encountered the landmark case of SEC v. W. J. Howey Co. on a hot summer afternoon in 1980 in a windowless law school
classroom [memo to self: afternoon summer law school classes, windowless rooms
and securities regulation are not a good combination] in Champaign, Illinois.
Interests in orange groves couldn’t be “securities,” could they? After all,
securities were traded on exchange floors by noisy agitated people in colorful
vests, and sold downtown by dignified brokers in expensive suits. How could interests
in fragrant stands of trees be securities?
We of course
learned that the definition of a security, in the form of an investment
contract, is a fluid facts and circumstances test with terms such as a “common
enterprise” and “expectation of profit” in play. Orange grove interests can
indeed be a security, with nary anyone in a neon vest waving their arms nor a
pair of wingtips in sight.
the SEC moved into another exotic locale that would have been far more
unimaginable in 1980 that orange grove interests. While the Commission decided not
to bring enforcement charges, the Enforcement Division did issue an investigation report that concluded that certain digital
currency interests were securities.
I am not
going to attempt to explain blockchain and distributed ledger technology to
readers here, or pretend that I understand the nuances of digital currencies. I
do not claim that all my terminology usage to describe these transactions are
accurate. When the SEC writes that “in exchange for ETH, The DAO created DAO
Tokens (proportional to the amount of ETH paid) that were then assigned to the
Ethereum Blockchain address of the person or entity remitting the ETH,” I
quickly shift to see how the Cubs are doing in the standings. That said, it is
extremely important for those engaged in digital coin transactions, and for
securities lawyers in general, to understand the significance of the
Enforcement Division’s recent statement.
Investigations are Rare and Important Pronouncements
report begins quietly enough, as the SEC states that “[t]he Commission has determined not to pursue an enforcement
action in this matter based on the conduct and activities known to the
Commission at this time.” The Enforcement Division then spends the next 17-plus
pages explaining its decision not to act.
A lawyer familiar with wordy
judges expounding endlessly on matters not relevant to the decision before them
might be inclined to dismiss these 17 pages as so much dictum, but that would be a huge mistake. Even when
not taking action, the SEC makes important policy pronouncements through these
reports. For example, the famous 2001 “Seaboard” report (which never mentions Seaboard), set forth
an analytical framework for evaluating cooperation by companies that could be
charged in enforcement proceedings. The report detailed the factors that the
SEC considers in determining whether, and to what extent, it grants leniency to
investigated companies for cooperating in its investigations and for related
good corporate citizenship. That report became engrained in the culture of all
involved in litigating with corporate defendants.
These reports are relatively rare
events, as the division has issued 15 such reports in more than 20 years. These
reports also form the basis of Enforcement Division policy and actions. They
are not the opinions of a staff attorney or the result of an administrative law
judge’s opinion. Rather, they reflect the views of the division’s leadership on
significant topics of interest to the SEC.
The SEC’s Views on Digital Currencies Have Evolved
In a 2013 letter,
then-Chair Mary Jo White recognized that as with all investment contracts, the
question of whether a particular digital currency interest is a security is
governed by a facts and circumstances test. While she indicated a possibility
that they would not meet the Howey
test, she stated that interests
issued by entities
owning virtual currencies or providing returns based on such assets likely would be
securities subject to SEC regulation.
In last week’s report,
however, the SEC stated that the so-called DAO tokens are securities as defined
in both the Securities Act and the Exchange Act. The division begins with a bit
of a truism, stating that “foundational principles of the securities laws apply
to virtual organizations or capital raising entities making use of distributed
ledger technology,” or in other words, if the securities laws apply, they
apply. The report then goes on to detail how these particular tokens satisfied
the current version of the Howey
- investors in the tokens invested “money,” which does not have to be
- the investors did so with a reasonable expectation of
- profits were to be derived from the managerial efforts
of others, as the efforts of the company that created the enterprise, and the
enterprise that sold the tokens were essential to profitability.
These elements are the classic components of the Howey definition, adapted for the digital paradigm. As the SEC
stated in the report, “[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 laws. The SEC also noted that
trading venues must comply with applicable registration requirements for
securities exchanges, and that the funding activities of entities selling these
interests might necessitate Investment Company Act registration.
Registration violations come with serious consequences. Issuers can
face significant civil penalties and criminal sanctions, as well as future
disqualifications from various benefits under the securities laws. Perhaps most
importantly, purchasers in unlawful unregistered offerings have a year to
return their securities for a refund of the purchase price.
Will this investigation report lead to widespread enforcement sweeps of
initial coin offerings or fundamental changes to how the industry does
business? No. Aside from the fact that the SEC tends to move rather slowly on
such fronts, each individual case will be dominated by its own particular and
unique facts. Establishing a jurisdictional nexus between the U.S. and these
transactions may also be problematic, as the deals are intentionally housed in
offshore financial centers.
That said, the report does indicate that digital currencies are
squarely on the SEC’s radar, and aren’t going away. The Commission has a
working group to deal with these matters, and is increasing its institutional
expertise on digital currency issues. Digital currency issuers and investors
should carefully review their conduct in light of federal securities law
requirements, and issuers that are subject to U.S. law should take affirmative
steps to determine that their offerings are either registered or exempt.
And the Cubs are back in first place.
For more on the legal issues surrounding blockchain, Bloomberg Law subscribers can access our our new “In Focus” page on the topic.