require a great deal of insight to recognize the significant role that Bitcoin and other similar cryptocurrencies play in our economy, and their significance as a financial medium of exchange should only increase in the future.
On July 25, 2017, the SEC published Release No. 34-81207 (the “DAO Release”) addressing capital formation through the use of a virtual currency (not unlike Bitcoin) called DAO Tokens. The DAO Release takes the unequivocal position that virtual currencies, when used in capital raising ventures, are still securities under the Securities Act of 1933, as amended (the “Securities Act”), and therefore require registration on both the federal and state level (unless valid exemptions from registration apply). Further, the DAO Release clarifies that any platform that facilitates buy/sell orders in virtual currency digital markets must register as a national securities exchange under the Securities Exchange Act of 1934 (the “Exchange Act”) (or operate under a valid exemption from such registration requirement).
In the DAO Release, the SEC described its investigation of The DAO, an unincorporated organization, and Slock.it UG, a German corporation. The DAO was a virtualized decentralized corporation implementing a distributed ledger (blockchain) to raise capital to fund “projects.” The premise of the capital raising was simple. Investors would send to The DAO Ether (ETH), a cryptocurrency not unlike Bitcoin, in exchange for DAO Tokens issued by The DAO. In this transaction, the DAO Tokens served as the securities, and ETH served as the cash to purchase the DAO Token securities. The ETH raised by the issuance of The DAO Tokens would be used to fund “projects” voted on by a majority of the shareholders of The DAO. Before voting could occur, however, the projects had to be approved by “Curators” who were employed by The DAO. The Curators were given great discretion in their approval process and thus took a vast majority of the managerial decisions out of the hands of the shareholders (entities and individuals who held The DAO Tokens).
Investors in The DAO could expect returns on their investment in two ways. First, returns from funded projects could be either distributed back to investors or retained in the investment pool to fund further investment. Second, investors could trade The DAO Tokens on platforms (secondary market) with other investors. As with stock, holding The DAO Tokens allowed investors the right to receive dividends (returns from projects), or trade the stocks on the secondary market (trade the tokens on platforms).
Under the United States federal securities laws, the term “security” is defined in Section 2(a)(1) of the Securities Act as, among other things, “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 . . . [,or] investment contract”. From the definitive US Supreme Court case, SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), an investment contract “is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The three main requirements of an investment contract are, (1) investment of money in a common enterprise, (2) with a reasonable expectation of profits, (3) solely from the entrepreneurial or managerial efforts of others (partaking in significant managerial decisions fails to meet the third requirement).
In the DAO Release, the SEC concluded that virtual currencies, when used to raise capital, meet the above stated definition of an “investment contract”. In reaching this conclusion, the SEC makes it clear that “[t]he 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 law.”
Because Section 5 of the Securities Act requires all securities to be registered unless a valid exemption exists, as securities, virtual currencies (when used to raise capital) must be registered or must qualify for an exemption. In this case, a virtual organization raised capital by receiving virtual currency and in exchange issued its own virtual currency. The SEC made it clear that, like issuing stock in return for receiving cash, organizations engaging in this type of capital raising will be subject to the Securities Act and the Exchange Act.
Furthermore, the SEC held that platforms that engage in facilitating trades of virtual currencies must register as national securities exchanges or face penalties under the Exchange Act.
As always, each case is different with different facts and circumstances. Before applying the general rule described in the DAO Release, one should look to the particular facts and circumstances of an issuer’s capital-raising activities.