Attorneys offer perspective on SEC ruling

| by Bradley Cooper
Attorneys offer perspective on SEC ruling

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The DAO recently got into hot water for holding a token sale that failed to comply with regulations set out by the U.S. Securities and Exchange Commission. The startup was selling tokens in exchange for Ether, and the SEC ruled that these tokens were securities and thus subject to federal securities laws.

This ruling raised a number of questions about initial coin offerings and the virtual currency industry in general. Blockchain Tech News spoke with Joshua Ashley Klayman, Daniel Kahan and Alfredo Silva, attorneys at the international law firm of Morrison & Foerster, to get some clarity on this issue.

BTN: What are the implications of this for future ICOs?

Klayman, Kahan and Silva: While many in the media and online have raised the possibility of the recent SEC guidance having a  potential chilling effect on token offerings by deterring potential issuers from engaging in token sales or shrinking the aggregate pool of capital invested in token offerings, another possibility is that the opposite may occur. 

By providing guidance to token offerings as a new type of capital markets financing, the SEC may actually have legitimized them in the eyes of certain sophisticated investors such as banks, large companies and venture, private equity and hedge funds. With greater legal certainty and confirmation from the SEC that the existing regulatory framework also applies to token offerings, reputable and responsible issuers may be more likely to engage in token sales.

At the same time, the SEC has given fair warning to potential fraudsters and those wishing to target unsophisticated and inexperienced retail investors without complying with applicable investor-protection regulations, and they may be more likely to avoid marketing, offering or selling tokens in the United States.

While some tokens will, going forward, be offered either as registered transactions or only to accredited investors under traditional private placement exemptions, many in the community have suggested that other tokens will instead simply be offered in offshore transactions. This, too, is nothing new, and launching token sales from outside the United States does not give the issuer a free pass to ignore U.S. securities laws.

What many people forget is that The DAO was, in many ways, an "offshore" offering and was launched from Switzerland by a Swiss foundation. Yet The DAO was the subject of last week's SEC enforcement action and clearly was subject to U.S. securities laws — and likely also was subject to, and failed to comply with, the laws of numerous other jurisdictions across the world. 

And cross-jurisdictional coordination makes sense: If an instrument is not a security simply because one has taken it out of paper form and moved it into an electronic ledger, then, theoretically, what would stop any issuer from taking any security and tokenizing it so as to avoid the securities laws of various international jurisdictions?

This is an absurd result, of course, and as foreign jurisdictions begin to better understand what blockchain tokens are — i.e., a new technology, a new form for representing a set of rights, but not a universally new set of rights itself — we expect that they will begin issuing guidance that is relatively in line with the SEC's report. 

BTN: What were the major pitfalls of the DAO's approach to the sale?

Klayman, Kahan and Silva: Some have said that The DAO's marketing efforts were much better than its smart contracts, referring to The DAO's lightning-fast capital raise of approximately $150 million of digital currency, swiftly followed by the taking of roughly $50 million of such currency as the result of a smart contract vulnerability. Just as The DAO's technical architecture may have been flawed, so was its approach to U.S. securities laws.

Sometimes, an issuer of a security attempts to comply with the U.S. securities laws generally, but due to a foot-fault or an ill-conceived approach to the sale, suffers some manner-of-sale defect that results in a breach of securities laws. That's not what happened here — the problem was not that The DAO tried to comply with securities laws and failed, but that The DAO may not have attempted to comply with them at all. 

There may be more than one reason for that. First, while The DAO's tokens appear to be nearly paradigmatic examples of a security, and The DAO essentially created a virtual venture fund, The DAO's organizers probably didn't think of its tokens as securities. After the SEC's report, no issuer offering tokens with features similar to those of The DAO's token can easily take that position.

Second, The DAO is an unincorporated association based in Europe, and conducted a virtual token offering and may have assumed that U.S. securities laws didn't apply to it because it was offshore.

However, unless all of the qualifications for an offshore exemption are met, the U.S. securities laws generally are applicable to a securities offering, regardless of where a security issuer is located and regardless of whether the issuer is an individual, a corporation or an unincorporated association.

As we understand it, in the case of The DAO, among other things, U.S. retail investors participated in the token offering and [the] marketing, offering or selling of The DAO's tokens was done in the United States.  Even if a security initially is issued in an offshore offering that is exempt from registration under the U.S. securities laws, there may be a "flowback" issue if tokens initially issued to non-U.S. persons ultimately are held by U.S. persons due to secondary trading. 

Among other things, flowback into the United States may cause the issuer to incur ongoing reporting requirements under U.S. law. The SEC report reminds us that issuers targeting the U.S. market must, even if based outside the U.S., understand and comply with the U.S. securities laws and regulations.  

BTN: How can virtual organizations better adhere to federal guidelines?

Klayman, Kahan and Silva: Consult with competent attorneys who are admitted in the jurisdictions relevant to the token sale and are knowledgeable in securities laws, tax laws, financial services laws and other U.S. federal and state regulatory frameworks that may apply to your token.  

Virtual organizations need to understand that many SEC regulations apply to them just as if they were incorporated entities. Keep in mind that corporations are not physical entities, either, but are simply a convenient legal fiction. Yet no one thinks that a corporation should not or cannot be regulated.

A virtual organization is not much different from a corporation in this regard — the latter just happens to be more formally recognized under the organizational laws of most jurisdictions. 

Remember also that U.S. federal laws are not the only laws; for example, individual states have their own "blue sky" laws that aim to regulate securities transactions. Similarly, securities laws are not the only laws; virtual organizations need to be aware of many other legal regimes, including contract law, tax law, financial services regulation and others.

In the token offering context, the question of whether a given token is a security is just the beginning of the analysis. For example, in the case of The DAO, the SEC concluded not only that The DAO token was a security, but also that the platform trading that security was an exchange. This is why having good legal counsel is critically important.

Next week on Blockchain Tech News: A discussion about blockchain regulation.

Topics: Blockchain, Exchanges, Regulation

Bradley Cooper

Bradley Cooper is a Technology Editor for His background is in information technology, advertising, and writing.

wwwView Bradley Cooper's profile on LinkedIn

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