On July 25, 2017, the U.S. Securities and Exchange Commission (“SEC”) released a Report of Investigation (“Report”) warning market participants that offers and sales of digital assets (“Tokens”) by “virtual” organizations are subject to federal securities laws. Commonly referred to as “Initial Coin Offerings” (“ICOs”) or “Token Sales,” these offers and sales of Tokens are conducted by organizations – known as “decentralized autonomous organizations” or “DAOs” – using distributed ledger or blockchain technology platforms in order to raise capital and were previously not covered by SEC regulations. The Report was issued pursuant to the SEC’s investigation into a hack of one of these organizations, referred to by the SEC as “The DAO.” In that hack, an attacker used a flaw in The DAO’s code to steal approximately one-third of The DAO’s Token assets—totaling more than $50 million.
When an investor seeks to participate in an ICO, he or she may use fiat currency (e.g., U.S. dollars) or other virtual currencies (e.g., BitCoin) to buy these Tokens. As a result, offerors like The DAO log and store the keys to each investor’s virtual “wallet,” similar to a bank account for Tokens and other virtual currencies, effectively creating a repository of highly sensitive personally identifiable information. Until the SEC’s release of the Report, ICOs and other virtual currency exchange platforms were largely unregulated, save for regulations imposed by the Financial Crimes Enforcement Network regarding anti-money laundering and “know your customer” policies. This made investing in any ICO a risky proposition due to the lack of oversight or remedies available in the event of a security breach not unlike the one suffered by The DAO.
By expanding securities laws to potentially cover ICOs, the SEC hopes to protect ICO investors and provide some risk mitigation to the prospect of investing in Tokens. SEC Chairman Jay Clayton stated: “The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring—first and foremost—that investors and our markets are protected.”
The registration and disclosure requirements imposed by SEC regulations are designed to provide investors with material information necessary to make informed investment decisions, as well as provide procedural protections to give ICO investors greater control over virtual organizations offering Tokens as a means of mitigating the damage than can be done by an attacker targeting the funds or personally identifiable information of an ICO or other virtual currency exchange.
More information on ICOs and virtual currency exchanges can be found in the Investor Bulletin published by the SEC on July 25, 2017.
