The SEC’s Big Digital Coin Ruling: What It Means

Jul 26, 2017

The Securities and Exchange Commission shook up the red-hot market for so-called Initial Coin Offerings (ICOs) on Tuesday by ruling that some of the "coins" for sale are actually securities—and are subject to the agency's regulation.

This is a big deal in light of a recent ICO-mania in which dozens of small companies have raised millions, or even hundreds of millions, of dollars through them, in many cases, from ordinary investors.

To get a sense of what the decision means, and the reaction so far, here's a plain English explainer of the news.

Just what the heck is an ICO?

An ICO works the same way as an initial public offering in that it's a way for a company to raise money from the public. In a typical ICO, which can last anywhere from a few hours to a few weeks, the company invites people to buy tokens (aka digital coins) to fund a project.

These projects involve blockchain software such as Ethereum, which runs across multiple computers in order to create a tamper-proof digital ledger. The software can also be programmed to do things like create so-called smart contracts or make investments.

To take part in the ICO, supporters of the project send digital money like bitcoin (or in some cases use credit cards) to a website run by the company and then receive digital tokens in return.

What exactly are these "coins" or tokens?

The tokens give the holder a right to participate in a given blockchain activity. For instance, a company might require people to have tokens to join an automated investment project or to get access to cloud computing services.

But the tokens can also be bought and sold on secondary markets. Just as college students may sell each other tokens to ride the subway, the owners of digital tokens can exchange them for cash or bitcoin on special websites.

So why did the SEC get involved?

ICO skeptics have long warned that, in many cases, the tokens for sale are simply a new form of shares—and that selling them without a license violates federal securities laws. In its ruling this week, the SEC confirmed just that: The agency said that, in the case of one recent ICO, the tokens in question are indeed securities.

What exactly did the ruling say?

The ruling followed an SEC investigation into a German corporation behind a group called "The DAO" (for "Decentralized Autonomous Organization") that raised $150 million in ICO last year.

The DAO invited people to buy tokens that would be used to pursue an automated investment strategy and entitle the token owners to receive "rewards." One individual leading the ICO, Christopher Jentzsch, even likened the process to receiving dividends. It's no surprise then the SEC concluded, in the case of The DAO, the tokens were securities.

The agency's conclusion applied only to The DAO but the ruling did provide some additional guidance about ICOs, noting the question of whether tokens are securities will depend on the particular "facts and circumstances" of each case. The SEC also appeared to acknowledge ICO-style offerings are here to stay:

This Report reiterates these fundamental principles of the U.S. federal securities laws and describes their applicability to a new paradigm—virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities. The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. [my emphasis]

Finally, the agency also said it would not take any enforcement action against Jentzsch or other organizers of The DAO ICO. It did not say why, but the reason is likely because the ICO issue is so novel and the SEC did not want to appear too heavy handed.

How did the market react?

The price of Ethereum, whose tokens (known as ethers) are used to conduct many ICOs, fell about 10% yesterday. But it's unclear how much of this is related to the SEC ruling or if it just reflects the currency's intrinsic volatility. It's also unclear if the ruling will chill the overall ICO market or simply cause companies to limit their token sales outside of the U.S.

What are the experts saying?

The reaction has been mixed with some suggesting the SEC ruling is very specific to The DAO, while others warn this is just the beginning of a bigger crackdown on ICOs. Here are some comments and tweets:

Barry Silbert, who holds a big position in bitcoin, suggested the ruling would at least lead to a slowdown:

Others said, in effect, "no duh!" and warned the SEC's ruling could be just the beginning:

“The writing is on the wall for many recent I.C.O.s: The S.E.C. is coming,” — attorney Brian Klein to the New York Times.

"Anyone who is surprised by this SEC investigation into ICOs either hasn’t been paying attention or has been entranced by greed which has made them oblivious to how the financial industry works. The name alone sounds like IPO – if it walks like a duck and sounds like a duck, it’s a duck." — Brad Garlinghouse, CEO of digital currency company Ripple.

Coin Center, an advocacy group for crypto-currency stressed that the SEC decision was specific to The DAO, and that other tokens would not be affected:

"We believe that applying the same facts and circumstances test to other tokens will mean that some do not fit into the definition of securities, particularly tokens with an underlying utility rather than a mere speculative investment value."

Alfredo Silva, a securities lawyer with the firm Morrison & Foerster, said the SEC's decision on The DAO came as no surprise, but he added that the agency must provide more clarity about how its findings will apply to other types of ICO tokens:

What hasn’t been clarified is whether so-called “app tokens,” or any other kinds of tokens, will not be considered securities. Ideally, the SEC will follow up this important initial announcement with a no action letter or other guidance to help practitioners and the larger blockchain community understand where it sees the distinction.”

Finally, FT's Alphaville blog wrote a mock letter to the Commissioner of the SEC, whining that their fictitious "Alphachain" tokens should be exempt from the agency's authority."

We’re certain we can demonstrate that we should not be regulated, because paperwork is hard, and we don’t want to do it. We also don’t want to tell anyone what we’re going to do with their money. [...]

Further, we state clearly in the introduction to our offering we want to promote our “vision of a future where Alphaville journalists retire young(ish) and live out their days sipping Mojitos on a tax-efficient beach.”

What happens now?

As some of the experts suggest, The Dao ruling is likely only the first shoe to drop. In the coming weeks or months, the SEC will likely announce more detailed guidelines as well as enforcement proceedings against some of the most fly-by-night ICOs. The agency has also posted a bulletin warning investors to be careful in deciding whether to invest in these things.

In the bigger picture, though, the SEC ruling is unlikely to affect the larger development of blockchain technology, which many people expect to become one of the most disruptive software innovations in decades. To see why, check out "7 Cryptocurrency Predictions Based on the Experts" — a summary of Fortune's roundtable on crypto issues at Aspen, Colo. this month.

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