In 2017, initial coin offerings (“ICOs”) have enabled over 70 start-up companies to raise more than $1 billion.  This alternative fund raising mechanism has captured the attention of the SEC.  On July 25, 2017, the SEC issued a Section 21(a) report of investigation[1] (the “Report”) and an investor bulletin[2](the “Bulletin”), which advised parties of the potential consequences and risks that ICOs create.

The Section 21(a) Report of Investigation on “The DAO”[3]

The Report investigated the facts and circumstances surrounding The DAO’s offering of DAO Tokens to raise capital in Ether[4] on the Ethereum Blockchain.[5]  From April 30, 2016 to May 28, 2016, The DAO sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether, which was valued at approximately $150 million.  An unknown individual or group attacked The DAO’s assets on June 17, 2016, before The DAO was able to use the capital it raised to finance projects.  The attack diverted one-third of The DAO’s assets to the attacker’s blockchain address.  The DAO offered a temporary buy back that enabled investors to receive a full return of their investment.  

The DAO’s record-setting offering and cyber-attack sparked the SEC’s interest.  The Commission did not open an enforcement action against The DAO, however.  Instead, it issued the Report to explain how The DAO Tokens were securities that should have been registered with the SEC, unless a valid exemption applied.

The DAO Tokens are securities because they are investment contracts.[6]  An investment contract existed because The DAO Tokens are investment opportunities that could earn investors virtual coins from successful projects and a rising secondary market.  The SEC identified the following factors, which led it to conclude that The DAO Tokens are securities.  DAO Token investors invested money when they used Ether to acquire DAO Tokens.  The DAO is a common enterprise.  Investors expected to earn profits because promotional materials stated that The DAO’s objective is to fund projects in exchange for a return on investment.  DAO Token holders relied on The DAO’s parent company, founders and Curators[7]to manage and present project proposals that could generate profits.  DAO Token holders relied on these sources of management because they had limited voting rights.  Based on these facts and circumstances, the Report identified The DAO’s virtual coin offering as a securities offering.

The Report concluded by cautioning those interested in using virtual organizations to raise capital through ICOs that they must take the appropriate steps to ensure compliance with U.S. federal securities laws if the facts and circumstances surrounding their ICO amounts to the offer and sale of securities.

The Investor Bulletin on Initial Coin Offerings

In addition to the Report, the SEC issued the Bulletin. The Bulletin highlights key terms, considerations, risks and red flags that investors should review before investing in ICOs.  Investors should know: (i) whether the virtual coins are considered securities; (ii) whether the person selling the virtual coins registered the offering with the SEC; (iii) what rights the virtual coins provide; (iv) how their investments will be used; (v) the promoter’s business plan; (vi) how and when money can be redeemed; (vii) any re-selling restrictions; (viii) information about the distributed ledger or blockchain used to facilitate the offering; and (ix) information about the offering parties’ cybersecurity audits.

The Bulletin further stressed that, if fraud or theft occurs, investors may have limited rights to recovery.  Key players in ICOs, such as third-party wallet services and virtual currency exchanges,  may be located overseas and/or operating unlawfully.  Due to the global nature of ICOs, law enforcement may face jurisdictional authority limitations and be unable to effectively trace, freeze or secure virtual money.  Moreover, no central authority exists to monitor user information, so law enforcement must rely on other sources.

To avoid fraud, investors should particularly keep an eye out for any offers that guarantee high returns, are unsolicited, sound too good to be true, pressure the buyer to buy immediately, come from an unlicensed seller or do not impose net worth or income requirements.


In a traditional approach, the SEC made it clear that those who offer and sell securities in the United States, including virtual organizations, must comply with the federal securities laws. Moreover, the SEC focused on the need for investors to familiarize themselves with key terms, considerations, risks and red flags surrounding ICOs before investing.  Although the SEC declined to pursue an enforcement action against The DAO in this instance, start-up companies in this space should seek legal counsel before considering ICOs to avoid an exorbitant enforcement action, which is conceivable to deter further violations of the securities laws through virtual coin offerings.


[3] The DAO is a virtual organization executed on a distributed ledger or blockchain.  The DAO was created to use smart contracts to perform projects.  The DAO sold DAO Tokens to investors to generate the funds for the projects. Investors who purchased DAO Tokens expected to earn virtual coins from the projects as a return on their investment. The DAO Tokens could be sold on secondary web-based platforms.  See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO at 1,Release No. 81207 (July 25, 2017).

[4] Ether is a virtual currency generated on the Ethereum Blockchain.

[5] “A blockchain is an electronic distributed ledger or list of entries that is maintained by various participants in a network of computers. Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure.  Some examples of blockchain are the Bitcoin and Ethereum blockchains, which are used to create and track transactions in bitcoin and ether, respectively.” See Investor Bulletin: Initial Coin Offerings at P. 1, (July 25, 2017).

[6] See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”).

[7] A Curator performs crucial security functions and maintains ultimate control over which proposals the virtual organization will submit, vote on, and fund.

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