Facts and Circumstances: Perhaps Not All ICOs Are Securities
Initial coin offerings (ICOs), also sometimes called token sales, have exploded as the fastest growing segment of the world-wide capital markets. ICOs gained prominence in 2016 following a $160 million raise by an entity called “The DAO.” (Connie Loizos, TechCrunch) ICO fundraises grew from an estimated $263 million in 2016 to north of $5 billion in 2017. (Oscar Williams-Grut, Business Insider) The trend has continued in 2018, with an estimated $9.5 billion raised through the first five months of the year. (Coinschedule; see also Katie Rooney, CNBC) Despite this growth, there is still considerable legal uncertainty as to the status of ICOs and whether they are subject to regulation as securities in the United States.
In February 2018, SEC Chairman Jay Clayton made the SEC’s position on ICOs clear, stating: “I believe every ICO I’ve seen is a security.” Chairman Clayton has since doubled-down on these comments, stating in March of this year that “I’m very unhappy that people are conducting ICOs like public offerings of stock when they should know that they should be following the private placement rules unless they’re registering with us.” (Evelyn Cheng, CNBC) In June of this year, the Chairman further clarified that the SEC is unwilling to exempt ICOs from security regulations and that the Commission still views ICOs as securities.
The SEC’s position— that virtually all ICOs are securities—is somewhat curious. For decades, courts have applied a “facts and circumstances” test in determining whether an instrument is a security, regardless of the particular form or technology used to effectuate the offering. Blanket statements that all ICOs are securities are inherently problematic because they fail to account for the individual facts and circumstances surrounding each offering. Moreover, as demonstrated by several examples below, such blanket statements do not hold-up upon closer examination of different types of assets sold through ICOs.
Tokens that Provide Immediate Utility
Many ICO issuers seek to avoid categorization as securities by positioning their offerings as “utility tokens.” Such tokens can be analogized to pre-orders or gift cards, whereby purchasers buy the tokens in order to gain utility within the issuing entity’s ecosystem. Most current ICOs are ostensibly marketing and selling such utility tokens on the promise that the tokens’ value will increase once the underlying platform or service is fully developed. The SEC has correctly taken the position that simply calling an issuance a utility token does not remove it from the security law framework. But, as demonstrated by Chairman Clayton’s comments, the Commission has failed to recognize that some utility tokens may well not actually be securities.
Under the Howey test, an instrument constitutes a security when there is  an investment of money  in a common enterprise  with an expectation of profit  derived solely from the efforts of others. Thus, in analyzing an ICO, the SEC must decide whether the investor purchased the asset based on a promise or expectation that the asset would appreciate in value based on the efforts of others. While it is difficult to answer this question where the token provides no immediate utility (because the platform is not functional at the time of sale), there is a strong argument to be made that issuers offering tokens that provide immediate utility on an existing platform are not issuing a security. If purchasers are motivated by the desire to utilize tokens, not by the speculative expectation of profits to be derived from the efforts of others, then such tokens look far more like gift cards than traditional securities.
The SEC has made clear that cryptocurrencies, defined as digital assets that serve as medium of exchange as opposed to those sold to fund underlying projects or companies, are not securities.1 Thus, it is now generally believed that bitcoin is not a security. But, this leaves open the more difficult question of whether other digital assets now serving as mediums of exchange but initially sold to fund projects should be classified as securities. Ether, the second largest cryptocurrency by market cap, was launched through an ICO by the Ethereum Foundation in 2014. The foundation marketed Ether as a way of raising funds for the development of the Ethereum blockchain. This marketing carried the promise (perhaps implicitly) that the value of Ether would increase as development of the underlying platform matured—arguably enticing purchasers with the promise the asset would increase in value based on the efforts of others.
The SEC has, in public documents, described Ether as “a virtual currency” and not a security. However, it remains unclear whether the SEC will stand by this position or what analysis was used to reach this conclusion. Some commentators have argued that even if Ether was a security when initially issued, because its value is no longer dependent on the Ethereum Foundation, it is no longer a security today.2 (Peter Van Valkenburgh, CoinCenter). While this argument has some superficial appeal, there is no precedent for the idea that an asset initially sold as an unregistered security can somehow transform into a different asset class based on subsequent use. In fact, under current securities law, every subsequent sale of an unregistered security is itself a violation of the Securities and Exchange Acts—meaning that if the tokens sold in the ICO were securities, each subsequent sale of those securities is its own legal violation.
Decentralized Autonomous Organizations
In July 2017, the SEC released The DAO Report, concluding that the digital tokens issued by The DAO were securities under the Howey test. However, the SEC’s report is subject to criticism because it fails to provide a full analysis of the Howey factors, and appears to ignore critical facts regarding the operation of The DAO. Notwithstanding the SEC’s report, there is a strong argument to be made that tokens issued by truly decentralized autonomous organizations (DAOs) are not securities because participants in a DAO are generally not reliant on the efforts of others. DAOs are entities operating without a centralized management team, instead vesting all corporate governance and decision-making authority collectively in the hands of token holders.
DAOs operate via smart contracts (pieces of computer code) deployed on a public blockchains. The terms of a DAO smart contract are binding on all token holders and dictate what actions the DAO can take and how those actions are taken. The DAO was designed to be a decentralized venture capital group providing funding for the development of decentralized blockchain applications. Pursuant to The DAO’s smart contract, DAO token holders could vote on whether to fund proposals submitted by outside contractors. All DAO token holders had access to and the right to vote on proposals, and no proposal could be approved (that is, no DAO resources could be used) unless approved by a majority of voting token holders.
Applying Howey’s “dependent on the efforts of others” requirement to a DAO framework, like the one implemented in The DAO, illustrates the problem with stating that all ICOs are securities. Token holders in a DAO are not investors in a company whose managers or promoters make decisions as to how to utilize company assets. Instead, they are parties to a mutually symmetric contract binding all participants to the same immutable terms. This raises the serious question of how DAO token holders could be “dependent on the efforts of others” as required by the Howey test. There is no central management, promoter, or other party that has control over the entity—so who exactly would DAO token holders be dependent upon?3
Every token holder in a DAO has equal rights, power, and access to information—much like a general partnership. The Fifth Circuit’s seminal decision in Williamson v. Tucker held that “a general partnership or joint venture interest generally cannot be an investment contract under the federal securities acts.” 645 F.2d 404, 422 (5th Cir. 1981). The Williamson court went on to recognize narrow exceptions to the general rule when the partnership agreement deprives the partners of real power in the enterprise or where the partners are dependent on the unique entrepreneurial or managerial experience of the promoter or manager. It seems unlikely that either of these exceptions would apply to the operation of a DAO because all DAO token holders are equally situated and there is no manager or promoter with special power over the entity. Thus, there is a strong argument that tokens issued by such entities are not securities under United States law.
The above three examples are by no means an exhaustive list of situations in which ICOs are likely not securities under United States law. Instead, they are meant to illustrate the need for a case-by-case analysis of individual ICOs to determine whether, based on the facts and circumstances of each issuance, the assets being sold fit into the investment contract definition articulated long ago by the Court in Howey (or into some other category of instrument defined as a Security in the Acts).
1 Statements by SEC Chairman Jay Clayton before the United States House of Representatives Committee on Appropriations, Financial Services Subcommittee, FY 2019 U.S. Securities & Exchange Commission, Thursday April 26, 2018, https://appropriations.house.gov/calendar/eventsingle.aspx?EventID=395258 (“[T]here are different types of cryptoassets. Let me try to divide them into two areas. A pure medium of exchange, the one that’s most often cited is, Bitcoin. As a replacement for currency, that has been determined by most people to not be a security.”).
2 Others have articulated the idea that Ether cannot be regulated as a security because it is now “too big to fail”—that is, that far too much money has been invested in Ether for regulators to step in at this late hour.
3 In the DAO Report, the SEC concludes that token holders were dependent on “curators” who had to first pre-approve all contracts prior to a vote by token holders. DAO Report at 12. For an in-depth critique of this conclusion see Randolph Robinson II, The New Digital Wild West: Regulating the Explosion of Initial Coin Offerings, U. Denver Legal Studies Research Paper No. 18-01, __ U. Tenn. L. Rev. __ (forthcoming), unpublished draft available at, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3087541.