Wall Street Main Street: DAO offerings are DOA

I recently finished reading the SEC’s 21(a) Report[1] (“Report”) on the so-called “Initial Coin Offering” (“ICO”) made by The DAO.[2] The Report is informative but hardly what I would call groundbreaking work. I hope that any of my securities law students would reach the same conclusions. This was a lay-up, a no brainer, under securities law “investment contract” principles.

It should be noted that The DAO is only tangentially connected to virtual currency such as “Bitcoins” and “Ether.” The DAO (“Decentralized Autonomous Organization”) is an Internet-based “Thing.” To get involved in the Thing, one must transfer to it a bunch of virtual currency Ethers. The trick here is that to obtain these virtual Ethers, one must pay money or money’s worth to someone else who has them to sell. Reality is a bummer.

With the pile of Ethers amassed in this ICO, human beings, or organizations run in turn by human beings (including, what a surprise, the originators of The DAO), called “Curators,” and not algorithms or some other mechanical secret sauce, will select projects in which to invest and then promote, with the hopeful result of economic gain for The DAO and, purportedly and eventually, the investors.

The reason The DAO was only tangentially related to virtual currency is that Ethers were simply the manner of consideration selected and required by the promoters. They could have required that investments be made in drachmas, goldfish or heads of lettuce. Regardless, anyone interested in participating would have to obtain the medium of exchange with dollars, Euros, yen, yuans, whatever.

The Report is interesting to me for at least two reasons. First, according to its language, this is not an interpretive position taken by the staff of the Commission, but a statement by the Commission itself. I don’t know how this would play in court, but it is voiced nonetheless as a conclusion of the Commission. Second, they gave The DAO a pass. The Commission will not take enforcement action against The DAO and those involved in its capital formation, at least to date. However, any efforts to accrue Ethers from prospective investors, or to accommodate those seeking to engage in secondary trading of these DAO positions henceforth proceed at their peril.

For me, the essence of these virtual currencies is an anarchic computer driven vision of currency without the support, interference or manipulation of any government. There will someday be a limit to the number of bitcoins, Ethers, what have you, in circulation. So the theory goes, their value will rise and fall based on market forces. How many sheep or eggs can you buy for one bitcoin? As long as there are enough buyers and sellers to maintain value, virtual currencies will survive. Like any form of exchange, liquidity is key. Who, if anyone, is maintaining the value of bitcoin and the like? Is it the market, or the marketers?

This is the larger and thornier issue for me. Left entirely unaddressed in the Report is whether virtual currencies themselves are investment contract securities.[3] You pay for them, and you are totally reliant on the blockchain system and those Internet-based exchanges or brokers that turn dollars into bitcoin and back to dollars to maintain their “market value.”

For me, it is a monetary version of the “Emperor’s new clothes.” Anyone proposing to use virtual currency as consideration, to buy or sell something, reflexively drops down to the market price of whatever it is in terms of dollars or Euros. As long as people see “clothes,” these units will have value and at least limited liquidity. The more that liquidity is generated by promoters, and not general market forces, securities implications rise.

Without nations and governments standing behind money (and principally, the U.S. and its dollars), the volatility of the value of virtual currency units is a certainty, and their very existence is tenuous at best. When will Jamie Dimon, or you, for that matter, agree to be paid in Bitcoin rather than U.S. dollars (assuming you have nothing to hide)?

At the moment, the answer appears to teeter on the fulcrum of public perception, confidence and recognition. Are those tulips I smell?

[1] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934:  The DAO, Securities and Exchange Commission, Release No. 81207 / July 25, 2017

[2] Described in the Report as an unincorporated organization organized by Slock.it UG, a German corporation, and its co-founder human beings Christoph Jentzsch, Simon Jentzsch and Stephan Tual.

[3] I’ll defer the question of whether bitcoins and the like are “money” under Section 8 of the U.S. Constitution.


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