SEC Report Raises More Questions Than It Answers
On July 25, 2017, the US Securities and Exchange Commission (SEC) published its Report of Investigation regarding The DAO. The agency concluded that tokens from The DAO met the criteria of a security and should have been treated as such. Despite finding regulatory noncompliance, the SEC opted not to pursue any enforcement actions in the matter.
In the wake of the SEC’s report, confusion spread in the cryptocurrency community. A few talking heads and mainstream media erroneously claimed that the agency’s findings apply to all cryptocurrencies and tokens. To be crystal clear, the SEC has only said that DAO tokens were securities. Accompanying analysis might be extrapolated to other token offerings, but the agency did not clarify the legal status of any other companies or projects.
However, as posited by blockchain lawyer and legal ambassador of the Delaware Blockchain Initiative Marco Santori, “Many tokens are securities. Those that ICO and return revenue/profits to investors are almost certainly securities.”
Token offerings frequently present a fundraising opportunity for a nascent company. It’s worth noting that blockchain-based securities have already been approved by the state of Delaware.
For now, the SEC’s report means that cryptocurrency, executable distributed code contracts, and blockchain-based tokens may or may not fall under the agency’s purview. The SEC humbly reminds companies and investors that securities must be registered with the Commission – guidance that allows for flexible interpretation down the road.
Let’s start with a simple question: why did the SEC decide against bringing an enforcement action? The agency could have tried to go after The DAO’s “curators,” the founders of Slock.it, or even the exchanges that facilitated the trade of DAO tokens.
Instead, by forgoing expensive and drawn-out prosecution, the SEC prevents the establishment of precedents for token offerings as securities. Classifying digital assets as securities is something that the agency is almost certain to revisit in the future. In the case of The DAO hack, the cryptocurrency community – led by the Ethereum Foundation – managed to resolve the issue of investor protection through a hard fork, so there was no real need for the SEC to intervene.
But, suspend disbelief for just a moment. There are other important questions to consider.
What if The DAO had been successful? How would the SEC have dealt with its securitization?
The agency stated that somebody should have registered the DAO tokens as a security. But who? In an open-source project, there are dozens, if not hundreds, of contributors and developers. By not bringing an enforcement action, the agency avoids legal entanglements that may take years to resolve through the courts. By decreeing that tokens offered in a token offering must be registered, but not addressing how Dapps ought to register, the SEC has hit the tennis ball into the crypto-community’s side of the court.
Will exchanges delist various tokens after the SEC’s announcement?
To learn the perspective of exchanges, ETHNews reached out to Aurélien Menant, founder and CEO of Gatecoin, a bitcoin and Ethereum token exchange based in Hong Kong and regulated by the Hong Kong Customs and Excise Department, who said:
“As we are not based in the US, have no operations in the country and only onboard residents from a limited number of US states based on communications with individual state regulators which allow crypto-crypto or fiat-crypto exchanges without an MSB license, the SEC’s report will have no impact on which tokens we are able to list on our exchange,” said Menant. “Moving forward, we will also implement a feature that will not allow our small number of US resident clients to trade ICO tokens. We will, however, continue to allow our US resident clients to trade bitcoin, Ethereum and other non-ICO cryptocurrencies.”
International exchanges must account for American customers, and by extension American securities law. Luckily for these international exchanges, American clients are just a small fraction of their customer base. By comparison, American exchanges, which have more American customers, might find their operations hampered by the SEC’s report.
Reacting to the SEC’s report, US-based exchange Bittrex issued a statement.
“Prior to listing any new token, Bittrex performs… facts and circumstance analysis and considers if a token might be deemed a security under the Howey Test, prior to listing. We strive to only list ‘use’ tokens or tokens which represent a good or service. We conduct a thorough compliance review to avoid listing tokens that may be deemed a security. We believe this is industry best practice and we are pleased that the SEC Report reaches a similar conclusion.”
Kraken and Poloniex (also based in the United States) have not yet replied to requests for comment.
Unfortunately, exchanges could be the biggest losers following the SEC’s report. Service providers are left uncertain whether they are operating within the bounds of American securities law. Bittrex, for example, might try to weed out tokens, but the company could make an inaccurate judgment and be subject to reprimands or fines by the SEC. Given the decentralized nature of tokens, holding developers liable is challenging. Decentralized exchanges present an even more complicated set of circumstances. Meanwhile, centralized exchanges are known entities, and thus have regulatory targets on their backs.
The overarching question is whether Ethereum itself remains immune from SEC regulation. Will the SEC classify Ether as a security? As has been noted countless times, the purpose of Ether is to pay transaction fees inside the Ethereum network.
From a technical perspective, the Proof-of-Work model for mining is evidence that members of the network are contributing to the managerial effort of Ethereum. Apart from its decentralized nature, Ethereum is distinguished by the utility of its executable distributed code contracts. The Ethereum blockchain is a work in progress and it would be foolish to regulate away potential innovation.
If the SEC classifies tokens and coins as securities, then investors might receive greater protections through disclosure and registration requirements. On the other hand, over-regulation could stifle development. If we’ve learned anything from the SEC’s report, it’s that, despite the absence of meaningful direction, the agency has been appropriately cautious in its tactics. The SEC must continue to walk a fine line between upholding its mission and allowing for the evolution of financial technology.