Size Does Matter — Part 3

A Philosophy of Securities Laws for Tokenized Networks

Dec 27, 2019 · 20 min read

Thanks (in no particular order) to Ameen Soleimani, Peter Pan, Marc Goldich, Drew Hinkes, Olta Andoni, Marc Boiron, Lewis Cohen, Grant Gulovsen, Adrian Cortez, Jake Brukhman and the rest of the Hardcore CryptoLaw crew for feedback on the ideas in this Part 3.

What Are “Blockchain Foundations”?

As we discussed in Part 2, the Exchange Act is huge and multifaceted might apply to various tokenized open networks in multifarious and variegated ways. I cannot comprehensively speculate on all of them in one article (not even a multi-part article).

What I’d like to do is focus especially closely on something very weird and unique to the blockchain world — the integral role of “Foundations” — and then discuss how they would be affected if the Exchange Act applies to them.

A blockchain technology “Foundation” is typically (not always) an organization that:

  • is allegedly run on a not-for-profit basis
  • serves as a steward of a blockchain protocol (usually with a focus on one particular network instantiating that protocol — e.g., the Ethereum mainnet in the case of the Ethereum Foundation)
  • is funded directly or indirectly by the sales of pre-mined network tokens to the general public or a narrower group of sophisticated investors
  • is staffed, or at least led at an executive level, by the developers who first launched that protocol/network
  • holds, and is staffed and/or led by individuals who also personally hold, a very material amount of the pre-mined network token — in the case of the Foundation, as its “treasury” and source of continued funding, and in the case of the individuals managing the Foundation, as part of their personal wealth
  • uses funding to directly or indirectly pay people to continue research and development for, or encourage adoption of, the protocol/network — which may be achieved through grants, investments, commercial partnerships or direct hiring

It appears to me that many blockchain Foundations, such as the Ethereum Foundation, the Tezos Foundation, and the MakerDAO Foundation, fit all or most aspects of this basic pattern. Let’s call that pattern the ‘prototypical blockchain Foundation’.

Interestingly, some for-profit companies, like Block.One, also would fit the prototypical blockchain Foundation pattern, but for the fact that they choose to operate on an expressly for-profit basis rather than styling themselves as non-profit Foundations. There are also some blockchain Foundations that significantly deviate from the prototypical pattern— for example, the ZCash Foundation is not funded by ICO proceeds but by donations from the recipients of a post-network-launch founders’ reward generated gradually by the protocol. Now that the founders’ reward is over, the protocol is being updated to give the ZCash Foundation new block rewards directly. The Electric Coin Company has similar funding, but operates on a for-profit basis and may work on multiple blockchain projects rather than ZCash alone. There also are other types of for-profit companies that are highly influential on certain protocols/networks, but arose significantly after network launch and/or have a much more diversified L2 or enterprise application focus — companies like Blockstream and ConsenSys could be viewed in this light. It would also be interesting to analyze the regulatory considerations around all these slightly different types of companies and Foundations, but in the interests of time/space/attention, I am not going to deal with them here. Instead, I will focus on the prototypical blockchain Foundation.

When will a prototypical blockchain Foundation be a securities issuer? When will it be a securities issuer that is subject to reporting obligations under the Exchange Act? What are the implications of this potential reporting status, and is it good or bad for the technology? Should the reporting obligations stop at some point — at the point of “sufficient decentralization”?

Let’s talk about all these things.

A Prototypical Foundation

To avoid throwing shade on specific projects, let’s take a hypothetical Foundation with the following fact. Some of the details listed below are not directly relevant to this Part 3, but will become more relevant in Part 4 when we discuss the process of “sufficient decentralization”. Feel free to skim for now.

  • Power Foundation raised $50M by selling network tokens (PowerCoins) for PowerChain to the public
  • the token sale was done based on a whitepaper which set forth the following roadmap for tech development: (a) launch as a Nakamoto-consensus PoW blockchain (b) add private transactions after launch (c) switch to a new consensus algorithm and leader-selection mechanism that enables the developers and users of DAPPs to receive block rewards→”(b)” will make PowerCoin a little more valuable but not that much more because there are many competitors with privacy solutions; by contrast, “(c)” is expected to ultimately make PowerCoin enormously more valuable because all DAPPs will want to be on PowerCoin to gain extra revenue from block rewards, fueling network effects
  • there was no KYC done on token buyers; Power Foundation has no idea who they are, where they live or whether they are “accredited investors,” but does suspect there are likely to be over 1,999 buyers, many of whom are in the U.S.
  • the Foundation used $1M of the token sale proceeds to develop a single software client embodying the protocol, the MegaZord
  • the Foundation funds a team of four full-time developers to maintain and improve MegaZord
  • all nodes on the Power network are powered by MegaZord
  • the Foundation also has a full-time marketing and finance department
  • the tokenomics are as follows: 100M total maximum supply (pre-mine and future mining combined); 20M supply at the time of the Token Sale (all pre-mined); 7M of pre-mine was sold in the Token Sale; 3M of pre-mine was rewarded to founders/developers who work for the Power Foundation; 10M of the pre-mine is being retained by the Foundation to fund future marketing and development
  • so, right after the Token Sale, the Foundation holds 50% of the current supply of the token, insiders of the Foundation hold 15% of the current supply of the token and the general public holds 50% of the current supply of the token; let’s also assume that the inflation rate from block production rewards is pretty low, like 2% / year, so these percentages may be pretty stable for a while
  • the Foundation has a grants group that aims to prospectively fund or retroactively reward developers who build things on top of PowerChain, integrate PowerCoin functionality into existing applications, etc.; many of these grants are paid in PowerCoins out of the Foundation’s stash, but some are also paid in ETH or BTC or USD, and some are paid in a mix of PowerCoins and other currencies

To me, it is pretty simple: at its current stage, the Power Foundations is a business for developing and marketing an open blockchain network. Even if the Power Foundation is not trying to generate profits at the entity level, it is managed by people who stand to profit from the tokens and likely have a strong profit motive.

The Power Foundation is funded by the proceeds of sales of network tokens to people who hoped to profit from them and is holding onto a stash of tokens it hopes to sell in the future after they have increased in value. The proceeds of those sales are what is referred to as “risk capital” in securities law. The token holders expect to achieve profits predominantly from the efforts of the Power Foundation and the people the Power Foundation pays as they continue to develop and market the network.

In my view, these facts make the tokens both “network equity shares” for financial purposes, and securities for legal purposes and they make Power Foundation a securities issuer.

Since the Power Foundation has more than $10M in assets, then if the Power tokens are held by more than 499 unaccredited investors (which they almost certainly are), then the Power Foundation will meet the “size matters” test and be subject to Exchange Act reporting.

What would this look like? Would it be good or bad?

Imagine A World Where Foundations Were Exchange Act Reporters

Let us imagine a world in which the Power Foundation is a “reporting company” under the Exchange Act.

  1. Positive Consequences

First, the positive consequences: token holders and the public would get all of the types of disclosures I listed in Part 2 of this article when I explained the purposes and effects of the Exchange Act. The Power Foundation would be the organization acting as “the securities issuer” in this circumstance. It would need to keep the public up to date regarding its financials, its sales of additional tokens, its governance and compensation arrangements, and any material conflicts of interest on the part executive officers or directors.

It’s hard for me to understand why this disclosure, in and of itself, would ever be anything but a positive thing. It’s also unlikely that an organization would ever provide this level of disclosure voluntarily, and even if it did so, the disclosure would be less trustworthy, because the SEC would not be reviewing the disclosure and discussing it with the Foundation before it is published to ensure it meets quality and credibility standards.

Not only would token holders and the public get more information about the Foundation, but the Foundation would also get more information about the market through regulations such as Section 13 of the Exchange Act. This could be very helpful, especially in the early stages of development. In the early stages, the network is very vulnerable (due to factors such as low token price (and/or hash rate, if applicable), potentially relatively high Gini coefficient, still experimental, etc.). During that early period, anything could ruin the network’s burgeoning network effect; the network must be managed with care if it wishes to reach escape velocity, and the Power Foundation will be able to manage it better if it is more informed about the marketplace.

For example, if Power Blockchain is a PoS network and someone was planning to 51% attack it by accumulating a huge stake, there would be a significant benefit to the fact that the attacker would be legally required to disclose the accumulation and plans once it reached the 5% ownership level. These disclosures would also operate as a natural regulation-based inducement to maintain and increase decentralization, since people accumulating too many tokens must either KYC themselves to the SEC and the public or be breaking the law, neither of which is very appealing.

Section 13 of the Exchange Act is essentially an out-of-protocol “silly whale penalty”: depending on your biases about how decentralization affects price, you might even consider it an added pumpamental for enhancing network equity. Sure, people can always break the law, accumulate, not disclose, and 51% attack anyway — but surely they will at least be somewhat deterred if they know the SEC may find them and retaliate.

Token holders would also have confidence that the Power Foundation’s executive officers and directors have interests aligned with theirs. Those officers and directors would be required to disclose their token holdings and their token purchases and sales; if they bought and sold tokens in a given six month period — making ‘short swing profits’ — they would be punished and required to return those profits to the Foundation for the benefit of the other token holders.

2. Negative Consequences

A. Compliance Costs

The biggest negative consequence to tokens being freely trading equity securities is that the Power Foundation will face a lot of compliance costs. “Public company compliance costs can range from $1.0 million to over $3.0 million annually even for such a relatively small company.” One has the sense that money could be “better spent” on development, marketing, etc. That, I suppose, is a values judgment, but I believe that the disclosures I outlined not only are very valuable from an investment perspective, but also would contribute to network security.

I also believe that not all of the same disclosure obligations as reporting companies face — such as the extensive financial controls obligations of the Sarbanes-Oxley Act — would be particularly important to most token investors, and that the SEC and legislators would be willing to work with token issuers to reduce disclosure obligations that impose an unreasonable cost/benefit ratio in the context of tokenized networks, even though those same obligations make more sense for traditional corporate entities.

B. Limited CryptoSecurities Exchanges

A current, but temporary, negative consequence associated with tokens being securities is the limited choice of token exchanges that are also qualified to be securities exchanges or securities ATSs. Of course, it is not exactly a choice whether a token is a security — it either is or isn’t. But since, in a way, I am advocating that tokens being a security can be a good thing, it is also incumbent upon me to note the potential negatives.

However, there are some good options — like OpenFinance, which allows trading of Ethereum-based tokens through MetaMask and has 24/7 trading hours. it should only be a matter of time until there are more venues for trading security tokens, and I would be surprised if Coinbase and Kraken do not eventually get registered as securities exchanges. Even some pure cryptocurrency exchanges are trading security tokens: for example, the non-U.S. version of Binance trades STX tokens, which are securities issued by a Blockstack in a qualified Regulation A+ offering.

Let’s also not forget the ever-exploding world of DeFi and decentralized exchanges. Uniswap is a completely autonomous, decentralized smart contract exchange which sets prices through an automated market making function, and now openly facilitates trades not only of cryptocurrencies but also security tokens. The 0x protocol is also interesting, in that it distributes functions that would ordinarily be performed by one centralized exchange operator across multiple smart contract mechanics and more limited types of market participants called relayers, and thus facilitates trust-reduced peer-to-peer trades.

I am not prepared at this point to comment on whether these decentralized solutions may escape regulation by the SEC as securities exchanges, but there is at least the possibility that they might do so — after all, there is no “intermediary” in the traditional sense, and thus many of the policy concerns underlying regulations of exchange operators arguably do not apply. Perhaps more to the point, a DEx like Uniswap is effectively unregulatable unless the SEC can somehow convince a wide cross-section of ETH client devs, node operators and miners to hardfork it away in an irregular state change — a highly unlikely scenario. In my personal opinion, this is the right way to escape regulation — by eliminating the need for intermediaries and decentralizing the power of potential censors. I see a bright future for such innovations.

C. Loss of Anonymity for Benevolent Whales

The same ability to identify ill-intentioned whales referred to above, can also be a negative — benevolent whales would be subject to the same disclosure requirements. Privacy-oriented whales would be deterred from buying as much of the token as they might otherwise be inclined to — they might try to keep their stakes below 5% of the supply, so that they never have to identify themselves in public filings. Alternatively, they might acquire large stakes and simply not disclose, thus breaking the law and opening themselves up to risk of SEC actions or lawsuits by the issuer. While discouraging evil whales is good, discouraging benevolent whales is bad — and you can’t do one without doing the other. This is a potentially material negative, particularly for a proof-of-stake network where benevolent whales may be seen as particularly critical to securing consensus.

D. Miscellaneous Negatives

There are a few other potential issues that people have occasionally raised as potential negatives of tokens constituting freely trading securities securities, but I consider them to be rather speculative, and there is fairly good evidence that, at least for the moment, the SEC does not take them seriously either. These include the following arguments, which I believe have largely been debunked:

  • if protocol tokens are securities, then every miner must become a registered broker-dealer (debunked in Section 1 here)
  • if protocol tokens are securities, then miners and/or the issuer and/or “the blockchain” would need to become a registered transfer agent or clearing agency (debunked in Section 2 and Section 5 here)
  • if protocol tokens are securities, then websites, wallets, or other interfaces to the blockchain need to be registered securities exchanges or ATSs (debunked in Section 3 here)
  • a Foundation would be violating Regulation M when it sells further protocol tokens, if they are securities (debunked as to one potential fact pattern in Section 6 here)
  • every Foundation, by virtue of holding tokens which are securities, would need to become a registered investment company (debunked in Section 7 here)
  • tokens would be taxed as securities — well, they are already taxed just as punitively, if not more so; while some attorneys have argued for more beneficial kinds of taxation , there is little evidence to suggest such approaches will be adopted even if tokens are not deemed securities

I very frequently hear other lawyers and various blockchain enthusiasts claim that blockchain tokens would become “unusable” if they were deemed securities. Kik and Telegram have both made such claims in the context of defending themselves against pending SEC suits. However, I have yet to hear a single example or strongly reasoned argument showing why an SEC-registered, freely trading network token would be unusable for its intended purposes merely because it is a security. If you have any examples of something I’m overlooking, by all means, contact me — I would love to hear them.

A Better Kind of Foundation?

We’ve discussed a lot about securities laws, in fairly granular and semi-technical detail. I realize it is probably a lot for non-lawyers, and that’s even with me eliding many technical nuances. I appreciate the patience and intellectual openness of anyone who has read everything so far.

To keep us grounded, before we break for Part 4 of this article, I want to pause here for a moment and get back to the problems I pointed out at the start of Part 1 of this article. Let’s do a bit of score-keeping and think about how securities laws could possibly help with them.

founders don’t want their token to be a security, so they can’t or won’t talk about, worry about, or work on token price

In a world where tokens are simply accepted as being securities, this would no longer be an issue. Then, an amazing thing could happen — protocol devs could actively and openly work to drive value to the token, without hiding their intentions. We all know influential devs like Vitalik want to create value for their network token of choice, and all holders of that token want and expect them to do so.

Moreover, with the planned transition to PoS, we can no longer pretend that issues of token value are incidental or trivial, since the security of the network directly depends on token value. So why are we playing these ridiculous games of make-believe that no one cares about and that leading devs are not in a position to positively impact valuation? It is simply not true.

What we arguably gain from such games is that a token is not classified as a security and $1–2M of compliance costs per year are saved.

What we lose from such games is disclosure, market momentum, and the ability and willingness of technical leaders like Vitalik Buterin to respond to basic questions about token value and market dynamics. Imagine if a CEO like Sundar Pichai or Elon Musk got on an investor call and refused to answer basic questions about price and finances and projections and market momentum? It’s no less absurd for Vitalik Buterin and other blockchain technology leaders to refuse such questions when token holders ask.

Here are the kinds of things Elon Musk says on investor calls: “Musk confidently told investors on the call that autonomous driving will transform Tesla into a company with a $500 billion market cap [and] existing Teslas will increase in value as self-driving capabilities are added via software, and will be worth up to $250,000 within three years.”

Shouldn’t we want blockchain founders to be able to talk to us the same way? They could, if only they weren’t trying to preposterously pretend their tokens are not securities.

the tech isn’t getting built as fast and well as it could be because everyone is engaging in “decentralization theater” to keep the regulators off their backs; instead of investments, project management and carefully negotiated joint ventures, we have “grants” and “rough social consensus”

In order to make software development look decentralized and thus (try to) avoid being subject to securities laws, Foundations don’t hire people and direct and manage their efforts — instead, they give “grants” to “independent teams” and then claim not to know exactly what those teams are doing.

This can be fine, and in fact is desirable, when a network is relatively mature and only needs maintenance and incremental improvements. However. when a network is waiting for a massive upgrade like the change from ETH 1.0 to ETH 2.0, this type of approach is counterproductive and potentially disastrous. This is no way to launch what is essentially a new network run on a new protocol.

Instead, new technologies should be launched start-up style — under the benevolent dictatorship of a founding genius (or at most a few founding geniuses). Why are we building 10 clients that all do the same thing with 10 separate teams engaged in overlapping efforts? Though having multiple clients could lead to a more decentralized network, and that is good, there is no independent, long-term funding plan for any of them — and thus no particular reason to expect that almost all of them won’t go the way of the Parity Client when their devs run out of grant money or just lose interest. This is not an efficient use of capital or time.

By contrast, if we embraced an initial period of relative centralization and coverage under the securities laws, these technology projects could be managed efficiently and aggressively to yield much better results for token holders, DAPP developers and users.

NOTE (post-publication update): For a counterpoint to this perspective, please read Ben Edington’s article here.

While he admits that Ethereum 2.0 project development takes the “bazaar” model farther than is typical even by open source standards (“we’ve taken it further. We’re applying this approach to the development of the Eth2 protocol itself, its very design and the R&D behind it…”) and confesses candidly that “failing to have answers on issues like [an exact date when Ethereum 2.0 will go live, a 2-year committed road map, and how cross-shard transactions will preserve DeFi composability] would have gotten me fired from my old, corporate job,” he nevertheless argues that this chaotic development process is “the magic of Ethereum’s development approach…Ethereum’s superpower.” I disagree. There is a difference between chaos and openness. But I felt his that his views were worth including here.

token HODLers have been punished by one of the worst bubble pops in human history, they feel like their investments turned founders into celebrity millionaires and the investors were left behind

Bubbles occur in regulated and unregulated markets, so it’s a bit hard to call this one. I do suspect that much of the current depression in token markets is due to regulatory uncertainty. To the extent regulation were actually embraced — perhaps recognizing that, while it comes with some costs, it also comes with benefits — that uncertainty would be reduced, and perhaps that set the stage for a market rebound. Of course, markets are complicated, and part of the intent of the regulations is to prevent speculative bubbles by smoothing out information asymmetries. Ideally, a regulated market might grow more slowly, but also more steadily and sanely; however, of course, even with regulations, there are no guarantees.

new money is sitting on the sidelines, deterred by the first three points and a host of Peter-Schiff- and Nouriel-Roubini-style shade thrown at blockchain, duly amplified by the normies in mass media

It is certainly possible that institutional investors and other sources of fresh capital could be enticed into funding tokenized network development by a more regulated market. This would be particularly true if, unlike with the ICOs of the past, Foundations gave tokenholders rights to enforce good Foundation governance— such as the right to vote on election of directors. In the past, granting such rights was likely avoided in part because developers feared that if they gave tokenholders rights, the tokens would be deemed to be securities. Once regulation is accepted as normal, this concern would no longer apply.

regulators are 2–3 years behind the tech curve, are easily duped, are confused, and are terrified of losing cases, so they only go after the easy targets that don’t require rethinking the laws

In my opinion, while some no action letters were obtained from the SEC this year stating that certain tokens are not securities, they did not really advance the dialogue — they were no-brainers as a matter of law, and the tokens present no realistic possibility of generating upside for tokenholders or fueling enthusiasm for a new open network. This is not the path to progress.

To me, it would make much more sense to do what Blockstack did with its Regulation A+ offering — embrace regulation, but work closely with the SEC to get flexibility where it counts. For example, the SEC appeared willing to accept Blockstack’s arguments that STX might be debt securities rather than equity securities (though I personally think those arguments are wrong), and that Blockstack and miners on the Blockstack network did not need to register as broker-dealers. By accepting regulation as a threshold matter, one opens the door to modifying regulations as they are applied to open network technology, so that the law complements rather than inhibits the technology.

legislators are primarily influenced by D.C. insider lobbyists, who in turn are funded by corporate-style blockchain projects, and are proposing truly terribly drafted and ill-considered laws

I will address this in part 4 when I discuss “sufficient decentralization.” Suffice it to say, I do not think that just because a database is a “blockchain” it should be subject to less regulation. A blockchain is just a data structure. By contrast, I do think open networks that essentially serve as ownerless, decentralized public infrastructure deserve special privileges and exemptions under the law. The lobbyists and legislators working on these issues are easily swayed by enterprise-style blockchain projects or projects more concerned with evading the consequences of their past mistakes than being good stewards of the law; they often do not recognize what makes decentralized networks special, and therefore do not know how to properly draft these types of laws.

millions of dollars are getting poured into securities law defense suits and “defense funds” instead of invested in tech development that could one day make the laws irrelevant

Obvious. Fewer securities law violations, fewer lawsuits, less waste.

our tech is “don’t trust, verify” but our governance is “just trust us,” with black-box “Foundations” making pretty much all major decisions for tokenized blockchain networks; they justify whatever they do based on meaninglessly vague concepts like “social contract”

This gets into deeper issues of governance, and does not depend solely on securities laws. Maybe I’ll save this for a Part 5 — or another article entirely. For now, it’s enough to consider that if tokenholders have good disclosure, they’ll have a greater chance of monitoring and providing feedback to Foundations, and they will be able to hold Foundations accountable for malfeasance.

the tech is creating new monsters every day; cryptocurrency exchanges are turning into investment banks that just hold your crypto and pay you interest; meanwhile, many DeFi projects are just a slightly de-risked variation on the same trend

I frankly don’t think securities laws will do much to reverse this; they might even make it worse. However, at least there would be greater accountability for such actors — many of them would have to become registered securities intermediaries.

the crypto whales of 2015–2017 are our new tech VC gods who need to get paid their vig before they’ll let you access the broader capital markets

Again, not a whole can be done here — wealth tends to concentrate. However, a more regulated market for open network tokens could bring in larger amounts of retail money (legally) as well as other types of large investors like investment banks and pension funds. To the extent you might think stakeholder diversity is positive, this could be beneficial to the health and governance of the network.

every lawyer whose career needs a boost is now a “crypto lawyer” and they’re making bank even as the tech and culture languish into utter inanity

Well, this would continue to be the case. Except maybe it’d be less litigation, and more advanced deal structuring. Over time, advanced deal structuring scales and becomes cheaper — SEC filings are public, and anyone can leverage them. By contrast, litigation facts are obscure, fact-specific, and don’t tend to help make life for new projects easier. You end up paying more in the long run when you took shortcuts early on.

the buzziest project launch of 2019 is fucking Libra by Facebook!!!!

Maybe with a more regulated market, more projects could get funding — and they’d be better, more inventive, more worthwhile for humanity?

In Part 4, we’re going to get to the good stuff — when do securities laws cease to apply? When is the point of “sufficient decentralization” reached?

There is no binding legal precedent on this yet. However, I fully expect that — provided we can avoid passing garbled legislation that makes things even more confusing — clear guidelines could be defined.

In Part 4, I will propose my own version of a test for when “sufficient decentralization” has been achieved and open network tokens should stop being securities. I can’t guarantee that test will be adopted or even considered by the powers that be, but perhaps it will add some momentum to the discussions and help provide some clarity.

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