Yesterday, the Securities and Exchange Commission (SEC) released a report saying that when the Decentralized Autonomous Organization (DAO) held token sales (or an ICO) during April and May 2016, they were selling securities, which need to meet regulatory requirements.
The finding may have ramifications for the founders of the DAO, but more significantly, the fallout from the report could slow the recent ICO frenzy and result in new due diligence requirements for future token sales.
Remember the DAO
The rapid creation and subsequent destruction of the DAO is a watershed moment for the ethereum protocol specifically, and for cryptocurrencies more broadly.
The DAO was created as an emblem of a new empire: A corporation without the corporate-ness. Rather than middle managers, computer code and smart contracts would guide a confederation of digital projects toward profitability. Instead of sleek office suites, the DAO would live on ethereum’s blockchain.
Judging by the USD $150 million raised during the month of DAO token sales, the idea has a market and support.
But then the DAO was hacked and about a third of the money raised was siphoned to another blockchain address. The high profile hack — and the effort to restore the stolen money to investors — resulted in a hardfork, basically undoing what was supposed to be a series of immutable transactions, and created two versions of ethereum.
In the year since the rise and fall of the DAO, the SEC looked at the way the founders of the DAO promoted and marketed the company, the terms of the DAO’s token sales, and the general intent of the project.
The DAO founders — and notably other ICO projects since — have said is that token sales exist as a form of crowdfunding, which under certain conditions is exempt from SEC regulations.
What the SEC found is that the DAO investors had a reasonable expectation of profit. The DAO sold tokens to raise capital, and then used that capital to start projects.
Token owners bought the tokens with the goal of making a return on their investment. Also, the tokens were being sold on secondary markets.
The SEC found that despite blockchain being a new technology and cryptocurrencies being a new form of finance, the underlying relationship between investors and companies selling digital tokens is analogous to traditional companies selling shares of a venture. According to the SEC press release about their investigation:
The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws. The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors’ protection.
So now what?
According to a Quartz story, ICOs have already raised USD $1.2 billion in the first part of 2017, with many more projects in the pipeline.
It will be interesting to see how the SEC report impacts the ICOs that just launched and future projects.
One big predicted impact is that token sales might be removed from exchanges and secondary market trading might be more regulated.
Slowing down what is starting to feel like a ridiculous runaway ICO sector is probably not a bad thing. But, like I mentioned in yesterday’s post, too many regulations too soon might hamper innovation.
What do you think? Should the SEC be more or less involved with regulating digital assets?