2017 witnessed explosive growth in the use of token generation events (also known as ICOs, for “initial coin offerings”) to raise capital for startups and other Internet firms. According to the New York Times, more than $3.2 billion had been raised by late October, already representing a 3,000% increase over 2016.
But 2017 also brought a Securities and Exchange Commission (SEC) report that sent shockwaves through the world of ICOs. In July 2017, the SEC released an investigative report on DAO Tokens, a virtual token created and sold by The DAO, a decentralized autonomous organization.
In its report, the SEC concluded that DAO Tokens were securities, and so had to be registered before they could be offered or sold. SEC registration is an onerous process, and so the SEC’s report has highlighted the importance of proper legal planning when developing a new virtual token.
A Brief History of The DAO
Decentralized autonomous organizations are essentially companies with a governance structure implemented through a blockchain. The concept was first introduced by the chief technology officer of Slock.it, a German blockchain company, and further developed in a white paper published on its website.
The DAO was established as a first-generation proof of concept for a decentralized autonomous venture capital fund. It was to be a for-profit business that would fund projects curated by DAO Curators, who were selected by Slock.it, and voted on by those who purchased DAO Tokens.
When The DAO was launched, it raised 12 million Ether (a cryptocurrency running on the Ethereum blockchain) from investors in exchange for DAO Tokens. At the time, this amount was valued at roughly $150 million.
However, the code that The DAO deployed to the Ethereum blockchain to permit purchases of DAO Tokens was flawed, and an attacker was able to steal one-third of the Ether raised by The DAO shortly after launch. Fortunately, an update to the Ethereum blockchain enabled all the Ether raised by the DAO—including the stolen Ether—to be returned to investors, but the damage to The DAO was already done.
Why DAO Tokens Were Securities
In its report, the SEC used the Howey test to determine that DAO Tokens were securities. The Howey test is derived from a 1946 U.S. Supreme Court case, and remains the principal framework for determining status as a security. The SEC examined the four Howey elements in its report, as summarized below.
- An investment of money: To purchase DAO Tokens, users were required to pay in Ether. Because Ether is something of value, the SEC found that the first element of Howey had been met.
- In a common enterprise: The SEC only briefly touched on the element of commonality, employing the broadest standard that federal courts use: so-called horizontal commonality. This standard is met when there is a pooling of investors’ funds, as there was in the case of The DAO.
- With an expectation of profits: The DAO was intended to be a for-profit entity. Investors would vote on projects to be funded by The DAO, and could then share in any return on those investments.
- Derived from the managerial efforts of others: The SEC pointed to two principal attributes of DAO Tokens in this regard: First, control over The DAO and what projects investors would consider funding was largely in the hands of Slock.it and its chosen DAO Curators. Second, investors’ voting rights were limited, both because of Slock.it’s control and because of the difficulty the pseudonymous, geographically dispersed investors would have in forming an effective voting bloc.
Conclusion: What Startups Can Learn from The DAO
The SEC’s report provides valuable insight into how federal securities laws will apply to virtual tokens going forward. The central takeaway is that such tokens may be securities under existing precedent, and must comply with existing laws if so. Accordingly, what follows are two of the most important lessons for startups to take from the SEC report:
- The need to avoid classification as a security: Although The DAO escaped prosecution in this case, failing to register a security before selling it in the United States can subject a person to both civil and criminal liability. Because registration is a cumbersome, expensive process, the optimal strategy for addressing securities law will often be structuring a token and ICO so that it fails the test for a security.
- The significance of a white paper: The SEC considered the contents of The DAO’s white paper and other marketing materials in understanding the nature of the token. Consequently, developers should work with a knowledgeable securities lawyer to review their white papers, websites, and similar materials.