Breaking the Howey Barrier: Uber Inspired Legal Strategy for Ethereum

Sean Pollock
Aug 9, 2017 · 9 min read

It’s June 2014 and Uber is starting to grow fast. They just opened up services in Austin, Orlando, and Miami, marking 128 cities and every continent on the globe. Despite the fact that the “ridesharing” company is illegal nearly everywhere.

“In 128 of our cities, we’ve got regulatory issues in about 128 of our cities”

There is no doubt that the service is orders of magnitude better than the legacy cab industry. You push a button and a car comes. No more waiving your hand in the street and painful credit card + paper receipt checkouts. The new Uber drivers on the block can sign up in a day for no cost and make better margins on each ride.

Meanwhile, cab drivers in New York are paying 100,000 USD for “medallions,” government issued licenses. Literally an ugly sticker that you have to stick to the hood of your car. In fact, the price for these certificates surged to as high as a million dollars just the year prior. Cab drivers have to take out loans to finance the purchase, and often never overcome the interest rate treadmill.

The cab industry is regulated by the government in almost every country, and there are explicit laws prohibiting such competition. Municipalities and federal governments around the world begin to crack down, and pass litigation trying to enforce things like mandatory insurance policies and finger-print background tests on Uber drivers.

Starting to sound familiar? So how did Uber break into a sector that was illegal for all intensive purposes?

The short answer, by completely ignoring regulation. Not only did they push into cities without the legal O.K., they opposed legal opposition and refused to compromise on any grounds.

The key to Uber’s success was that it reached users fast enough! Before the slow tide of litigation followed several years later. Since the general population could clearly see the benefits of the technology, it made the legal front a winnable battle.

SEC Reports DAO Tokens are Securities

The day has come. The SEC filed its report on the DAO and has concluded that the DAO tokens were indeed securities.

Under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).

Anyone or any “virtual” organizations involved in token sales are required to register with the SEC or file for exemption. Also any exchange facilitating the trading of tokens within the United States must also register with the SEC or file for an exemption.

One of the biggest problems is that regulation comes with expensive legal and auditing work. The average tech IPO today in the US raises around 100 million with 10 million going to legal and financial costs. Most of the fees go to underwriters who take on average 7% from the total amount raised. The next big chunk goes to external auditors and SEC counseling which can cost on the order of millions. There is also continual compliance costs for external auditing and quarterly earnings reports.

We are already a far cry from the free and automated future blockchains can offer.

The SEC also has a tight grip on the exchange approval process, just ask the Winklevi! The big exchanges like Nasdaq have absurdly high barriers to entry: at least 45,000,000 market cap and 450 share holders. This makes only the biggest companies suitable candidates for an IPO, also known as crowd funding…

Say goodbye to anonymous ICO contributions and startup crowd funding. And hello to underwriters, external auditors, legal and financial reporting, and heavy advisory fees. Oh my!

Loopholes?

The Jobs Act passed in 2012 made an attempt to reduce SEC restrictions to open up room for legal crowd funding. However, the associated regulation makes it pretty much worthless. You can only raise up to $1 million and max individual contributions of $2,000.

There has got to be another way, right?

Lets take a glance at Regulation D for circumstances where we can avoid the painful SEC registration process.

[504] Sales are capped at 1 million. The company cannot solicit to the general public, no second hand market allowed without registration.

[506] Can raise an unlimited amount. Stocks are restricted for 6 months and resale of unregistered securities is illegal. Can solicit (advertise) only if selling to accredited investors.

506 is the only viable options, but what are these accredited investors?

In short, Accredited investors are people who make $200k or a have a million dollars in assets. This requirement only favors the most wealthy and shuts out 97% of the US population from investment opportunities. Furthermore, it would be illegal to resell shares without registration putting a barrier against a liquid second hand market.

It is starting to sound like the SEC is even worse than the cab industry!

Time to put on your tinfoil hat?

The report states that the SEC will regulate on a “case by case” basis. If you are an Ethereum developer based in the United States, I do not blame you if that statement makes you paranoid.

The SEC has a century of legal fodder from the Securities and Exchange Acts to the more aggressive Sarbanes Oxley which considers failure to register with the SEC a highly punishable white collar crime.

The US gov also has the Computer Fraud and Abuse Act in its arsenal. There is a lineage of aggressive use of this law in the cases of Aaron Schwartz and Sergey Aleynikov. It would not be a stretch to see this applied to blockchain protocols, especially privacy perserving features.

But wait, chill! Utility tokens are not considered securities so we are fine, right?

The Howey Test

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

Realistically under this definition, almost all ERC20 tokens released this year would be considered securities. Even some of the so called “utility” tokens could be easily classified as securities.

Take Augur’s REP as an example. REP holders invest money (ETH) and expect to see profits. Augur is the common enterprise, and profit is coming from prediction market participants on a software platform developed by the efforts of a third party.

Utility Token Bias

The immediate danger of this ruling is that developers will bias towards “utility” tokens to avoid legal scrutiny from the SEC.

There is a case for utility tokens in protocols that require a programatic monetary policy to function, like mining incentives through an inflation schedule. Although not necessary, voting or casper style staking could also benefit from a native token, because it reduces the burden of forex calculations.

However, in many circumstances tokens with native voting or staking mechanism are unnecessary or poor design decisions. Especially since these token holders are still primarily humans, it requires active participation on the act of the token holders to vote or participate in the staking procedure.

REP holders have normal jobs like software engineering and don’t want to sit around all day reporting on prediction markets. The most attractive investment classes are securities which offer passive income and lead to proper specialization of labor.

Token Abstraction

The utility token bias will cause issuers to entangle identity of the company that is producing the software with some utility in order to avoid Howey classification. Now there are arguments for and against economic abstraction, and I admit my bias is towards the former. But, we should not allow regulation to make the decision for us.

Even if a utility token is necessary it would be advantageous to separate out the utility token from the fundraising token. Having multiple incentive structures on one asset is a recipe for disaster.

Take Ethereum for an example of such messy entanglement:

Transactions on the EVM do not allow for economic abstraction, meaning you have to purchase Gas with Eth and Eth only. The price of Eth is no longer simply determined by speculation on the value of Ethereum as a software platform, but also fundamentally tied to the utility of purchasing Gas for computation.

Imagine a world where the EVM is at full capacity (like two years from now) causing the price of Eth to respond to the shortage of computational resources. Now holders of Eth are happy benefiting from the increased pressure on the currency which will push the price higher. Users who pay for transactions are not as happy…

Good news! The Ethereum foundation finishes the first sharding protocol that results in a 10X increase in throughput. Bad news! This would directly correlate with a 1/10 decrease on the utility valuation of Eth due to the inflation of computational resources into the ecosystem. Do you think Eth speculators will be aligned with users at this point?

Multiple Series Game

If we analyzed the game theoretics of the uber legislation in Austin TX, we might be baffled as to why Uber and Lyft pulled out.

Lets say Uber gets 100 profit without fingerprint mandates and 90 profit with the regulation. Now if they pull out of the city they would be getting, well nothing.

So why in the hell would they leave?

Because it is not just a one time game. If Uber would have stayed, it would be a signal for future legal battles in other municipalities. And if this game were to be simply repeated in 10 other cities, they would be losing! If you have ever been to ATX, you know just how painful this is. In fact the municipality has recently conceded and Uber is coming back on its own terms.

Likewise, the way the Ethereum community acts in response to the US SEC regulations is a signal to other governments elsewhere. If we show we are willing to accept any legal regulations bestowed, they will start to pile on elsewhere.

Luckily, unlike Uber which relies on huge metal boxes blatantly traversing the streets in plain site. Ethereum users can interact anonymously and there is virtually no way to censor a blockchain. Under legal pressure the game theoretic optimum is not to pull out, but rather continue as “banned but operating.”

General Washington Crossing the Delaware

Fast forward to now and it is clear that ridesharing has won against the regulated cab industry. Almost every urban metroplex now benefits from effortless and more efficient transportation. Try to even imagine a world without Uber.

If Uber would have succumbed to legal pressure, our progress as a society would have been stunted in a big way. As Ethereum developers, entrepreneurs and users we should take note of Uber’s success and not prematurely concede to regulation. Remember, the key is spreading fast enough so ordinary people recognize the benefits!

This is much bigger than ridesharing or transportation.

We have chance to create a financial-legal infrastructure on the internet that is free. Free from accredited investing, free from lawyer/auditor fees, free from capital restrictions, free from excessive taxation. Free!

Many of us look nostalgically at the progress of the internet. The peer to peer TCP/IP “web” quickly devolved into big companies owning client-server architectures. Let’s not let this happen with advent of blockchain protocols.

The legal process is slow to our advantage. We have a 2–3 year window in which to pull off the ultimate heist. The clock is ticking. This change will only occur if we are able to gift this technology to the masses before the law catches up.

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