SEC v. DAO

The beginning of the New Era

July 25th of 2017, the ICO Market is booming; the media is pouring oil into the fire of Crypto-hype; Bitcoin price is at the $2,600 mark; SEC issues a report on DAO. The air is electrified with tension at this point as this document is entering the history marking the beginning of the new era for the ICOs: the sale of a distributed ledger token constitutes an illegal sale of unregistered securities. This is when the evolution starts to take place.

Already today in the beginning of 2018, ICOs are starting to become more and more compliant as they try to follow the ever-emerging body of regulations across the globe. Christopher Pallotta and Vincent Molinari in their article for Coindesk are expressing the very same feelings and predictions we have in the Crypto Lawyers Corporation: the ICOs as we know them will no longer exist in the nearby future. Instead, we will have Tokenized assets trading across the globe in a very complex, secure, regulated and democratic manner.

In this article, we would like to step back, recap, and evaluate the key takeaways from the report almost half a year later.

What is DAO?

The acronym DAO stands for Decentralized Autonomous Organization: a virtual organization embodied in computer code and executed on a distributed ledger or blockchain. As declared by the DAO founders, a German for-profit entity Slock.it, the purpose of DAO is in solving organizational governance and decision-making issues through the use of smart contracts and distributed ledger technology. The investors participating in the DAO by using the DAO tokens, which could be purchased with Ether. The tokens grant certain limited voting and ownership rights to the holder.

Widely distributed promotional materials of Stock.it were claiming profits to the investors through the return on investments made by the DAO system from its decentralized funding of the profitable projects. Yet, the decentralization of DAO is a suspicious subject as the Stock.it are introducing the “curators” in their White Paper: people who would be in charge of filtering the torrent of applications submitted to the DAO.

DAO Tokens don’t have any limited supply, are bought by investors using pseudonyms or “pseudonymity”, as referred in the White Paper, with no specific requirements as to the level of sophistication or wealth (from the buyers), typically required for private offerings of securities in the United States.

At the time of closing of the offering, the DAO has raised approximately an equivalent of US$150 million in Ether, making it one of the first Unicorns of the crypto-world.

The DAO’s code exhibited vulnerabilities in June 2016 when an unknown individual or group (the “Attacker”) diverted approximately one-third of the total Ether raised by The DAO to an Etherium Blockchain address controlled by the Attacker. To fix the problem, Slock.it’s founders endorsed a “hard fork” to the Etherium protocol, in effect reversing the Attacker’s transfer. Such a “hard fork” is controversial in the cryptocurrency community because a critical characteristic of a distributed ledger is its immutability.

The origins of the conflict

Following the infamous Parity hack (where 1/3 of the collected Ether gets stolen by a group of hackers) a lot of investors are losing significant capital, which leads to a massive outrage and the public attention subsequently. Ethereum Network is going through a contradictive hard fork and the Ethereum Classic is born as a result. Remember, The DAO is one of the biggest projects in the space at that time making it is the loudest scandal. SEC that was at that time already closely monitoring the market, researching the matter, and making public announcements to warn the investors, decides to enter the game and protect the consumers.

Feel free to read our post on the SEC and its importance in defending the interests of the investors.

As a result of the tedious investigation, the Commission is publishing a report that many in the crypto-community see as the warning to all of the ICO founders and especially the bad actors conducting illegal securities crowd sales under the mask of the distributed ledger tokens.

Guilty with no enforcement

Curiously enough, the SEC decided to decline to bring an enforcement action and ended up just publishing the investigative report: The DAO may have engaged in an unregistered offering of securities and violated the Section 5 of the Securities Act. Among other analytical methods, the SEC is using the Howey Test in making its conclusions. Following the report, the test becomes the main tool for all of the ICO founders in determining whether they are offering securities or not.

the SEC stated that it:

“welcome[s] and encourage[s] the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities.”

SEC Chairman Jay Clayton noted that:

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

Conclusions

  1. The Howey test proves its accuracy and relevancy even 60 years away from its creation. It is currently the most popular reference tool available to the founders, determining whether any token will be considered the security or not if sold to the US investors.
  2. SEC is building a portfolio of cases, reports, and precedents regulating the ICO market step by step. Slowly but surely the Commission will eliminate all of the unregistered sellers of the securities, forcing the evolution of the technology.
  3. All of the businesses conducting the ICOs have now a reference point to compare their token architectures with and determine whether they share similarities with the DAO project or not.
  4. Additionally, businesses that are operating with the tokens on a day-to-day basis such as private crypto exchanges for instance, now have to re-evaluate some of their tokens and make sure they are not dealing with any securities in order to comply with all of the global and local regulations.
  5. The market is strengthening and becoming more appealing to the bigger players (not just startups). Companies like Overstock and Kodak are investing into the development of their own blockchain-based projects.
  6. Cybersecurity continues to be one of the major concerns for the Internet-based businesses. As more and more assets being digitalized on a daily basis we foresee some major regulations being imposed on the internet businesses dealing with the crypto-currencies as they have to provide an adequate level of security to their clients.

Starting your ICO? Consult first!

We live in the world of changes where the advanced security protocols are aiming to change the very structure of the Internet we’ve come to know up until today. The innovations in the blockchain and the services and infrastructures that are being built on top of it are changing the landscape of the Web.

If you’re looking to launch your ICO consulting with the legal professional is a must! At Crypto Lawyers Corporation we provide a free consultation for the founders. Feel free to reach out now with questions or concerns. Additionally, if you’re seeking for the pre-sale investors one of the core features of the Crypto Lawyers Corporation is our extensive IR network, modern and trustworthy legal and escrow services. Learn more about why every ICO needs an escrow here.

Learn more: How to choose the right country for your ICO?

 

About Crypto Lawyers Corporation

This blog was created in order to educate the Crypto Lawyers Corporation clients and partners about the developing world of ICO campaigns, be an introduction to the world of Blockchain, the latest industry updates and share our professional experience. However, none of the materials in this blog should be regarded as legal or investment advice.