On July 25, 2017, the SEC issued a report on the sales of digital assets through initial coin offerings (ICOs) and token sales, specifically addressing whether DAO tokens qualify as securities. The SEC concluded that DAO tokens act as securities, requiring registration as an exchange due to their structure resembling investment contracts under the Howey test. Companies engaging in similar transactions should consult legal counsel to navigate potential regulatory compliance regarding securities law.

1. SEC Update: Virtual Organizations and the SEC
July 2017
On July 25, 2017, the United States Securities and
Exchange Commission (SEC) issued an investigative
report regarding the sales of digital assets by virtual
organizations through offers and sales that have
come to be known as “Initial Coin Offerings” and
“Token Sales.”
In Release No. 81207, “Report of Investigation
Pursuant to Section 21(a) of the Securities and
Exchange Commission Act of 1934: The DAO,” the
SEC gives its first guidance as to whether or not it
may view initial coin offerings and token sales as a
security offering. The following provides a brief
overview of the SEC’s report.
Issue
Are The DAO tokens securities? Did The DAO
qualify as an issuer of securities?
Conclusion
Yes, because they involve investment contracts, The
DAO acted as an issuer, and The DAO meets the
Exchange Act's definition of "exchange."
Background
The DAO was created by Slock-It as a virtual
organization in a computer's code on a type of
distributed ledger called a blockchain. It was designed
to create and hold assets. Slock-It distributed
promotional materials to potential shareholders that
if they were to invest in DAO tokens using ETH
(Ethereum virtual currency), they would receive
(financial) rewards from the projects they were
funding.
In May 2016, Slock-It submitted a security proposal
claiming that their computer code was weak. Shortly
after, a hacker stole the code and about 1/3 of the
invested assets, however the code prevented the
attacker from receiving the funds for 27 days after
the initial hack. Slock-It endorsed a protocol to
restore the investments to shareholders as if the
attack had not occurred. The investment holders
could opt-in to have their investments returned to
them. Slock-It transferred funds, including those held
by the attacker, to a recovery address where the
holders could exchange their DAO tokens for ETH
to avoid loss.
Application of Securities Law
Under Section 2(a)(1) of the Securities Act and
Section 3(a)(10) of the Exchange Act, a security
includes “an investment contract.” See 15 U.S.C. §§
77b-77c. An investment contract is an investment of
money in a common enterprise with a reasonable
expectation of profits to be derived from the
entrepreneurial or managerial efforts of others. See
SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J.
Howey Co., 328 U.S. 293, 301 (1946). In analyzing
whether something is a security, “form should be
disregarded for substance,” Tcherepnin v. Knight, 389
U.S. 332, 336 (1967), “and the emphasis should be
on economic realities underlying a transaction, and
not on the name appended thereto.” United Housing
Found., Inc. v. Forman, 421 U.S. 837, 849 (1975).
Finding #1: Analysis under the Howey Test
The Howey test is a long-standing test that can help
to determine whether a transaction is an investment
contract that would be subject to the Securities Act.
Under the Howey test, a transaction is an investment
contract if:
1) It is an investment of money;
2) There is an expectation of profits from the
investment;
3) The investment of money is in a common
enterprise; and
4) Any profit comes from the efforts of a
promoter or third party.
These factors are weighed and applied on a case-by-
case basis turning on the facts.
Factor 1: An Investment of Money
Money does not have to be cash. Investors used
ETH in exchange for DAO tokens. Under SEC v.
Shavers, No. 4:13-CV-416, 2014 WL 4652121, at *1
(E.D. Tex. Sept. 18, 2014), the court held that an
investment of Bitcoin, a virtual currency, meets the

2. SEC Update: Virtual Organizations and the SEC
July 2017
first prong of Howey. Under this precedent, The
DAO could also meet the first prong of Howey.
Factor 2: An Expectation of Profit
Investors in The DAO invested in money. Investors
were motivated by promotional materials to fund
projects in order to receive a share of profits as a
return on that investment.
Factors 3 and 4: A Common Enterprise & Profits
Coming From the Efforts of a Promoter or Third
Party
Slock-It made efforts essential to The DAO
enterprise. Almost no work was done by The DAO
token holders, only by Slock-It and its curators
(which is like a Board of Trustees).
Finding #2: DAO as an Issuer
If DAO tokens are securities, DAO was required to
register as an exchange. 15 U.S.C. 78c(a)(1).
Exchange Act defines an “exchange” as “any
organization, association, or group of persons,
whether incorporated or unincorporated, which
constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers
of securities, or for otherwise performing with
respect to securities the functions commonly
performed by a stock exchange as that term is
generally understood.…”
Exchange Act Rule 3b-16(a) provides a test to assess
whether a trading system meets the definition of
exchange under the Exchange Act. Under Exchange
Act Rule 3b-16(a), an organization, association, or
group of persons shall be considered to constitute,
maintain, or provide “a marketplace or facilities for
bringing together purchasers and sellers of securities
or for otherwise performing with respect to
securities the functions commonly performed by a
stock exchange,” if such organization, association, or
group of persons: (1) brings together the orders for
securities of multiple buyers and sellers; and (2) uses
established, non-discretionary methods (whether by
providing a trading facility or by setting rules) under
which such orders interact with each other, and the
buyers and sellers entering such orders agree to the
terms of the trade. A system that meets the criteria
of Rule 3b-16(a), and is not excluded under Rule 3b-
16(b), must register as a national securities exchange
pursuant to Sections 5 and 6 of the Exchange Act 41
or operate pursuant to an appropriate exemption.
According to the SEC's notice, the Platforms that
traded DAO Tokens appear to have satisfied the
criteria of Rule 3b- 16(a) and do not appear to have
been excluded from Rule 3b-16(b).
Conclusion
DAO tokens meet the criteria for being securities
because Slock-It and its curators used investment
contracts under the Howey test. The DAO was an
issuer of these tokens, and it worked as a trading
system, so it should have been registered as an
exchange.
Takeaway
In light of the SEC’s guidance, companies should be
aware that whether or not a transaction constitutes a
security depends on a case-by-case basis. Given that
the SEC has come out of the gate providing guidance
to companies who may be trying to ignore U.S.
securities regulation, or have been avoiding taking a
measured legal approach to Initial Coin Offerings and
Token Sales, companies should seek counsel to
assess their risk.
Gagnier Margossian LLP advises its clients on
navigating the registration requirements under the
Securities Act or applicable exemptions.
Learn more about our ICO Advisory Services.
Questions? Contact GAMALLP
Christina M. Gagnier
gagnier@gamallp.com