In a report likely to jolt the red-hot market for so-called "Initial Coin Offerings" (ICOs), the Securities and Exchange Commission on Tuesday found that the "coins" in one prominent ICO were in fact securities—meaning the transactions fell afoul of federal investment laws.
The report comes at a time when dozens of companies have completed, or are in the midst of, raising hundreds of millions through the ICO process—offerings that are now likely to come under renewed scrutiny.
"As discussed in the Report, virtual coins or tokens may be securities and subject to the federal securities laws. The federal securities laws provide disclosure requirements and other important protections of which investors should be aware. In addition, the bulletin reminds investors of red flags of investment fraud, and that new technologies may be used to perpetrate investment schemes that may not comply with the federal securities laws," said the SEC in a press release accompanying the report.
In the release, the SEC explained that its inquiry focused on a 2016 offering known as "The DAO," which was built atop the Ethereum blockchain—a popular form of distributed ledger software. The DAO experiment quickly became a debacle after hackers stole the tokens in question (most of them were recovered) and the legal fallout triggered out the SEC investigation.
In its release on Tuesday, the SEC added that it would not bring charges against those involved "given the facts and circumstances."
The announcement, however, appears to be a clear shot across the bow for the numerous other entities that are raising money through ICOs.
The proponents of the ICOs typically argue that the tokens they issue are not securities, but are instead a form of credit akin to subway tokens that give owners access to the network.
At the same time, however, many such tokens are traded on secondary markets and are the source of intense speculative interest, which casts in doubt claims they are not securities.
In a phone call with Fortune, a spokesman for the SEC declined to comment as to whether other ICO investigations are underway.
In Tuesday's announcement, the SEC also pointedly stated that token sales conducted via ICOs do not qualify as crowd-funding. While recent changes to securities law permit companies to raise money from small investors through Kickstarter-style projects, the SEC noted the "DAO" project did not comply with formalities for doing so, such as registering as a broker-dealer or registering the website with regulators.
ICOs: A Quick Way to Raise $200M
The popularity of ICOs is apparent from listing descriptions on Smith + Crown, a website that lists recent offerings, including one from a company called EOS that is valued at $232.6 million, and another worth $153 million conducted by a company called Bancor.
The success of these all-but-unknown companies in raising millions—or hundreds of millions— of dollars is all the more striking given that many of these firms did not exist a year ago, while others do not even have a functioning prototype.
Their ability to raise these amounts is due in part to investors' desire to invest in blockchain technology, but it is also driven by the ease by which anyone can launch or take part in an ICO.
Unlike a conventional IPO, where a company sells equity to investors in the form of shares, the recent spate of ICOs have not heeded SEC requirements for selling investments to the public. The ICO companies, for instance, provide little guidance about their finances or their future business plans.
The ICO route is also lightning quick compared to an IPO. There is little paperwork and the ICO companies typically do not work with lawyers, underwriters or stock exchanges. Instead, the sale is conducted over a website where the company accepts digital currency such as bitcoins or ether (or credit cards in the case of some overseas transactions) and the investors receive digital tokens.
ICOs can, though, provide token purchasers with a modicum of reassurance in the form of the software code that creates and runs the tokens. A company can, for instance, impose conditions from disposing of tokens within a given period of time.
Tuesday's SEC ruling may dampen enthusiasm for ICOs in the United States, though it will not limit companies from pursuing them overseas.
In its ruling, the agency also suggested it's looking for a way to encourage the promise of blockchain-based financial innovation—described in papers like this highly-cited one by venture capitalist Balaji Srinivasan—while also protecting investors from scammers.
"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.
This story was updated several times to provide additional details.