Written by Steve Gow and Conrad Druzeta, with contributions from Michael Whitt, Andrew Pollock and Simon Grant
Companies considering an Initial Coin Offering, Token Offering or other blockchain-enabled means of capital raising should pay attention to recent guidance issued by the United States Securities and Exchange Commission (SEC). On July 25, 2017, the SEC released a report of investigation (the Report) setting out its finding that cryptocurrency tokens sold to the public by The DAO, an unincorporated organization created by German company Slock.it UG, are securities under U.S. federal securities laws. The Report concluded that The DAO, Slock.it UG, Slock.it's co-founders and intermediaries may have violated U.S. federal securities laws by: (i) offering and selling unregistered securities; (ii) participating in the offer and sale of unregistered securities and (iii) failing to register as a national securities exchange without an applicable exemption.
The SEC declined to seek enforcement action at this time but deemed it appropriate to issue the Report to caution others who would use a decentralized autonomous organization (a DAO Entity), or other distributed ledger technology or blockchain-enabled means for capital raising (such as Initial Coin Offerings or Token Sales) to take appropriate steps to ensure compliance with U.S. federal securities laws. The SEC's press release accompanying the Report states that:
"… the federal securities laws 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."
The Howey Test
In the Report, the SEC considered the legal test initially formulated in the seminal 1946 case of SEC v WJ Howey Co. (the Howey Test) to determine whether the cryptocurrency tokens sold by The DAO (the DAO Tokens) are "investment contracts" within the meaning of Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 and therefore constitute "securities" under U.S. federal securities laws. The Howey Test, as restated by the SEC in light of subsequent judicial refinements to the test, provides that 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 SEC applied the Howey Test to the facts of the DAO Token offering and concluded that the DAO Tokens are investment contracts for the following reasons:
- Investors purchased the DAO Tokens with Ether, a virtual cryptocurrency. According to the SEC, such an investment is the type of contribution of value that can create an investment contract under the Howey Test. The investment need not be in cash.
- Investors who purchased DAO Tokens were investing in a common enterprise and reasonably expected to earn profits through the receipt of "rewards" that The DAO founders represented to investors would take the form of "any [Ether] received by a DAO [Entity] generated from projects the DAO [Entity] funded". The SEC noted that the fact that such "projects" could encompass services and the creation of goods for use by holders of DAO Tokens does not change the analysis that investors purchased DAO Tokens with the expectation of earning profits from the efforts of others.
- The efforts of The DAO, Slock.it UG and its co-founders in promoting the sale of the DAO Tokens and selecting the "curators" of The DAO platform, together with the lack of meaningful participation by investors in the management of The DAO, led the SEC to conclude that the investors' profits were to be derived from the managerial efforts of others, namely, Slock.it UG, its co-founders and the curators of The DAO.
Interestingly, the SEC did not indicate that all "crypto-instruments" issued in connection with ICO's and similar transactions will automatically be deemed to be securities. The SEC has indicated a determination of whether a particular token, coin or other crypto-instrument is a security will be made on a fact-specific analysis based on existing fundamental principles of U.S. federal securities laws.
Canadian Securities Laws Implications of the Report
Whether a token or other instrument sold in connection with an ICO, Token Offering or similar transaction is a security under Canadian securities laws depends on the specific features of such instrument. Similar to U.S. law, Canadian securities legislation broadly defines "security" to include any "investment contract".
The leading Canadian decision considering the meaning of "investment contract" is the decision of the Supreme Court of Canada in Pacific Coast Coin Exchange of Canada v Ontario (Securities Commission),  2 SCR 112 (Pacific Coast). In Pacific Coast, the Court adopted the U.S. Howey Test with two refinements. First, the efforts of others upon which the investor relies to realize profits must be "the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise". Second, the Court defined "common enterprise" as "one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties." The Court also cautioned that it is the clear legislative policy behind Canadian securities legislation to replace the harshness of caveat emptor (buyer beware) in securities transactions and Canadian courts should seek to attain this goal even if legal tests must be continually broadened.
The SEC's Report comes on the heels of a press release issued on March 8, 2017, by the Ontario Securities Commission (OSC) advising businesses that use distributed ledger technology as part of their financial products or service offerings (e.g., ICO's or Token Offerings) may be subject to Ontario securities law.
In light of the guidance recently issued by the OSC in its March 8, 2017 press release and the SEC in the Report, it appears that the current regulatory trend in Canada and the U.S. is to apply existing securities laws to transactions involving cryptocurrencies that have features resembling traditional securities, notwithstanding the fact that novel or complex technology is involved.
In order to minimize the risk of non-compliance with Canadian securities laws, businesses considering raising capital through an ICO, Token Sale, Token Crowdsale or similar transaction should consult counsel to understand the regulatory framework, including whether a business is required to comply with prospectus, registration or marketplace requirements or whether a valid exemption from such requirements may apply under Canadian securities laws.