Jason Somensatto is counsel at Morvillo LLP where he focuses his practice on internal investigations, government enforcement actions and white-collar criminal matters.
In this opinion piece, Somensatto discusses the impact of a new SEC ruling on the use of blockchain-based tokens for fundraising, arguing that entrepreneurs should not ignore their legal risks.
Almost three years ago, I wrote an article about the potential legal implications of crowdfunding a cryptocurrency project through a token sale.
At the time, the article was intended as a cautionary note to the nascent initial coin offering (ICO) industry from my vantage point as a lawyer who spends much of his time opposite the SEC, arguing what constitutes a violation of U.S. securities laws.
Since then, the market for ICOs has ballooned, and ICOs have become a common and seemingly lucrative way to fund new decentralized applications like Tezos and Bancor. With the expansion of the ICO market, there has also been a steady increase in the discussion about their legal implications.
The primary issue that has been debated is whether tokens are or should be considered regulated securities under U.S. law. The answer to that question is important because the U.S. imposes strict regulations on the sales of regulated securities such as requiring filing of a detailed registration statement or limiting the offering to so-called accredited investors.
That issue came to a head this week when the SEC released a report in which it asserted for the first time that the sale of a distributed ledger token constituted an illegal sale of unregistered securities. This article is not intended to analyze the SEC’s report as it is self-explanatory and surely many will analyze its wording carefully.
This article is instead intended to explain the risks of potential SEC enforcement actions now facing developers who conduct an ICO without accounting for the U.S. securities laws.
Up to this point, virtually every ICO has taken the position that its tokens are not securities. For developers who continue to hold that position, it is important to understand the risks being undertaken, and how the issue of whether a token is a security will actually be decided in any particular case.
Although the report noted that the question of whether a particular token is a security is an individualized inquiry based on the particular facts and circumstances, it also took the unusual step of explicitly directing the report to others selling distributed ledger tokens to raise capital, effectively putting the industry on notice.
The SEC enforcement process
Assuming we will see more ICOs subject to SEC scrutiny through investigations and potential enforcement actions, it is imperative that ICO developers understand how long and painful an SEC investigation can be.
The expectation that the SEC will provide its opinion quickly after a summary investigation is misguided. Most investigations take several months (often more than a year) and involve expansive document requests, numerous witness interviews and extended negotiations about charges and potential settlements.
During the investigation period, the SEC is primarily attempting to gather facts to determine if a violation of the securities laws occurred and deciding whether to file an enforcement action. As reflected by the findings in the report about the DAO, the SEC will go to great efforts to understand all aspects of the relevant conduct and will dissect every comment made by an ICO developer before taking a position.
At the end of an investigation, absent a settlement, the SEC may choose to bring a formal enforcement action either through an in-house administrative proceeding or via a civil lawsuit in federal court. In anticipation of a formal hearing in front of a judge or jury, traditional discovery practices may apply to some extent, so there could be another round of document production, depositions, and also motions practice.
Finally, the alleged wrongdoer’s case is decided at a hearing or trial that often takes place years after the conduct at issue.
To fully understand the inconvenience and cost of this process, it is worth noting that my firm is representing multiple clients in SEC enforcement actions with respect to transactions that date back more than five years.
When the legal issue gets decided
Beyond the sheer length, cost and invasiveness of an SEC enforcement action, developers should consider how their legal position that their tokens are not securities will be resolved.
During the initial investigation, there are some opportunities to make important legal arguments, often in the form written submissions. However, the audience for these arguments is typically just the staff enforcement lawyer or their superiors in the enforcement division.
By the nature of their positions, these lawyers are often biased in favor of interpreting facts in a manner that will allow them to bring to a case. Although some can be open-minded to legal arguments during an investigation, considering the recent report issued about the DAO tokens, it seems unlikely that the enforcement attorneys would start an investigation without having already developed a position that generally disfavors the argument that a particular token is not a security.
Rather, it should be assumed that the staff will either be antagonistic to the argument or posture about leaving such a thorny legal issue up to a judge or jury.
Even if the SEC walks away from an investigation into a token sale based on a compelling argument that the securities laws are not implicated, unlike in the circumstance involving the DAO, that decision will not be made public and there will be no precedent under which others will be able to easily argue that future token sales do not constitute securities offerings.
So, the risk to others of an investigation does not go away once the first development team successfully avoids formal SEC charges.
Most people facing potential formal charges by the SEC ultimately settle before a lawsuit can be filed. In the event of a settlement, the SEC will require that an order stating the SEC’s position be issued to the public, similar to the report issued about the DAO.
Although those facing charges have some input over the content and wording of a settlement order, it is usually written from the perspective of the SEC in a manner that suggests wrongdoing by the settling party. The only acknowledgment of a competing position is usually a short statement noting that the alleged wrongdoer neither admits nor denies the allegations in the order.
In the context of an ICO enforcement action, that means any settlement will most certainly allege that the token sale constituted the illegal sale of unregistered securities.
Assuming developers have not run out of money or lost faith in their convictions, and thus chosen to litigate against the SEC instead of settle, the legal issue of whether the relevant token is in fact a security will ultimately come to a resolution as part of the formal proceeding.
At that point, an SEC-employed administrative law judge or a federal judge or jury with likely no background in decentralized applications or the basics of ICOs will decide the issue. The SEC, in an effort to make its case, will argue all the reasons why, for example, the $5 million you raised from U.S. investors to fund a brand new type of file sharing program looks a lot like the DAO token sale and every other capital raise that the SEC regulates once you brush away the technical jargon.
Frankly, your legal argument may look a lot weaker in the context of how it is actually decided than it does when discussing it with your tech-savvy lawyer who is also heavily invested in numerous ICOs.
This summary is not intended to suggest that fighting the SEC on this issue is a lost cause. However, developers must understand that the decision of whether a token is a security will likely only come after months of investigation, back and forth between lawyers, and may be decided by someone not familiar with distributed ledger technology.
Talk to a lawyer before your ICO
This raises one point worth a quick discussion: if you are considering an ICO, it is important that you speak to a lawyer about your project.
Not only will a lawyer help you potentially mitigate the risk of running afoul of the law, the truth is that if the SEC does come to investigate, the fact that you relied on a lawyer’s advice could help you avoid charges.
That being said, be wary of any lawyer giving you a blanket opinion that an ICO can be easily structured to avoid the securities law and the precedent set by the report issued this week. This is a naive position that fails to understand the impact of the SEC’s report and how the securities law work.
Rather, a good lawyer will want to know all about your project before providing any opinion or advice, and will likely seek to impose changes to ensure compliance with the securities laws.
Influential figures in the community have already opined that other ICOs should be able to avoid the DAO’s fate, and I have even written about some of the different characteristics between distributed ledger tokens and traditional securities.
However, at this stage, developers should be highly skeptical of anyone claiming to be able to structure an ICO that will not run the risk of being subject to SEC scrutiny.
Future outlook
A fundamental risk when planning for an ICO that must be considered is the risk of potential SEC enforcement in this new area that does not have easily applicable precedent.
The SEC explicitly noted in the DAO report that its findings were intended to put the industry on notice.
As a result, I doubt this is the last we will hear from the SEC on this issue, and I expect future enforcement action releases for those who blindly continue raising capital through ICOs.
Developers should understand the risk posed by such a strategy and how the issue will be resolved before rushing to raise money and ending up in the SEC’s crosshairs.
Gavel and coins image via Shutterstock
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