SEC Determines Interests in Virtual Organizations Are Subject to U.S. Securities Laws

The SEC determined that tokens sold to investors by a “virtual” organization may be considered securities and, thus, are subject to applicable federal securities laws.

In an Investigative Report, the SEC explained that organizations using blockchain or other distributed ledger technology in capital-raising activities must ensure compliance with securities laws. In the report, the SEC scrutinized an incident involving a “Decentralized Autonomous Organization” (“DAO”). A DAO is described as “a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” In this matter, the DAO offered tokens in exchange for initial cryptocurrency investments and eventually was victimized by a hacker who diverted significant cryptocurrency assets raised by the DAO. The SEC investigated whether the DAO had violated securities law by offering and selling unregistered securities.

The SEC decided not to pursue charges but sounded a warning to issuers:

“[Registration] requirements 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.”

In an Investor Bulletin, the SEC cautioned investors about potential risks associated with initial coin offerings. The SEC explained the function of distributed ledger technologies, such as blockchain, as well as virtual currency and how it is traded via the exchanges. The SEC warned investors that virtual currency offerings may be particularly susceptible to fraud and theft, and that tracing these currencies is difficult. The SEC noted that virtual currency offerings are often unregistered and operate unlawfully or overseas. As a result, recovering stolen virtual currency can be particularly difficult. The SEC warned investors to be wary of several signs that may indicate investment fraud, including “guaranteed” high rates of return, unsolicited offers and unlicensed issuers.

Lofchie Comment: Notwithstanding the somewhat exotic nature of the relevant asset (i.e., the virtual currency), the SEC’s finding that an asset that represents an ownership interest in a profit-making venture (or that depends on the management expertise of others) is a completely unsurprising result and well within the bounds of existing law.