Just one month before the SEC report was published, Coindesk published an article covering an interview with Greg Medcraft, chairman of the Australian Securities and Investments Commission (ASIC), Australia’s corporate, markets and financial services regulator. The article is titled “ASIC on Blockchain: Australia’s Securities Watchdog ‘unlikely’ to regulate ICOs”. In that interview, Medcraft was quoted saying that not many [ICOs] possess the characteristics of traditional securities and therefore fall outside the mandate of traditional securities regulators.
To be classified as a security it would have to have some sort of financial conditions attached to it. Financial obligations have to be offered in relation to it, either it’s equity or it’s a debt-like instrument or principal instrument or a derivative on that.
This is because the definition of a security includes shares and debentures or a legal or equitable right or interest to a share or debenture. The Coindesk article considers whether an ICO could be classified as a security in Australia, but does not address the broader question, whether an ICO token could be classified as a financial product. Similarly, this Australian Financial Review article states that the lawyers for Powerledger, an Australian start up that recently conducted an ICO, advised that their virtual tokens did not constitute a ‘security’ in Australia.
So why is the ‘financial product’ question important?
1. Securities are only one type of financial product.
2. The US definition of ‘securities’ is synonymous with ‘securities’ in India and South Africa, ‘investments’ in the UK and ‘financial product’ in Australia.
… digital currencies such as bitcoins are not currently financial products.
The keyword is ‘currently’, i.e. 2014, the year ICOs were born. Since then, the use of digital currencies have evolved dramatically (from tokenisation of assets to allowing access to software platforms), and billions of money have poured into ICOs. At the time of writing, at least 148 ICOs have taken place in 2017 raising more than $USD 2.2billion (compared to 46 ICOs and $USD96 million in 2016).
Update 1: On 28 September 2017, ASIC posted guidance about the potential application of the Corporations Act to ICOs. In summary, the legal status of an ICO is dependent of the circumstances of the ICO. It discusses when an ICO could be a managed investment scheme, offer of shares or a derivative, non-cash payment facility (all of which are types of financial products).
With this in mind, this article will now reconsider whether The DAO Tokens could fall under the definition of a financial product. The first step is to consider whether specific exclusions under s765A of the Corporations Act apply to The DAO. These include certain types of insurance, a funeral benefit and things declared by ASIC not to be a financial product — none of which are applicable to The DAO.
Having concluded that none of the exclusions apply to The DAO, the next step is to consider the list of specific inclusions under s764A of the Corporations Act that are financial products. This list includes a number of things such as securities (which covers shares), derivatives and interests in a managed investment scheme — on first glance it appears that a managed investment scheme may be involved.
If The DAO is not a financial product under the list of specific inclusions, it may be a financial product under the general definition under s763A of the Corporations Act. It is defined as a facility through which a person makes a financial investment, manages financial risk, or makes non-cash payments — it is possible that the sending of ETH for DAO Tokens may be considered a financial investment.
Managed Investment Schemes
We now consider whether The DAO falls under the definition of a managed investment scheme. I have included the 4 limbs of the Howey Test below for comparison.
1. People contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme
Howey test: Investment of money
A Western Australian Supreme Court provides further guidance on this limb: the money or money’s worth must be contributed for the purpose of acquiring the relevant rights to benefits. Furthermore, it is irrelevant whether the right is actual, prospective, contingent or enforceable. The “rights” may have arisen from representations made by the promoters to the lenders.
From April 30, 2016 through May 28, 2016 a total of approximately 12 million Ether (a type of digital currency, also known as ETH), worth approximately $USD150 million at the time of the offering, was sent to The DAO’s Ethereum Blockchain address.
As the SEC report recounts, Christoph Jentzsch (founder and CEO of Slock.it, the German company that created The DAO) publicly described his proposal for The DAO as a “for profit DAO [Entity],” where participants would send ETH to The DAO to purchase DAO Tokens, which would permit the participant to vote and entitle the participant to “rewards.” In exchange for ETH, The DAO created DAO Tokens proportional to the amount of ETH paid that were then assigned to the Ethereum Blockchain address of the person or entity remitting ETH.
Thus money’s worth (ETH, now worth approximately $290USD around the time of writing) was contributed as consideration to acquire the right to vote (through The DAO Tokens) and receive rewards (in the form of ETH) arising from the projects invested by The DAO.
2. Any of the contributions are to be pooled, or used in a common enterprise
Howey test: Common enterprise
The pooling and common enterprise requirements are alternatives but they will both be considered below. The Federal Court has said that knowing where resources are located and that the resources are available to the members fulfills the pooling condition. This limb is likely to be satisfied since all of the ETH raised in the offering as well as any future profits earned by The DAO were to be pooled and held in The DAO’s Ethereum Blockchain address.
The other question is whether there was a common enterprise where the pooled contributions were to be invested in separate projects. The Federal Court of Appeals considered this and held that “It is sufficient if there are two or more closely connected operations if the two operations constituting the enterprise contribute to the overall purpose that united them.” In this case, the overall purpose was to fund products in exchange for a return on investment — it can therefore be concluded that investments in multiple projects would have contributed to the overall purpose of obtaining a return on investment.
3. To produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme
Howey test: Reasonable expectation of profits
‘Property’ is defined as any legal or equitable estate or interest … in real or personal property of any description … The Token Holders did not receive any legal or equitable interests in future rewards, and in any event, ETH is not considered real or personal property.
‘Benefit’ is defined as any benefit, whether by way of payment of cash or otherwise. Although the Corporations Act defines “financial benefit” in s9, that definition applies to Chapter 2E only (and not to unregistered managed investment schemes). A New South Wales Supreme Court case provides guidance on the definition of a financial benefit in the context of Chapter 2E, “Clearly enough, “financial benefit” is to be given the broadest of interpretation. Importantly, “economic and commercial substance of conduct is to prevail over its legal form”. Under s229(2)(c) of the Corporations Act, a financial benefit does not have to involve money.
4. The members do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions)
Howey test: derived from the entrepreneurial or managerial efforts of others
Day-to-day control means control-in-fact, rather than control as a legal right. A Victorian Supreme Court judge has said “The existence of a right in a member to be consulted or to give directions as to the operation of the scheme does not necessarily lead to the conclusion that that member has day-to-day control over its operation.”
Furthermore, day-to-day control entails that members as whole participate in the routine, ordinary, everyday business decisions over the management of a scheme, and that the members are bound by the decision made.
The DAO Token Holder’s input was limited to:
putting forth proposals to fund a project
voting on proposals to fund a project
voting to use any rewards to fund new projects or to distribute ETH to DAO Token holders
voting on proposals to replace a Curator.
The DAO Token holders did not, for example, promote The DAO, solicit US web-based platforms to trade DAO Tokens, safeguard investor funds, select the initial Curators, monitor online forums or participate in decisions to address security issues in The DAO’s code following the hack. These roles were performed by Slock.it, its co-founders and The DAO’s Curators.
Even if their voting rights did amount to day-to-day control, any control was illusory as the Curators would ultimately decide whether a proposal should be whitelisted for a vote by the token holders. If the investors wanted to replace the Curators, their ability to do so was also controlled by the Curators. Furthermore, the SEC also notes that the pseudonymity and dispersion of the token holders made it difficult for token holders to join together to effect change or to exercise meaningful control.
This limb is likely to be satisfied since token holders cannot be said to have day-to-day control over the operation of the scheme. As the SEC notes, investors had little choice but to rely on the expertise of The DAO’s creators and the Curators.
Even if The DAO did not involve a managed investment scheme, the sending of ETH for DAO Tokens may be considered a financial investment. The definition of a financial investment is very similar to a managed investment scheme and there is no pooling/common enterprise requirement.
1. The Investor gives money or money’s worth to another person
This limb has already been discussed above and is likely to be satisfied.
2. Financial return or benefit
Under s763B(a)(i)-(iii) of the Corporations Act one of the following need apply to satisfy the second limb.
The DAO uses ETH to generate a financial return or benefit;
The investor intends that The DAO will use ETH to generate a financial return or benefit; or
The DAO intends that ETH will be used to generate a financial return or benefit.
Whilst the second point is likely to be satisfied, the final point will be the easiest to prove from the promotional materials disseminated by Slock.it. However the question still remains, whether rewards in the form of ETH would be considered a financial return or benefit.
3. The investor has no day-to-day control over the use of the contribution to generate the return or benefit
This limb is similar to the final limb of a managed investment scheme except for one key difference: this focuses on the control over the ‘use of the contribution’(narrow focus) instead of the ‘operation of the scheme’ (broad focus). Under a literal interpretation, this limb may not be satisfied since the Token Holder will have some degree of control over the use of ETH due to their voting rights.
It may be argued that the voting rights did not constitute ‘day-to-day’ control over the use of the contributions since the Curators had “complete control over the whitelist … the order in which things get whitelisted, the duration for which [proposals] get whitelisted, when things get unwhitelisted … [and] clear ability to control the order and frequency of proposals.” This quote from Vlad Zamfir, one of the Curators suggests that the Curators could have effectively controlled the use of the contributions:
“[C]urators can whitelist proposals, but if there is a yes bias then they are choosing who the money goes to by deciding the order in which proposals go forward.”
It is difficult to predict the outcome as this is all theoretical. For instance, it would be difficult to conclude that the Token Holders had day-to-day control over the use of contributions if the Curators whitelisted one project per month. On the other hand if numerous proposals were being whitelisted regularly and Token Holders were voting on a wide range of proposals, that may be evidence that that the Token Holders had some degree of control and the limb would not be satisfied.
AU — UK — HK — US
One thing I noticed when conducting this analysis was the similarities between Australia’s managed investment scheme, United Kingdom’s collective investment scheme, Hong Kong’s collective investment scheme and United State’s Howey Test for an investment contract. The tests generally have the following elements (1) an investment/contribution/arrangement (2) pooling of funds/common enterprise (3) profit/financial reward/benefit/return (4) management by someone other than the investor. It will be interesting to see whether the courts of the respective jurisdictions will come to a similar conclusion regarding the regulation of The DAO/ICOs.
This article suggests that it is possible for The DAO to fall under the definition of a financial product in the form of a managed investment scheme. It is likely to hinge on the definition of “financial benefit” and whether it is broad enough to include profits in the form of ETH.
It also suggests that purchases of DAO Tokens are unlikely to be a financial investment, unless the courts are able to take a flexible approach to find that Token Holders had no day-to-day control over the use of the pooled ETH due to the Curator’s exclusive and unfettered ability to whitelist proposals.
The next question is who is responsible for complying with the regulations and were they operating the scheme in this jurisdiction? Even if Slock.it was found to be operating The DAO in Australia, and the law compelled it to take a specific action (such as halting the issuance of tokens or winding up), would Slock.it have the power to control The DAO? Can The DAO be regulated?
Theoretically, Slock.it would have no control over The DAO as it was controlled by smart contracts and operated in a decentralised fashion where participants could update or alter the code through majority consensus. Despite this, Slock.it and its co-founders showed that it did have significant influence over The DAO following the events of the hack.
The issue of regulating a decentralised platform with no single operator or attempting to pierce the tech veil raises further questions outside the scope of this article.
Note: this is not legal advice and all thoughts are mine alone.
 The definition of a managed investment scheme under the Corporations Act is a matter of statue and thus there is more certainty and ability to predict how regulators will perceive the ICO. This is unlike the Howey Test which is based on common law. For example, the Howey Test requires an expectation of profits depending solely on the efforts of a promoter or third party — US courts have been unanimous in declining to give literal meaning to the word ‘solely’ in this context and have taken a flexible approach where ‘solely’ has been interpreted to include significant or essential managerial efforts.
 The term ‘operate’ refers to the acts which constitute the management of or the carrying out of the activities which constitute the managed investment scheme — ASIC v Pegasus Leveraged Options Group Pty Ltd (2002) 41 ACSR 561 per Davies AJ at 574