Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC must generally approve rules and rule changes by self-regulatory organizations, which are referred to as SROs. According to this SEC web page, there are 37 active SROs.  The volume of rule filings submitted for approval is high.  In 2016, the NYSE alone made 91 rule filings.  Whether or not you agree with the result, the SEC takes this responsibility seriously, as demonstrated by its denial of two proposed bitcoin exchange traded funds.

But a recent decision by the United States Court of Appeals for the District of Columbia Circuit paints a different picture. Susquehanna International Group, LLP, et al., v. SEC involved a rule change by the Option Clearing Corporation to permit the OCC to increase its capital.  Two nonshareholder exchanges and a market participant sought judicial review of the SEC’s approval of the rule.  Reviewing the rule under the Administrative Procedure Act, the Court found the SEC’s approval was arbitrary and capricious, unsupported by substantial evidence, and otherwise not in accordance with law.

The primary reason the Court gave for reaching its conclusion was the SEC effectively abdicated its responsibilities under the Administrative Procedure Act to the OCC. According to the Court, the SEC’s approval order reflects little or no evidence of the basis for the OCC’s own determinations — and few indications that the SEC even knew what that evidence was.

For example, the Court noted:

The Order’s shortcomings are apparent in its discussion of whether the Plan pays dividends to shareholder exchanges at a reasonable rate. That is a central issue: if the dividend rate represents an unnecessary windfall for shareholders, as Petitioners argue, then the Plan may run afoul of the Exchange Act’s prohibitions by unnecessarily or inappropriately burdening competition, harming the interests of investors and the public, or unfairly discriminating against nonshareholders and clearing members . . . The SEC found that the Plan heeds those statutory prohibitions because the dividends represent a reasonable return on the shareholders’ capital contribution . . .

Why did the SEC find the return reasonable? The Order says only that the Plan is “designed to set the dividends . . . at a level that [OCC’s] Board, with the assistance of independent outside financial experts, has determined to be reasonable for the cost and risks associated” with the shareholders’ obligations . . .

That explanation raises more questions than it answers. Who were those independent experts? How does the SEC know they were independent? What analysis did they and OCC’s Board perform? How did they measure the “level” of the dividends? How did they measure the “cost and risks”? And how did they determine that the dividend level was reasonable for the associated cost and risks? The Order is silent on all counts. Instead, the SEC candidly admits that it simply “rel[ied] on the Board’s analysis” of “the rate of return the Stockholder Exchanges were receiving for their capital investment” . . . That is, to decide whether the dividend level was reasonable, the SEC took OCC’s word for it.

While perhaps the OCC’s plan merited more scrutiny by the SEC, if the decision is carried to extremes it could have a negative effect on the ability of the SEC to approve SRO rules. Must the SEC independently verify every aspect of a proposed rule change, many of which are routine? The inability of the SEC to approve rule changes in a timely manner could impair the efficient conduct of an SRO’s business, stifle innovative technologies, and impair capital formation and investor protection.

In Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, the Delaware Court of Chancery declined to permit the purchaser of a business to recover a working capital shortfall as a result of a purchase price adjustment because of a contractual limitation.  The Court of Chancery has rendered another decision precluding a working capital recovery in Sparton Corp. v. O’Neil.

The merger agreement was negotiated and executed on behalf of the stockholders and optionholders of target Hunter Technology Corporation by a representative (the “Equity Representative”). Hunter was the sole party to make representations and warranties in the merger agreement to purchaser Sparton. In the merger agreement, Hunter represented its financial statements were prepared in accordance with GAAP.  Sparton disclaimed reliance on any other representations and warranties related to Hunter that were not included in the merger agreement.

The merger agreement provided for a preclosing estimate of an “Allocable Amount” which included working capital, with a subsequent true up of the Allocable Amount. While the stockholders and optionholders of Hunter agreed to indemnify Sparton for breaches of representations and warranties, including those related to the financial statements, the indemnification provision precluded recovery for any loss included in the calculation of the final Allocable Amount, except in the case of fraud. Based in part on the alleged oral representations of the Equity Representative, the parties agreed that the working capital adjustment was capped at $750,000 and that was the exclusive remedy for any overstatement of working capital, except in the case of fraud. A working capital escrow of like amount was also established.

Sparton alleged before the working capital estimate was calculated the Equity Representative and others artificially overstated the value of Hunter’s accounts by, among other things, adding amounts to invoices that were not owed and invoicing customers for work that had not yet been completed. Sparton also alleged that before closing the Equity Representative and others caused Hunter to write off the overstated amounts causing Hunter’s working capital to revert to its actual, lower value. Sparton claimed that as a result it overpaid for Hunter’s working capital by $2,579,455.

Following Closing, Sparton presented the Equity Representative with its post-closing working capital adjustments of $2,579,455. The Equity Representative did not dispute the amount and released the $750,000 working capital escrow to Sparton.  To mitigate its damages, Sparton requested an additional $550,000 from a separate indemnity escrow which the Equity Representative declined.

Sparton sued to recover its losses. The defendant stockholders and optionholders moved to dismiss.  Sparton did not dispute the applicability of the contractual limitations but argued its claim should survive the motion to dismiss because the contract was fraudulently induced and therefore any contractual limitations did not apply.  The Court noted that Delaware honors disclaimers on extra-contractual representations and that Sparton could not rely on any extra-contractual representations made by the Equity Representatives or others.

The Court noted that the stockholders and optionholders did not agree to indemnify for any losses resulting from Hunter’s misrepresentations to the extent the loss was included in the Allocable Amount, except in the case of fraud. For Sparton to state claim for fraud, Sparton must plead the circumstances constituting the fraud with particularity under Court of Chancery Rule 9(b), while knowledge may be averred generally.  To satisfy Rule 9(b), a complaint must allege: (1) the time, place, and contents of the false representation; (2) the identity of the person making the representation; and (3) what the person intended to gain by making the representations.

The Court of Chancery held Sparton did not satisfy the pleading standards for fraud. Some of the reasons cited by the Court include:

  • The complaint does not identify who specifically did what or how they “assisted” in allegedly misstating the invoices or financial statements.
  • Sparton did not specify the invoices at issue or the amounts by which they were doctored.
  • The knowledge requirement was not met because none of the stockholders or optionholders personally represented anything about the accuracy of the financial statements, signaling they were not in a position to know the veracity of the statements.

The United States District Court for the District of Minnesota considered the application of the fiduciary duties of directors in the context of a merger under the Minnesota Business Corporation Act. The case, Lusk et al v. Akradi et al, involved the acquisition of Life Time Fitness, Inc. by a group of private equity firms, referred to as the Buyout Group.

Life Time initially considered the benefits of conversion to a REIT. Thereafter, an unsolicited offer was received, and the Board determined to solicit other bids. A special committee was formed consisting of independent and disinterested directors. The special committee permitted Bahram Akradi, Lifetime’s Chairman of the Board, President and CEO, to solicit bids. The special committee “discussed their beliefs that potential bidders were more likely to submit the highest bids possible if they were permitted to discuss potential arrangements with senior members of Life Time’s management team and that such discussions could be helpful in connection with arranging financing for a transaction.” The Special Committee allegedly “permitted Akradi to negotiate the terms of a rollover investment and his continued employment at the surviving company with potential buyers.”

In the final negotiations, Party A delivered a revised proposal with an offer of $72.00 per share, but did not provide a rollover investment or continued employment for Akradi. The Buyout Group also submitted a bid of $72.10 per share and requested Akradi roll over $125 million in equity. The Special Committee and the Board both unanimously approved the merger with the Buyout Group.

Claims against the Board

Life Time’s articles of incorporation exculpated its directors to the fullest extent permissible under Minnesota law. Accordingly, any breach of fiduciary claim against the Defendants sounding in “negligence or even gross negligence” arising from the merger would fail as a matter of law because “such allegations would constitute only a breach of the exculpated duty of care.” Plaintiffs argued they pleaded non-exculpated breach of loyalty and good faith claims against the Board and Akradi.

Plaintiff’s sole allegation that members of the Board, other than Akradi, violated the duty of loyalty was the acceleration of director equity awards as a result of the merger. The Court rejected this claim, noting that the acceleration aligned the directors’ interest with Life Time’s shareholders, as the Board was entitled to merger consideration with the “same terms and conditions as applied to holders of Life Time common stock.” The Court noted that Delaware courts repeatedly hold that vesting of stock options during a merger is not a breach of the directors’ duty of loyalty.  The Court held the Board had an incentive by virtue of their stock options to obtain the maximum merger consideration. Such an incentive aligns the Board with the shareholder interests.

As to the good faith claim, Plaintiffs alleged that the Board acted inappropriately by: failing to allow a bidding war between Party A and the Buyout Group; failing to consider REIT analyses; abdicating the sales process to Akradi; and agreeing to deal protection devices with the Buyout Group.

With respect to Plaintiffs’ allegations that the Board failed to allow a bidding war or consider REIT analyses, the Court noted the law is clear that the Board is not liable for failing to carry out a perfect process, which would at most lead to an exculpated duty of care claim. Life Time’s proxy statement disclosed that the Board sought highest and best offers from Party A and the Buyout Group, Party A indicated that its best and final offer was $72.00 per share, and the Board relied on financial analyses that indicated $72.10 was fair merger consideration. The Court noted Plaintiffs’ allegation that the Board ignored the value of Life Time’s real estate conflicted with the proxy statement’s disclosure that the Board met with the financial advisors to discuss the two merger proposals as well as a REIT conversion, and considered the REIT analyses as well as the “uncertainties and risks associated” with a REIT conversion.

The Court also found the Board did not breach the duty of good faith by allowing Akradi to privately negotiate terms with bidders. According to the Court, “it is appropriate for a board to enlist the efforts of management in negotiating a sale of control,” and “[i]t is well within the business judgment of the Board to determine how merger negotiations will be conducted.”

Finally, Plaintiffs asserted that the Defendants improperly adopted deal protection devices such as a no-solicitation provision, a matching rights provision, and a termination fee. The Court described the devices as routine that may sometimes be necessary to secure a strong bid.  The Court held adopting deal protection devices alone is not enough to rise to a level of “sustained or systematic failure of the board to exercise oversight” to satisfy a breach of good faith claim.

Claims against Akradi

Plaintiffs alleged Akradi had a conflict of interest with Life Time’s shareholders because, instead of pursuing a REIT transaction, Akradi forced an undervalued sale to his favored bidder to ensure his continuing interest in the surviving company.

The Court found that, pursuant to Minn. Stat. § 302A.255, the disinterested Life Time shareholders ratified the transaction, precluding a breach of loyalty claim against Akradi. Minnesota Statute § 302A.255, subd. 1, provides that “[a] contract . . . between a corporation and an organization in or of which one or more of its directors . . . have a material financial interest, is not void or voidable because the director or directors or the other organizations are parties” if the “material facts” of the transaction and the director’s interest are “fully disclosed” and the transaction is approved by an affirmative vote by two-thirds of disinterested shareholders entitled to vote.  It was not disputed that that the disinterested Life Time shareholders – excluding Akradi’s and the Board’s shares – approved the transaction, with 81.65% voting in favor.

The Court observed that although Minn. Stat. § 302A.255 does not define or explain what it means to fully disclose a material fact for purposes of shareholder ratification, Minnesota courts addressing materiality for breach of fiduciary duty claims have turned to federal law. In a ruling earlier in the case, the Court had already addressed and dismissed Plaintiffs’ federal securities law claim that the proxy statement allegedly omitted the full terms of Akradi’s rollover agreement. The Court found that the “[s]hareholders had substantial information about Akradi’s Rollover Agreement . . . and the proxy painted a ‘sufficiently accurate picture so as not to mislead.'” Thus, paralleling federal securities law, the Court found that by virtue of the proxy statement, the shareholders were duly informed about Akradi’s conflict of interest for purposes of Minn. Stat. § 302A.255.

Development International has released its annual survey of conflict minerals reports for the 2016 reporting period which were filed in 2017. Despite the SEC’s no action position which relaxed conflict minerals reporting obligations, many issuers continued to file conflicts minerals reports in accordance with previous SEC guidance. The survey notes the following:

  • 1,153 issuers filed a conflict mineral disclosure (CMD) describing their due diligence on conflict minerals in their supply chains. The survey noted an overall 5.6% drop in companies filing a CMD vis-à-vis reporting year 2015.
  • 125 issuers did not file a 2016 Conflict Mineral Report (CMR), which had done so for the previous year. 30 of these 125 former CMR filers did submit a Form SD, whereas 95 did not file anything for RY2016.
  • 16 companies opted to undertake an independent private sector audit (IPSA) for 2016, representing three fewer companies than in 2015 (one of which, however, was acquired in 2016 and no longer subject to SEC filings). Eight companies specified their product(s) was/were DRC conflict free without having undertaken an IPSA. Four companies had an IPSA performed but did not make a DRC Conflict Free claim.
  • Issuers continued to report implausible countries of origins for conflict minerals. For instance, 113 filers reported Hong Kong or Singapore as likely counties of origin of conflict minerals in their supply chains.

In June, Treasury issued a report noting that it believes duties imposed on bank boards are too voluminous, lack appropriate tailoring, and undermine the important distinction between the role of management and that of boards of directors. The Board of Governors of the Federal Reserve System is now requesting comment on a corporate governance proposal to enhance the effectiveness of boards of directors.

The Fed’s proposal would refocus the Federal Reserve’s supervisory expectations for the largest firms’ boards of directors on their core responsibilities, which will promote the safety and soundness of the firms. Boards’ core responsibilities include oversight of the types and levels of risk a firm may take and aligning the firm’s business strategy with those risk decisions. Additionally, the proposal would reduce unnecessary burden for the boards of smaller institutions.

The corporate governance proposal is made up of three parts. First, it identifies the attributes of effective boards of directors, such as setting a clear and consistent strategic direction for the firm as a whole, supporting independent risk management, and holding the management of the firm accountable. For the largest institutions, Federal Reserve supervisors would use these attributes to inform their evaluation of a firm’s governance and controls. Second, it clarifies that for all supervised firms, most supervisory findings should be communicated to the firm’s senior management for corrective action, rather than to its board of directors. And third, the proposal identifies existing supervisory expectations for boards of directors that could be eliminated or revised.

As is usual in the doldrums of summer, ISS has released its 2018 policy survey which generally foreshadows changes to ISS’ voting policies. In prior years, not everything on the survey resulted in a new voting policy.  Likewise, there could be some new voting policies not discussed in the policy survey.

The highlights from the 2018 policy survey include:

    • Gender Diversity on Boards. ISS is soliciting information on gender diversity on Boards. ISS notes the focus on gender diversity in corporate boardrooms has increased in numerous markets in recent years. Many of these markets have implemented enhanced disclosure requirements, best practice recommendations or regulatory quotas to drive increased female representation on public company boards. Despite this heightened attention, there have been varying levels of progress amongst companies in increasing the number of female directors on boards and some institutional investors continue to express frustration with a perceived lack of progress in boosting gender diversity in certain markets or industry sectors.
    • Share Issuance and Buyback Proposals. ISS is soliciting information about share issuances and buyback proposals. ISS notes its 2018 Governance Principles Survey Rules regarding shareholder approval of share issuances and buybacks vary by market. ISS notes US listing rules do not require shareholder approval for share repurchases, and only require shareholder approval for share issuances in excess of 20 percent of issued capital where such issuances are private placements at a price below book value or market value, or where the issuances will result in a change of control or are in connection with an acquisition. Any other share issuances, up to the number of shares authorized in the charter, do not require a shareholder vote. By contrast, many European markets in principle require shareholder approval of all share issuances and share buybacks, but allow companies to seek approval for annual mandates covering share issuances during the coming year, up to a specified percentage of issued capital, or share buybacks during the coming year.
    • Virtual/Hybrid Meetings. ISS is soliciting information about virtual and hybrid meetings. ISS notes in the US, UK and some other markets worldwide, companies are permitted to use electronic means of communication to facilitate the participation of shareholders at general meetings. In some cases, companies may employ technological means to allow such participation as a supplement to the physical meeting (these are known as “hybrid meetings”), while in other cases the “virtual shareholder meeting” entirely supplants the physical meeting. In the UK, a number of companies have sought or are seeking shareholder approval to amend their articles of association in order to be able to hold hybrid or virtual-only shareholder meetings. In the US, companies have generally made the switch to a hybrid or virtual-only meeting without a shareholder vote, following changes in state laws on the matter.
    • Pay Ratio Between Senior Executives and Employees. ISS is soliciting information about the SEC’s pay ratio rules. ISS Notes beginning in 2018 (unless the rule is repealed prior to implementation), U.S. issuers will be required to report in their proxy statement the ratio of CEO pay to the pay of the median company employee. Similar rules have been proposed in the UK, where companies are already required to compare the year-on-year percentage change in compensation between the CEO and other employees (though long-term incentives are excluded). The EU Shareholder Rights Directive, which member states will have to incorporate into their local laws by 2019, requires disclosure of the annual change in each executive’s pay over five years, along with company performance and the change in average employee pay.

 

The Office of the Comptroller of the Currency is seeking comment to assist in determining how the final rule implementing section 13 of the Bank Holding Company Act, which is referred to as the Volcker Rule, could be revised to better accomplish the purposes of the statute. The OCC’s request is limited to regulatory actions that may be undertaken to achieve these objectives; the OCC is not requesting comment on changes to the underlying Volcker statute.

The OCC’s notice indicates that a report recently issued by the Department of the Treasury identifies problems with the design of the final rule – the inclusion of a “purpose” test for defining proprietary trading, for example. The report also contains recommendations for revisions to the final rule. The OCC’s objective in issuing the notice is to gather additional, more specific information that could provide focused support for any reconsideration of the final rule that the rulewriting agencies (i.e. the OCC, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation and in consultation and coordination with the Securities and Exchange Commission and the Commodity Futures Trading Commission) may undertake and contribute to the development of the bases for particular changes that may be proposed.

The information that the OCC is soliciting could support the revisions to the final rule advanced in the Treasury Report and elsewhere; it also may support additional revisions that are consistent with the spirit of the Treasury Report. In any case, the OCC and the other Volcker rulewriting agencies will need to explain the basis for any changes to the current rule that may be proposed.

In DFC Global Corp. v Muirfield Value Partners, L.P. et al, the Delaware Supreme Court declined to adopt a presumption that in an arm’s length merger the deal price is the best estimate of fair value for purposes of an appraisal rights action.  The Supreme Court also found the Chancery Court erred by not giving appropriate weight to the price paid by a private equity buyer because a sponsor focuses on achieving certain internal rates of return and on reaching a deal within its financing constraints.

DFC was a NASDAQ listed company in the pay day loan business. It had experienced rapid growth in the past and was relatively heavily leveraged. In more recent years, it faced a period of regulatory uncertainty resulting from the financial crisis.

Given the regulatory headwinds, the DFC Board hired a financial advisor to explore a sale. Initially the advisor contacted six private equity sponsors.  None of the six sponsors, together with another party, decided to proceed with the transaction. Over the next year, the advisor reached out to 35 more private equity sponsors and three strategic buyers.  Financial projections provided to the sponsors were revised and lowered during the sales process.  Loan Star ultimately agreed to acquire the Company at $9.50 per share.

In determining fair value, the Court of Chancery, without appropriate supporting rational, gave equal weight to the deal price, a comparable companies analysis and a discounted cash flow analysis. The fair value determine by the Court of Chancery was $10.21 per share.

The Supreme Court declined to adopt a presumption that the transaction price was the best estimate of fair value because it would be contrary to the Delaware appraisal statute. Simply put, the appraisal statute requires the court to consider “all relevant factors” and a presumption would be contrary to the statutory command. It would also be contrary to controlling precedent, as established in Golden Telecom, Inc. v. Glob. GT LP and elsewhere.  The Supreme Court noted however that the sale value resulting from a robust market check “will often be the most reliable evidence of fair value and that second-guessing the value arrived upon by the collective views of many sophisticated parties with a real stake in the matter is hazardous.”

The Supreme Court also rejected the Chancery Court’s finding that the deal price was unreliable because Lone Star, a private equity firm, required a specific rate of return on its transaction with DFC. The Supreme Court found that was illogical because all disciplined buyers, both strategic and financial, have internal rates of return that they expect in exchange for taking on the large risk of a merger, or for that matter, any sizeable investment of its capital. That a buyer focuses on hitting its internal rate of return has no rational connection to whether the price it pays as a result of a competitive process is a fair one. According to the Supreme Court, that was especially true here when there were no conflicts of interest and when there were objective factors that support the fairness of the price paid, including:

  • the failure of other buyers to pursue the company when they had a free chance to do so;
  • the unwillingness of lenders to lend to the buyers because of fears of being paid back;
  • a credit rating agency putting the company’s long-term debt on negative credit watch; and
  • the company’s failure to meet its own projections.

The Supreme Court also found untenable the idea that the deal price cannot be relied upon as a reliable indicia of fair value because lenders would not finance the acquisition by Lone Star at a higher price. Lenders get paid before equity. If lenders fear getting paid back, then that is not a reason to think that the equity is being undervalued.

Given the SEC’s investigative report on initial coin offerings, I thought it would be interesting to review a small sample to see what else is really out there. I turned to coinmarketcap.com for information. In many cases the offering of coins has been completed.

We have also published a summary titled “When is an Initial Coin Offering a Security?” I omitted describing offerings that clearly appear to be a security from the summaries below.

EOS

EOS.IO is software that introduces a blockchain architecture designed to enable vertical and horizontal scaling of decentralized applications (the “EOS.IO Software”). This is achieved through an operating system-like construct upon which applications can be built. The software provides accounts, authentication, databases, asynchronous communication and the scheduling of applications across multiple CPU cores and/or clusters. The resulting technology is a blockchain architecture that has the potential to scale to millions of transactions per second, eliminates user fees and allows for quick and easy deployment of decentralized applications.

What does EOS stand for? EOS believes that EOS means different things to different people. EOS has received numerous amazing interpretations of what EOS stands for or what it should stand for so EOS has decided not to formally define it.

According to the website, the EOS Tokens do not have any rights, uses, purpose, attributes, functionalities or features, express or implied, including, without limitation, any uses, purpose, attributes, functionalities or features on the EOS Platform.

U.S. citizens, residents and entities are excluded from purchasing EOS Tokens in the token distribution because of some of the logistical challenges associated with differing regulations in the many states of the United States of America. The sponsor does not believe that the distribution of EOS Tokens or the EOS Tokens themselves are securities, commodities, swaps on either securities or commodities, or similar financial instruments. According to the website, EOS Tokens are not designed for investment or speculative purposes and should not be considered as a type of investment.

QTUM

Qtum is a hybrid blockchain application platform. Qtum’s core technology combines a fork of bitcoin core, an Account Abstraction Layer allowing for multiple Virtual Machines including the Ethereum Virtual Machine (EVM) and Proof-of-Stake consensus aimed at tackling industry use cases.

QTUMs are cryptographic software tokens used to engage with distributed applications (“dApps”) and smart contracts on the Qtum platform. QTUMs will serve as the staking currency of the Qtum blockchain and fuel computational operations performed by the Qtum network.

The development and maintenance of the Qtum Blockchain, as well as all services provided by Qtum, are directed and supervised by the Qtum Foundation – a non-profit organization, representing Qtum’s stake and token holders.

Veritaseum

Veritaseum is a smart contracts-based, peer-to-peer wallet interface (in beta) that currently interacts with Bitcoin blockchain (to be ported to Ethereum). It allows non-technical individuals and entities to quickly create, enter and manage smart contracts directly with others without an authoritative 3rd party.

This offering, which is completed, is closest to a prospectus, and includes risk factors.

Veritas are redeemable solely to Veritaseum LLC for various products and services offered by Veritaseum LLC, or to access various features or aspects of the Veritaseum Platform or other Veritaseum LLC software products.

Ownership of Veritas carries no rights, express or implied.

Veritaseum LLC will cooperate with all law enforcement inquiries, subpoenas, or requests provided they are fully supported and documented by the law in the relevant jurisdictions. In accord with one of the core principles of the Veritaseum project transparency—Veritaseum LLC will endeavor to publish any legal inquiries upon receipt.

Gnosis

Gnosis.pm is a decentralized prediction market built on the Ethereum protocol. Gnosis provides an open platform for anyone to predict the outcome of any event and plans to drastically simplify the creation of customized prediction market applications. A prediction market allows users to buy and trade binary positions on the outcome of any arbitrary event.

This website claims instead of building on a rent extracting platform, Gnosis makes it possible to make a one-time purchase of a sufficient amount of GNO tokens and then use the generated WIZ tokens to pay for Gnosis fees. At a very basic level, GNO tokens function as fee credit (WIZ) generation machines. As a result, GNO tokens give access to the platform at a fixed cost, comparable to holding a license.

The site also states GNO tokens are functional utility tokens within the Gnosis platform. GNO tokens are not securities. GNO tokens are non-refundable. GNO tokens are not for speculative investment.

As discussed in a post from last week, the SEC determined that Initial Coin Offerings can be securities. The finding stems from the SEC’s investigation into The DAO’s offering and sale of DAO Tokens (a form of virtual currency that were at times referred to as “Initial Coin Offerings”). Based on a review of the facts and circumstances and the substance and economic realities of the offering and sale, the SEC determined that DAO Tokens were securities; a type of investment contract under Sections 2(a)(1) of the Securities Act and 3(a)(10) of the Exchange Act.

In its report, the SEC presented facts in support of the following three elements required for establishing an investment contract under the Securities Act (See SEC v. W.J. Howey Co., 328 U.S. 293 (1948)): (i) an investment of money in a common enterprise; (ii) a reasonable expectation of profits; and (iii) profits derived from the managerial efforts of others.

DAO Token holders invested money in a common enterprise:

The first prong of the test requires a showing that investors invested money of some form in a common enterprise. As noted in the report, it is not necessary that money be in the form of cash; contributions other than cash, such as Bitcoins and services, have been consider “money”. In the case of The DAO, participants purchased DAO Tokens using virtual currency (ETH), which the SEC found was sufficient to establish that DAO Token holders invested money.

DAO Token holders had a reasonable expectation of profits:

The second prong requires a showing that investors had a reasonable exception of profits. In the report, the SEC noted that marketing and informational materials promoted The DAO as a for-profit entity with an objective of investing in projects in exchange for a return on its investments. Similar materials also informed potential investors that, as DAO Token holders, they could expect to receive dividends and various forms of “rewards”. Based on the information in these materials, the SEC found that DAO Token holders had a reasonable expectation of profits, regardless of whether the rewards could come in the form of goods and/or services.

DAO Token holder profits were derived from the managerial efforts of others:

Under the last prong, facts must support a showing that managerial efforts, other than from investors, are essential to obtaining profits. Central to the review is whether such efforts will “affect the failure and success of the enterprise.” In the report, the SEC presented facts establishing that i) The DAO founders (Slock.it) and Curators were essential to The DAO’s operations and success and ii) DAO Token holders could not effectively exercise control over the enterprise. The reported noted that The DAO founders provided expertise and managerial support; actively engaged in The DAO operations, including responding a security breach; appointed Curators who oversaw the DAO Token holder proposal process; and actively monitored and engaged in investor forums. Additionally, the SEC found that DAO Token holders had limited voting rights, which prevented them from effecting meaningful change or control over the enterprise. The SEC specifically identified the voting structure and DAO Token holder numerosity, pseudonymity and dispersion as obstacles to investor influence.

It should be noted that the SEC did not take the position that all coin offerings are securities. The SEC expressly stated that a determination will need to be made based on the facts and circumstances of each case. Based on the facts from the investigation, the SEC decided not to bring charges against The DAO or make findings of violations. The SEC instead cautioned industry and market participants that federal securities laws apply to all those who offer and sell securities in the United States. As The DAO investigation highlighted, such laws extend to traditional companies and decentralized autonomous organizations, securities purchases using standard U.S. currency and virtual currencies, and distributions in certificated form and through ledger technology.