I 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.
This week, 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.
The DAO 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.
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 test:
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.
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