DBF Special Report

Hi Degens!

Today we bring to you a special report in collaboration with one of our newest ambassadors, Lynx. If you’re in our discord or follow our twitter, you would’ve noticed Lynx around and the DBF account re-tweeting several of Lynx’s educational and informational threads. If you haven’t yet, give her a follow! https://twitter.com/LynxHelek

In today’s report, Lynx takes us through a deep dive into the latest hot topic in the web3 space — the SEC’s investigation into Yuga Labs and Ape Coin.

NFTs are Dead! Long live NFTs!

A policy analysis of Securities and Exchange Commission review of Bored Ape Yacht Club

Authored by Jo Marquardt, also known as Lynx Helek

  • A Quick Review of Yuga Labs, ApeCoin, and Otherwise
  • A Concise Summary of Law — The Securities Act of 1933 and The Howey Test
  • Brief Summary of Precedent — Paragon Coin (PRG) and BlockFi Lending
  • Thoughts Based on Precedent
  • Disclaimers
  • References

A Quick Review of Yuga Labs, ApeCoin and Otherside

Matt Robinson recently published an opinion piece in Bloomberg, a popular finance media outlet, regarding the recent SEC interest in Bored Ape Yacht Club and its community activities. Yuga Labs is the parent company that launched Bored Ape Yacht Club, Mutant Ape Yacht Club, Bored Ape Kennel Club and subsequently purchased the rights to CryptoPunks NFTs.

The real conversation, however, hinges around the ApeCoin DAO, Ape Coin and Otherdeed NFTs. If purchasers of any of these tokens (including NFTs) had reason to believe they would derive profit in the future, then reasonably Matt Robinson has made the appropriate argument that these tokens should be registered as securities with the SEC.

However, this scenario is not that simple. The ApeCoin DAO is responsible for creation of Ape Coin and Yuga Labs denies responsibility for the creation of the DAO despite receiving Ape Coin from the DAO and adopting Ape Coin as the token for its upcoming metaverse known as Otherside. This will be an interesting case test to see if a reasonably decentralized entity, such as the Ape Coin DAO, can be subjected to SEC regulations. If the DAO is reasonably decentralized, then they may be able to win the argument that the DAO is not an entity subject to US securities requirements because it cannot be proved that the DAO exists within the United States. It seems this is a question of jurisdiction and not a matter of form.

Additionally, there are undertones that the Otherside NFT offering by Yuga Labs created a fractionalized security in that the land for the metaverse was parceled up and sold in parts to the community.

In short there are several topics that are expected to be explored by the SEC in its probe:

  1. Is Ape Coin DAO really independent of Yuga Labs?
  2. Is Ape Coin DAO sufficiently decentralized to skirt the requirements to register with the SEC?
  3. Did purchasers of NFT offerings by Yuga Labs have a reasonable expectation to receive profits?
  4. Do Otherdeed NFTs constitute fractionalization and thereby are they subject to securities requirements?

A Concise Summary of Law

The Securities Act of 1933

Section 2 of The Securities Act of 1933 provides a lengthy definition for what constitutes a security. In brief, anything that looks like profit sharing agreements, or has anything to do with profit could fall under the definition of a security. In the section below, we will see that most NFT and crypto projects have run afoul of sections 5(a) and 5(b).

Sections 5(a), 5(b) and 5(c) indicate that if there is a security, the statement describing the security must be registered with the SEC before any means of communication about the security occurs. Additionally, the registered statement must be present in the communication. This would include social media marketing. Keep in mind that The Securities Act of 1933 only governs transactions where the transaction occurs across state lines. It is recommended to consult the rules within the organization’s home state for intrastate communications regarding securities. (15 U.S.C. § 77a et seq. 2019)

The Howey Test

In 1946, the SEC sued Mr. W.J. Howey. He was a fruit farmer and created a cooperative and agreed to share the proceeds of the fruits sold back to the other farms that participated in the cooperative. It was determined that he had created a security through the profit sharing agreements and thus did need to comply with SEC regulations. If “there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others” (US Supreme Court 1946) then it is a security and it does need to comply with SEC regulations.

Brief summary of Precedent

November 16, 2018: Paragon Coin (PRG)

Paragon Coin is an unfortunate but prime example of the lack of expertise in the legal industry for tokens. They sought to launch a token that would support efforts to legalize cannabis in the United States. Even under legal guidance, they still found themselves to be the target of an SEC investigation. The SEC enforced penalties under Sections 5(a) and 5(b) of The Securities Act of 1933 for not having registered the token before minting the token and for not having the proper statement regarding being a registered security on the materials related to the mint. Paragon was to refund the original investors the mint price for the token less any income the original investors received from subsequent resales (Securities and Exchange Commission). Paragon was unable to refund all the monies due to original investors and subsequently filed for bankruptcy (Paragon). Penalty was assessed a penalty of $250k USD.

Operating Recommendations from this summary:

  1. Be prepared to fully refund the original mint proceeds on an offering, or offer a free mint.
  2. Legal counsel must include expertise in securities law
  3. Seek guidance from the SEC prior to initial token offering
  4. If registration of a security is appropriate, verify all marketing materials, websites, tweets, etc. contain the required and SEC approved statement regarding such security.

September 2022: BlockFi Lending, LLC

BlockFi Lending offered BlockFi Interest Accounts (BIAs) to customers of its platform. In exchange for lending crypto to BlockFi’s custodial wallet, which BlockFi then would lend to institutional borrowers and invest in interest earning assets, BlockFi promised a variable interest rate of return on the assets to the individual.

The SEC found that BlockFi did not register as an Investment Company and did not qualify for the exclusion provided for market intermediary (Securities and Exchange Commission, 2022). BlockFi Lending has stopped offering BIAs to customers in the United States (Learn, n.d.). United States customers can no longer make new deposits to BIAs and existing BIA assets for United States investors have been released from the lending protocol. Penalty assessed was $50M USD.

Operating Recommendations from this summary:

  1. Do not assume that market intermediary exclusion noted in section 3(c)(a) of the Investment Company Act apply when operating a lending protocol. Seek confirmation from SEC of exclusion.

Thoughts based on precedent

The SEC is not yet concerned with all NFTs, or even tokens for that matter. The scope of their interest as of late has resided on whether or not consumers had a reasonable expectation to receive profit from purchase of the NFT or subsequent utilities provided to the NFT owners. If the NFT is just art and is being considered art, then one may reasonably argue that it would not be a security and is not subject to the SEC. But when airdrops, percent interest earnings, or statements on websites or social media are made that would imply the consumer has a reasonable expectation to profit from the ownership of the NFT or token, then it falls within the scope of SEC securities regulations. As much as those in web3 may differentiate an NFT from a token or coin, under regulation to date, a token is a token is a token whether it is fungible or not.

If the BlockFi, LLC findings have any implication to the situation at hand, which they might not, then we might expect to see Ape Coin no longer offered in the United States through various exchange platforms until Ape Coin becomes compliant with the SEC and has the approved language attached to its public offerings. The bigger concern though still remains as this: if there is a finding by the SEC, who is responsible for the bill… Yuga labs or Ape Coin DAO? Additionally, how large will the penalties be for such a finding and will the entity fined be able to continue to operate after remediation. As we saw with Paragon Coin, the entity behind the offering found it necessary to file for bankruptcy.

If the SEC is unable to make a finding, Yuga Labs and Ape Coin DAO may have just handed the web3 community a blueprint for the creation of large scale projects that avoid the complications of securities regulations in the United States. The devil is in the details though and many projects in the future will fail in attempting to follow in the footsteps of what would become Big Yuga.

If you made it this far, thanks for reading the latest DBF Special Report!

About Us: Degen Brain Finance (DBF) is a Learn2Earn, NFT, and DeFi Platform that aims to raise the IQ of crypto investors.

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Disclaimer

Under penalty of law, it is illegal to practice law in the State of Texas or to provide legal recommendations without a license to practice law from the State Bar or without the supervision of an attorney. Any information contained within this article is to be construed as a policy analysis and a precedent brief. This is not legal or financial advice. Please consult with the appropriate licensed advisor.

Limited Permissions under Copyright

Limited permissions are hereby granted for reproduction of this article for educational purposes. The ownership of this article belongs to LynxHelek, LLC, a limited liability company registered in the State of Texas. Degen Brain Finance has licensed the content of this article for initial publication. Further republication of this article is permitted in the public domain with the following stipulations:

  1. The original author is to be credited as Lynx Helek
  2. A link to the original article should point to the publication found on Degen Brain Finance Medium page
  3. Do not derive profit from reprinting

Go forth and educate the world, but if you make profit from this article, send me the proceeds please! LynxHelek.eth I’ve got bills to pay. Thanks!

References

15 U.S.C. § 77a et seq. 2019. “SECURITIES ACT OF 1933 [References in brackets ø¿ are to title 15, United States Code] [As Amended Through P.L. 115–174, Ena.” GovInfo, October 2, 2019. https://www.govinfo.gov/content/pkg/COMPS-1884/pdf/COMPS-1884.pdf.

“Learn.” n.d. BlockFi. Accessed October 12, 2022. https://blockfi.com/learn/blockfi-news.

Paragon. 2020. “Paragon Coin Bankruptcy — (PRG).” Paragon Coin Bankruptcy — (PRG). https://paragoncoin.com/.

Robinson, Matt. 2022. “US SEC Investigates Bored-Ape’s Yuga Labs Unregistered Digital Assets Sales.” Bloomberg.com, October 11, 2022. https://www.bloomberg.com/news/articles/2022-10-11/bored-ape-creator-yuga-labs-faces-sec-probe-over-unregistered-offerings.

Robinson, Matt. 2022. “US SEC Investigates Bored-Ape’s Yuga Labs Unregistered Digital Assets Sales.” Bloomberg.com, October 11, 2022. https://www.bloomberg.com/news/articles/2022-10-11/bored-ape-creator-yuga-labs-faces-sec-probe-over-unregistered-offerings.

Securities and Exchange Commission. 2022. “BlockFi Lending LLC.” SEC.gov, February 14, 2022. https://www.sec.gov/litigation/admin/2022/33-11029.pdf.

Securities and Exchange Commission. 2022. “Proposed Plan of Distribution.” Administrative Proceeding File no. 3–18897, October 3, 2022. https://www.sec.gov/litigation/admin/2022/34-95965-pdp.pdf.

US Supreme Court. 1946. “SECURITIES & EXCHANGE COMMISSION v. W.J. HOWEY CO. ET AL.” https://scholar.google.com/scholar_case?case=12975052269830471754&q=SEC+v.+W.J.+Howey+Co.,+328+U.S.+293+(1946)+(%22Howey%22)&hl=en&as_sdt=6,44&as_vis=1.

Yuga Labs. n.d. “The Otherside Litepaper.” Enter the Otherside. Accessed October 12, 2022. https://otherside.xyz/litepaper.

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