Virtual assets may be regulated under securities laws

Digital assets may be regulated under federal securities laws, the SEC said in a July 25, 2017, statement.

The conclusion was based on an investigation of unregistered digital tokens sold by a virtual organization known as The DAO, created by Slock.it UG in Germany. The SEC determined that the tokens were securities and subject to its registration rules. The SEC decided not to bring charges against the DAO but rather to caution the industry and investors. Slock.it did not respond to a request for comment as this story was being written.

“The federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology,” the SEC said.

The market regulator is studying the emerging virtual market, and it said that not every digital asset will be classified as a security. The classification will depend on the particular asset and the economics of the transaction.

“The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us,” SEC Chairman Jay Clayton said. “We seek to foster innovative and beneficial ways to raise capital, while ensuring—first and foremost—that investors and our markets are protected.”

The SEC said issuers of distributed ledger or blockchain technology-based securities must register their offerings unless a valid exemption applies. The agency also wants securities exchanges that allow trading in the currencies to register unless they have an exemption.

“Those participating in unregistered offerings also may be liable for violations of the securities laws,” the statement said. “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.”

Blockchain is a database that maintains a growing list of ordered records to record transactions. The best-known example of blockchain is the Bitcoin virtual currency.

The DAO is an example of a Decentralized Autonomous Organization—a term used to describe a virtual organization embodied in computer code and executed on a blockchain.

According to the Report of Investigation, the SEC said the DAO’s virtual tokens are securities because Slock.it created the DAO to make a profit by creating and holding assets through the sale of tokens to investors. In the spring of 2016, the DAO sold about 1.15 billion tokens in exchange for 12 million Ether virtual currency used on the Ethereum Blockchain. The total amount raised was valued at $150 million. Investors were told they would get a portion of the anticipated earnings from certain projects as a return on their investment in DAO tokens. In addition, investors could monetize their investments in the tokens by reselling them on a number of web-based platforms that supported secondary trading in the DAO tokens.

To support its determination that DAO tokens are securities, the SEC highlighted Section 2 of the Securities Act of 1933 and Section 3 of the Securities Exchange Act of 1934, which says that a security includes an investment contract.

“An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others,” the SEC said, adding that “money” need not take the form of cash.

While the DAO has been described as a “crowdfunding contract,” the SEC said it would not have met the requirements of the Regulation Crowdfunding exemption because it was not a broker-dealer or a funding portal.

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