By Jim Falvey
Technology usually outpaces the law. It can take months, if not years, for legislators, regulators and courts to gain an understanding of technology and then to apply existing law to the new technology and/or create new laws for the technological developments. In the remarkable world of cryptocurrencies and distributed ledger technology (often referred to as “Blockchain”), we are seeing both occur.
In May 2016, a virtual organization called The DAO, which stands for Decentralized Autonomous Organization, came onto the scene in the Ethereum world. For the uninitiated, the Ethereum Blockchain sponsors the second most significant virtual currency in the world behind Bitcoin, known as Ether (“ETH”). The total market capitalization of the Ether is about $27 billion.
The DAO, which took its name from the description of itself (its approach to naming itself is not unlike a well-known rock group in the 60s calling itself, “The Band” – elegant in its simplicity), sought to raise ETH to fund projects to generate profit. That sounds awfully similar to private equity and/or venture capital raising dollars to fund projects to make money. However, there are a few wrinkles between the two models. For example, to raise capital/ETH in order to fund projects, The DAO itself issued what it called “DAO Tokens” in exchange for ETH. So, instead of creating a VC firm and raising US dollars to fund projects and providing shares and/or ownership interest in the VC to those who provided funds, The DAO raised Ether in exchange for DAO Tokens.
DAO Tokens resemble shares of stock, but are not exactly on par with traditional equity. The owners of DAO Tokens can vote on various projects that The DAO funds. Any earnings from these projects are distributed among those individuals or entities that hold DAO Tokens. Additionally, DAO Token holders can monetize their investments in DAO Tokens by re-selling DAO Tokens on a number of web-based platforms that support secondary trading in DAO Tokens.
In shorthand, the process described above has been referred to as an “initial coin offering” or an “ICO.” A virtual company issues a new cryptocurrency or tokens in itself in exchange for an existing established cryptocurrency, such as Bitcoin or Ether, or it could even seek to raise a fiat currency, like the U.S. Dollar, Japanese Yen or British Pound. The process is actually quite simple when you take away the terminology and focus on what is happening – money is raised in exchange for something that may have value in the future (say, a token) depending on what is created with the money that is raised (and whether a profit is forthcoming).
The DAO has said that it will not have a management team per se and will be governed by the terms of a White Paper. The White Paper purports to describe “the first implementation of a [DAO Entity] code to automate organizational governance and decision making.” The White Paper goes on to say that the DAO Entity will use smart contracts to attempt to solve governance issues it described as inherent in traditional corporations. “Smart Contracts” are code-based documents which contain instructions that formalize, automate and enforce terms of a contract using software.
Although The DAO experienced a cyber-attack, which is not the focus of this document, the overall experience associated with The DAO’s ICO was largely successful. The DAO raised over $50 million of ETH. Additionally, secondary trading of The DAO’s Tokens was robust. As described by the U.S. Securities & Exchange Commission (“SEC”):
During the period from May 28, 2016 through September 6, 2016, one such Platform executed more than 557,378 buy and sell transactions in DAO Tokens by more than 15,000 of its U.S. and foreign customers. During the period from May 28, 2016 through August 1, 2016, another such Platform executed more than 22,207 buy and sell transactions in DAO Tokens by more than 700 of its U.S. customers.
Having worked in the exchange world, my experience is that new contracts takes months, if not years to reach the level of trading that the DAO Tokens saw in the first few months of their existence. Recognizing that the SEC cited these numbers for different purposes, the significant volume over a short period of time by a large group of traders reflected by the transactions will certainly capture the interest of the traditional exchange community (such as the Chicago Mercantile Exchange, the IntercontinentalExchange, the New York Stock Exchange, the London Stock Exchange, etc.).
Given the success and publicity of The DAO, the SEC decided to examine the mechanics of the ICO to determine if U.S. law was in anyway implicated. In a Release dated July 25, 2017, the SEC said a few things that are important to consider going forward:
- The SEC rules apply to “old and traditional” transactions, as well as new things that come along the road of software development – including inventions not yet developed. Anyone undertaking an ICO and trading Tokens on an exchange-like facility or doing anything in the fundraising world ignores the SEC rules at their peril.
- The DAO Tokens were “securities” under the ’33 Securities Act and the ’34 Exchange Act (absent an exemption, which the Commission did not explore).
- The platforms on which the secondary trading of the Tokens occurred likely should have registered as a National Securities Exchange and/or find an exemption, such as becoming an alternative trading system (“ATS”).
- Decentralized Autonomous Organizations may be investment companies subject to registration under the Investment Company Act of 1940.
- But, despite the purported violations identified in this matter, the SEC did not take action here and left the reasoning behind that decision confidential.
ICOs, the creation of new virtual currency and tokens, as well as secondary trading of these items are all exciting and innovative inventions. It is likely that additional items will be created by brilliant minds over the next several months and years making our world operate more efficiently and effectively. But the creators of these inventions and projects must still operate within the law – not only in the U.S., but throughout the world. I believe that most regulators seek innovations within the industries that they oversee. So, following the law need not be a painful process. Indeed, in many cases, attorneys and consultants can assist in helping step through the tapestry of regulations throughout the world to ensure compliance.