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‘Back to the basics’: What the SEC’s ruling on DAO tokens mean for the industry

In a ruling issued Tuesday, the U.S. Securities and Exchange Commission finally came out and said what the blockchain community has known all along: DAO tokens are securities and are “subject to the requirements of the federal securities law.”

The DAO, which stands for Decentralized Autonomous Organization, was the automated, leaderless ethereum-based funding vehicle that suffered a massive hack last year after raising millions of dollars from investors in the token sale. This ruling could be “the end of the beginning phase for blockchain,” said Emin Gun Sirer, associate professor at Cornell University and co-director of the Initiative for Cryptocurrencies and Smart Contracts.

“What we were beginning to see with the ICO craze was every Jack and Jill coming up with an old idea, wrapping it up in a token and issuing securities in a virtual company of some kind,” Sirer said. “I hope we will see a return back to the basics. There’s a lot of infrastructure work to be done. People will start to take a close look at their own ICOs and quite a few will fail these rules the SEC applied.”

The rules follow a three-pronged test known as the Howey Test. A token is a security if they’re selling something for money; are they promising future profits; and the future profits predicated on the efforts of other people and third parties.

Here are three key takeaways from the ruling.

This doesn’t change much
If anything, the ruling was “a reminder” of something people already knew was coming and maybe were surprised was taking so long, according to Angela Walch, an associate professor at St. Mary’s University School of Law and research fellow at the Centre for Blockchain Technologies at University College London.

“It’s not like they came out with a new conclusion of law or policy, they reminded us that the existing policy applies to these new forms of fundraising,” she said. “The only difference is that we’re doing it in a technological way and calling it something different.”

The SEC tends not to give guidance on whether something is a security or not so as not to discourage innovation. In the guidance it didn’t even define what a security is or isn’t. The fact that the DAO tokens are treated in the eyes of the SEC as legal securities doesn’t mean the market is going to suddenly shut down. People that want to continue with their ICO plans can probably do so — in a way that’s compliant with U.S. securities laws.

There is some uncertainty as to what will happen to token sales that will happen in the interim, Walch said. Those that occur after this point are clearly on notice and need to figure out how to comply with securities law. But there’s some ambiguity among people that launched their token sales between the the time of the DAO and now. They’re not necessarily off the hook.

“I think the future is bright for non-securities tokens,” said Marco Santori, a partner at law firm Cooley LLP, tweeted Wednesday. “This is the first step in a critical maturation process.”

This isn’t the end of ICOs
If anything, the guidance could slow down the pace a little bit, according to David Lucking, a partner at law firm Allen & Overy. There has been a lot of focus on ICOs in the last year, and many people have set them up without really considering the legal ramifications.

“The SEC is sort of putting the market back on notice: the tokens themselves can be treated as securities, and the platforms on which these tokens trade may be treated as securities exchanges. Both things are regulated in the U.S.,” he said.

Of course, not all tokens are securities. The SEC was pretty clear it would take a case by case approach to this kind of activity, “depending on the particular facts and circumstances,” making it a nice time to be a lawyer versed in crypto.

“It will bring back to the forefront the need to involve lawyers, which for so many people is not that desirable because obviously, the beauty of blockchain and distributed ledger technology is somewhat to disintermediate established ways of doing things and established market participants,” Lucking said. “This reins that in a little bit.”

Sirer highlighted the quick emotional reaction by many in the blockchain community — some gloated about having seen this coming, some worried all tokens were securities and that this might affect their ICOs — to guidance on a narrow class of activity pretty specific to the DAO. The SEC could issue other findings — that will inevitably come later, but for now, not just any ICO is binding by the SECs recent findings.

“We’re living through a time of ICO mania,” he said. “There are worthless ICOs, there are scam ICOs and all sort of other rogue ICOs that shouldn’t exist. But this ruling doesn’t say anything about them — this is a ruling on the DAO and things like the DAO.”

Implications for bitcoin and ethereum
Many people that read that guidance couldn’t help but notice the SEC’s choice identifier of ethereum as a “virtual currency” as opposed to a virtual “token” or “coin.”

“My reading of this is it has no implications for the underlying infrastructure,” Sirer said. “Currencies themselves are not regulated by the SEC, securities are regulated by the SEC.”

Plus virtual currencies in the U.S. got their ruling in March 2013. It’s legal to own and transfer them without a license (although the exchange doing the actual transferring may need one).

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Why one VC is bullish on ICOs

In the past three months, companies have raised more than $300 million, not through venture investors or banks, but from token sales, also known as initial coin offerings.

Venture capital has become synonymous with innovation and wealth creation over the last half century. Today, corporate VCs (established corporations that with dedicated funds for external startup companies) are on the rise; the number of active corporate VCs per quarter more than doubled between 2012 and 2016, according to CB Insights. Enthusiasts of token sales are optimistic that they can unseat venture capitalists, as an investment vehicle that removes the need for the middle man and provides more liquidity.

The VCs themselves haven’t shown much concern over that idea (it may be too early for that). If anything, some are looking beyond that detail at all the possibility for innovation.

“It’s much like you agreeing to pay in advance a two-year subscription to the Wall Street Journal or New York Times,” said Ryan Gilbert, partner and founder of Propel Venture Partners, the BBVA Ventures spinoff that launched as its own LLC last year, at the Tearsheet Money Conference this week. “The subscriptions we used to know are the coin offerings of today.”

Of course, it’s not clear if the tokens sold constitute securities. The Securities and Exchange Commission hasn’t issued any formal guidance on tokens as securities and regulators tend to take a do-no-harm approach to new business concepts and technologies that haven’t proved harmful.

“Yes, what’s happening today might be controversial,” Gilbert said. “But when regulators learn more about what’s truly happening, they’ll recognize… what’s going to help deliver financial services to everyone at the lowest possible price, how are we going to truly have transparency, is knowing both where a transaction starts and ends and what the true costs are going to be.”

Gilbert’s stance reflects a growing interest in public blockchains by bank executives as well. A Cognizant survey released this week of 1,520 executives from 578 financial services firms shows 86 percent see public blockchains becoming more prominent in the next five years; 80% said the same about private blockchains.

In the original bitcoin blockchain, transactions are recorded on a public ledger anyone can see, although users are pseudonymous, identifiable only by alphanumeric addresses. That doesn’t mesh well with the need for privacy in high-stakes transactions between massive companies, which is why banks — which were initially hostile have sought “permissioned” blockchain-like solutions that allow for more privacy in terms of how data is stored and who can access it.

At least two of Propel’s portfolio companies have raised money through token sales. For example, the blockchain-based digital advertising system Brave “managed to raise $24 million in about 29 seconds,” Gilbert said.

In financial services, the token sale opportunity could perhaps manifest in payments, through a bank transfer service that uses these types of tokens as a means of compensation.

It’s hard for the everyday person to justify paying $17 to wire $100 from the U.S. to Mexico, especially when the cost of that wire probably looks more like 75 cents. But using these kinds of tokens, the supply and demand sides can come together to “dictate the true price of that token for the value exchange… whether that payout point at Guadalajara or Mexico City actually has that cash from the sales of the day to disperse to you as a recipient.”

Other investors are more cautious. Mike Sigal, a partner at 500 Startups, didn’t comment on his investments but noted that one of the hardest things for an early stage company to do is acquire customers and activate the entrepreneur’s community, and that a token sale could be a tool for it to truly get its community engaged, speaking at the Bloomberg Bloomberg Buy-Side Week Focus on Fintech event this week. For Citi Ventures, they’re still a solution in search of a problem. Arvind Purushotham, the group’s co-head, said it looks at blockchain investments with direct applicability to its business. It’s an investor in Chain, but hasn’t made any cryptocurrency investments.

The early-stage fund Future\Perfect Ventures has several portfolio companies now planning ICOs, said Jalak Jobanputra, its founder and managing partner. But it’s a Wild West, and it’s unclear whether these token sales have real technology behind them or if it’s just a quick way to make money and take advantage of momentum, she explained.

“There will be something really lasting out of this but there will be a lot of catches in the process,” she said. “Tokens related to the business are one element of it but some companies want to raise just to have a capital raise. You really have to dig in and see what you’re going to own… It would be dangerous for these companies if there was immediate liquidity or lack of liquidity. All of those terms are up in the air right now.”