On July 25 2018 the U.S. SEC issued a so-called Section 21(a) report of its investigation into an offering of cryptographic blockchain tokens by “The DAO,” the acronym of “Distributed Autonomous Organization. Even though the SEC did not take any enforcement action against The DAO people, the agency warned others engaged in similar activities that an unregistered public placement of security tokens may be an illegal public offering of securities. Consequently, many of the thousands Tokens Sales carried out after the issuance of this DAO report must be regarded as such illegal securities transactions.
The DAO Standard for Security Tokens
For the SEC, the findings of the DAO report provided a guideline for its investigations and enforcement actions against token issuers (ICO issuers), broker-dealers and exchanges. Since then, the SEC has referred to the DAO Report in almost all charges and settlements, e.g. in the TokenLot case:
This is the SEC’s first case charging unregistered broker-dealers for selling digital tokens after the SEC issued The DAO Report in 2017 cautioning that those who offer and sell digital securities must comply with the federal securities laws […] TokenLot operated from July 2017 through late February, with most of its business occurring after The DAO Report on the applicability of securities laws to digital assets.
The SEC demonstrated that it will take action against all responsible parties involved in ICOs and public Token Sales. The pattern is easy to see. Essentially, the SEC takes action against unregulated security tokens as well as against securities fraud through false statements and misleading information provided by issuers and their advisors. Read our report on security fraud and misleading information here.
Definition of Security Token
Currently, no generally accepted and applicable legal definition of security token across the different jurisdictions is available. In this regard, the different legal situations in the individual jurisdictional regimes must also be pointed out. Particularly between continental Europe and North America, there are different approaches to the assessment of financial instruments. What is certain, however, is that every offering of tokens to US citizens automatically entails a responsibility on the part of the US authorities. In addition, the SEC, as the leading international regulator, has a high level of authority, especially in connection with financial innovations. So what does the SEC’s Security Token Definition look like?
The DAO report states that where an ICO or other distribution of tokens is presented to investors as an investment opportunity—implicitly or explicitly on the basis of profits that investors (token holders) might derive from the future success of a business, or from selling the tokens into a rising market—the SEC will conclude that the tokens are securities. If this broad definition of a security token were applied, more than 90% of all ICOs would presumably qualify as securities transactions.
A worthwhile reading on the DAO Report and its consequences can be found on the Harvard Law School Forum.
Consequences of Unregistered Public Security Token Offerings
Before security token can be offered for sale to the public, they first must be registered with the Securities and Exchange Commission (SEC) in the US. Any security token that does not have an effective registration statement on file with the SEC is considered “unregistered.” Most other regulatory regimes do have a similar approach. There are, of course, exemptions such as raising capital by soliciting investments from “qualified investors.”
For the issuer, not only the public offering of unregistered securities to the public constitutes a violation of securities laws, but also the involvement of an unregistered broker-dealer in the sale and distribution process. In the definition of securities laws in most countries – first and foremost the U.S. with the Securities and Exchange Commission (SEC) – securities may only be sold to potential investors by licensed (registered) broker-dealers. So even if the issuer had registered the security token as a security with the supervisory authority, the involvement of an unregistered broker-dealer would be illegal. As a matter of fact during the past 18 months most of the ICOs and Token Sales advisors/promoters/affiliates acted as broker-dealers under securities laws. Furthermore, exchanges trading security tokens will need to register and receive a respective license.
That said, the legal problems in issuing, distributing and selling security tokens will arise on three levels:
- Issuer sells and distributes unregistered securities (most often with the support of unregistered broker-dealers);
- Advisors, Promotors, and Affiliate sell and distribute unregistered securities as unregistered dealer-brokers;
- Exchange provide trading facilities for unregistered securities without a license;
It doesn’t need a rocket scientist to assume that the SEC and other financial regulators will go for those illicit ICOs and their actors. Finally, many investors and their lawyers will take this situation to rescind the subscription contracts and ask for payback of their funds – if the tokens will not result in the huge profits as promised and as expected.
An additional problem of the ICOs are the many false and misleading statements in whitepapers, social media, and press releases. It will probably take years before the market has digested the many criminal complaints, regulatory enforcement actions, and penalties. Disappointed investors are usually well advised to use any means to get their money back and lawyers are happy about every new lawsuit. That is their business. Also, the regulators have built up personal resources worldwide to prosecute crypto-related misdemeanors. These new resources must be fed with new cases.