Security Token Offering in USA

Investigation report of SEC on Decentralized Autonomous Organization

In 2017, SEC issued a report of investigation, the so-called Decentralized Autonomous Organization (DAO) report that provided an analysis on whether a digital token could be considered as a security. This report has signification ramification for fundraising implementation via a distributed ledger or blockchain technology.

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Also, reading Initial Public Offerings versus Blockchain Initial Coin Offerings Crowdfunding article is highly recommended as it reviews the differences between traditional Initial Public Offering investments and blockchain Initial Coin Offering or ICO. Furthermore, it discusses the causes of the ICO bubble that led to its downfall. Another related article is Blockchain Crowdfunding via Security Token or Initial Coin Offerings which discusses differences between security token investments and ICO.


Report of Investigation Pursuant to Section 21(a) of the Exchange Act – The DAO – the application of the Howey test

In the DAO report, the SEC studied the case of the DAO as an example of fundraising by a virtual organization embodied in computer code and executed on a distributed ledger or blockchain. The SEC provided an analysis on whether the DAO had violated US federal securities laws. This is the most thorough and complete analysis from the SEC on security tokens offerings to date and provides general guidance for a token issuer who uses a DAO entity or other distributed ledger or blockchain-enabled means for fundraising.

The key facts of the case are as follows:

  • The DAO was an incorporated virtual organization created by, a German company, and its founders in 2016 to attract investments through the sale of tokens (DAO tokens) to investors, and such investments would be used to fund projects in order to make profits.
  • The investors of DAO tokens would later share the profits derived from these projects as a return on their investments in DAO tokens.
  • Moreover, the DAO token holders could monetize their investments in DAO tokens by reselling based on the issuer’s promise that DAO tokens would be traded on a number of web-based platforms that supported secondary trading in the DAO tokens.
  • During the offering period, the DAO sold around 1.15 billion DAO tokens (in exchange for a total of about 12 million ether (ETH)), which was valued at approximately USD 150 million.
  • The founder of described the DAO as for profit and an effort to create a crowdfunding contract to raise funds to grow a company in the crypto space.
  • The white paper of the DAO described the investment opportunity as the first implementation of a code to automate organizational governance and decision making, and said that it could be used by individuals working together outside the traditional corporate form. The system should be autonomous where the project proposals (in the form of smart contracts) were posted on the Ethereum blockchain, and the votes were carried out by the code of the DAO.
  • However, the setup of the voting process would give some control by the founders of, who chose the curators to review, select, and determine which proposals would be subject to voting by all DAO token holders. The curators had the ultimate discretion as to whether to submit a proposal for voting, and determined that on the order and frequency of proposals should be whitelisted for voting. The mechanism of voting was arranged in a way that token holders had to pledge a certain token in order to vote. The tokens pledged were not allowed to be transferred or traded until the end of the voting cycle.
  • This meant that either token holders had to vote yes or not to vote at all in order to have free transferability of their tokens.
  • After launch, the DAO tokens were traded on electronic platforms using virtual or fiat currencies. From May 2016 to September 2016, there were about 580,000 buy and sell transactions of the DAO token by more than 15,700 of US and foreign customers of the electronic platforms on the secondary markets. This is a large secondary market.


Legal analysis by the SEC

Under Section 5 of the Securities Act of 1933, as amended, the offer or sale of securities in the US to the public must be registered unless it falls under the exemptions.

The SEC first explains that the foundational principles of the securities apply to virtual organizations or capital-raising entities making use of distributed ledger technology. Therefore, the US securities law will apply to an ICO if it is targeted to the public in the US.

The issue is whether the offer or sale of a digital token will be considered an offer or sale of a “security” under US securities law. The closest term to be applied to the issuance of DAO tokens is whether the DAO token will be considered as an investment contract. The DAO report provided a thorough analysis by using the traditional Howey test.

Under the Howey test, 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.

In analyzing whether something is a security, form should be disregarded for substance, and the emphasis should be on economic realities underlying a transaction.

Basically, this seems to mean that it does not matter what you called it. If the so-called utility tokens being offered or sold have a security nature and satisfy the Howey test, they will be considered securities and will be covered under the securities law and the regime of the SEC.

The process to identify a security involves the following information:

  • Investment of money: In the DAO case, the issuer offered and sold DAO tokens to investors in exchange for their ETH as their investments. This activity was regarded a contribution of value that can be considered as an investment contract under the Howey test.
  • Common enterprise: The DAO token investors’ ETH, the investments, was put in the DAO—that is, the common enterprise. With their investments in DAO, the investors reasonably expected to earn profits through this common enterprise when they put their ETH into the DAO’s Ethereum blockchain address in exchange for DAO tokens.
  • Reasonable expectation of profits: The promotional materials regarding DAO investments described it as a for-profit entity for the purposes of generating profits though funding projects with profitable prospects. When they made their investments, DAO token holders were convinced by the promotional materials and expected that they would derive and share in future profits from the projects funded by the DAO.
  • Entrepreneurial or managerial efforts of others: The way the DAO operated was that and its cofounders put in a lot of effort in actively maintaining and overseeing the DAO’s operations. The DAO curators appointed by the founders had the power to determine whether a proposal should be put to a vote by DAO token investors. and its cofounders monitored the DAO closely and addressed issues as they arose. As a result, investors’ profits would be derived from the managerial efforts of, its cofounders, and the DAO curators.


Although DAO token investors might have been able to vote on which projects they should fund, these voting rights were limited because the curators were the ones with the control over which proposals should be whitelisted for a vote by DAO token investors. Therefore, the DAO token investors could only vote on the proposals selected by the curators.

In fact, DAO token investors had to and did rely on the significant managerial efforts provided by and its cofounders and the DAO’s curators to operate the DAO and make profits.


SEC’s conclusion

The SEC concluded that the issuance of DAO tokens is considered an offering of security and hence this would be covered under the Securities Act. Therefore, the issuer must register such an offer regarding the sale of such DAO tokens. Issuers also include any unincorporated organization such as the DAO.

The SEC also concluded that the DAO is required to register the offer and sale of DAO tokens, unless a valid exemption from such a registration applied. Otherwise, those who participated in an unregistered offer and sale of securities not subject to a valid exemption are liable for violating Section 5 of the Securities Act.


Security trading

In addition, the SEC also concluded that as the DAO tokens were traded on electronic platforms using virtual or fiat currencies, such trading of DAO tokens will be considered as the trading of security. Hence, those trading platforms that provided a secondary market for the buying and selling of DAO tokens should be required to register with the SEC under Section 5 of the Securities Exchange Act of 1934, as there is no applicable exemption in this case.

The DAO reports provide a quick and clear analysis on how the SEC approached such a type of digital tokens offering, and it is a reliable guideline for token issuers to follow; however, as the SEC summarized at the end of the analysis, whether or not a particular transaction involves the offer and sale of a security, regardless of the terminology used, will depend on the facts and circumstances, including the economic realities of the transaction. As a result, an issuer, before launching an STO, should carefully consider the nature of the tokens being offered, the mechanism of the investment in these tokens, the use of these tokens, the control of the DAO, how the investors will be rewarded, and the expectations of the token holders. Each case has its unique circumstances and considerations, so it is recommended that a thorough legal analysis is conducted before launching the issuance of the tokens.


At DC Web Makers Company, we consult small to large companies on how to navigate through blockchain technology. Specifically, we assess your industry and company business processes and needs and determine whether your business will benefit from blockchain technology.

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