Death of the ICO?

2017, Jul 26    

Just last week, Charles Hoskinson (former CEO of Ethereum) was quoted saying that ICOs were “a ticking time-bomb.” Prescient as that remark was, I’m not sure he knew it would go off so soon, or that the SEC would be pressing the detonator.

For the past 24 hours the cryptocurrency community has been scrambling to interpret the SEC report of investigation into the DAO (Decentralized Autonomous Organization) initial coin offering, or ICO. The main takeaway from the report is that DAO tokens were, in fact, securities under US law. This is a big deal because securities are subject to onerous legal requirements, which will deter or outright stop many enterprises from fundraising through an ICO.

Media websites and blogs are now teeming with clickbait headlines shouting “Tokens are Securities.” But that’s not actually true. The SEC has yet to issue any regulations regarding tokens, and certainly has not deemed all tokens to be securities. Instead, the findings of the report are limited to the specific facts of the DAO ICO. While we now know that DAO tokens are securities, that does not mean we should assume all tokens are securities.

So where does that leave us? Is it possible to create a token that is not a security and conduct an ICO without SEC registration? Let’s dig through the SEC’s DAO report and see what conclusions we can distill.

What was the DAO

The DAO was a virtual organization proposed by a company called Analogous to an investor-directed venture capital fund, it allowed members of the public to propose projects (e.g., a startup) to DAO token holders. Curators (individuals unilaterally appointed by to perform essential DAO tasks) would initially review proposals and approve some for a general vote. DAO token holders could then vote on which projects to fund.

Definition of a Security

There are several types of securities, but for the DAO the SEC considered only “investment contracts.” An investment contract is:

  • an investment of money in a common enterprise
  • with the reasonable expectation of profits
  • derived from the entrepreneurial or managerial efforts of others.

In analyzing the DAO ICO, the SEC evaluated each of these elements in turn. In the DAO’s case, the first two factors were pretty clear-cut, but the third required in-depth review.

An investment of money in a common enterprise

Historically, the word “money” has been interpreted broadly, so the SEC opined that Ether is money in this context. They also concluded that the DAO was a common enterprise — the DAO was taking in money from many sources for the purpose of running a for-profit business.

With the reasonable expectation of profits

The SEC considers “dividends, other periodic payments, or the increased value of the investment” to be profits within the meaning of an investment contract. Prior to the ICO, the DAO marketed itself as a for-profit entity that would yield returns for its token buyers. So investors definitely had a reason to expect a potential profit from buying and selling tokens.

Derived from the entrepreneurial or managerial efforts of others

This is where the SEC did some significant analysis. First, it identifies the crux of the question to be “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” In looking at the facts of the DAO, the SEC divided its analysis into two parts: i) the management of the DAO and ii) the voting rights of token holders.

Management of the DAO

The SEC asked whether anyone other than token buyers had been responsible for the management of the DAO. They answered that question in the affirmative, noting the following:

  • (the company that launched the DAO) created online forums for DAO token holders and answered questions about the DAO
  • stepped in when the DAO was hacked, working to resolve the situation
  • Curators controlled what proposals token holders could vote on

These factors demonstrated that and curators were actively involved in high-level decision making for the DAO.

Voting Rights

The SEC found that the DAO’s voting structure did not give token buyers enough power to exercise meaningful control over the enterprise, thus requiring the managerial efforts of others. They arrived at this conclusion because:

  • Token holders could only vote on proposals that were pre-approved by curators
  • Even if a proposal was cleared by a curator, token holders could not effectively negotiate the terms of a contract or obtain more information about it
  • Token holders could not easily band together to exercise control because they were many in number and mostly anonymous

In short, the SEC found that a) non-investors were managing the DAO and b) the token holders’ voting structure did not allow them to control the entity.

Are All Tokens Securities?

Probably not. Had the SEC found that the facts of the DAO ICO did not satisfy any single part of the definition of an investment contract, the DAO token would not have been considered a security. So it may be possible to create a token and associated smart contracts that do not fall completely within the definition of a security.

Admittedly, the first two elements of the definition are difficult to avoid: “an investment of money in a common enterprise with the reasonable expectation of profits.” ICOs need Ether (money), and, for the most part, token buyers are looking for a return (profit). This leaves us with one last possibility: creating a token where the profit is not “derived from the entrepreneurial or managerial efforts of others.”

But can we construct an entity governed by smart contracts where all management decisions are executed by token holders? We’ll explore that in our next post.

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