Size Does Matter — Part 4
A Philosophy of Securities Laws for Tokenized Networks
Recap of Past Parts+ Introduction
- In Part 1, I summarized the current state of the blockchain industry and attributed much of its troubles to conflicts of interest, contradictions and suboptimal path dependencies arising from securities law avoidance tactics. I suggested that the primary function of tokens is serving as “shares of network equity” which are bought for investment purposes and allow the value of an open network to be shared by its community without the network being owned or controlled by anyone.
- In Part 2, I gave you a crash course in the Exchange Act…which is what requires securities issuers who meet the “size matters” test to become SEC-reporting companies. I described how many such disclosure rules are useful and typically do not prohibit positive transactions.
- In Part 3, I showed how the Exchange Act would apply to a specific hypothetical token seller, the Power Foundation (which developed PowerChain / PowerCoin) and discussed the pros and cons of the resulting reporting obligations with attention to preserving the merits of open network technology.
Now, in this Part 4, comes what some might consider the good stuff…I will provide a complete framework for understanding how and why securities laws apply to open network tokens, and when they cease doing so.
This is commonly misunderstood and much speculated about topic. I happen to think I have a better take on it than pretty much anyone, and I am eager to dispel some myths and try to set the conversation going in a more positive direction that will enable the tokenized open network to thrive.
A Brief History of the SEC’s “Mutation Doctrine”
Starting with its 21(a) report on TheDAO in the summer of 2017, the SEC declared war on ICOs, spreading waves of paranoia through the ether of a tokenphoric blockchain industry. These “bad vibes” didn’t cancel the party, but they hurt — like the first, faint tension in the jaw and temples at the start of a bad comedown.
Not long after, the SEC took action against the issuers of RECoin and PlexCoin, but these were fraudulent offerings, not merely unregsitered securities sales.
Cryptolawyers propounded various theories, none of which turned out to be very good. Some thought the SEC was only targeting fraudulent offerings. Others, that the sole reason tokens could be deemed to be securities is because words like “investment” were used in the Whitepaper, and if one just avoided those words, there would be no problem at all — this was called the “manner of sale” theory. The deeply misguided SAFT Whitepaper was published, and a group of lawyers, one being particularly handsome and fashionable, published a critique of that. It seemed there was a new pet theory every week.
Still, the party raged on. There was Kik/KIN, SIRIN and more.
And so SEC Chairman Jay Clayton was all like:
In December, the SEC announced its first settlement in connection with a clearly non-fraudulent ICO, that of Muchee Inc. It was meant to send a message: no, we’re not only targeting frauds and yes, your “pure utility” token can still be a security.
On February 28, 2018, shit got real: The NYTimes published a story “Subpoenas Signal S.E.C. Crackdown on Initial Coin Offerings” reporting that SEC subpoenas regarding ICOs “had gone out to as many as 80 companies and individuals”. At the same time, many U.S. state securities regulators began their own subpoenas and investigations. This sent the industry into a panic, and undoubtedly contributed to the steady decline of prices from January 2018’s highs in the coming months.
On June 14, 2018, amidst rumors that the SEC might be about to make a major announcement about either XRP or ETH (with many fearing the announcement would be a major lawsuit), came an unexpected lifeline: Gary Hinman’s speech “Digital Asset Transactions: When Howey Met Gary (Plastic)”.
Hinman was (and, as of the date of this writing, still is) the Director of the SEC’s Division of Corporation Finance . He started the speech by discussing that tokens could represent investment contracts when they are sold as part of an investment by promoters to develop an enterprise. Then, he dropped a bombshell few could have predicted:
If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract. . .
[P]utting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. . .[A]pplying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
Hinman concluded the speech with a list of factors that should be considered in determining whether “sufficient decentralization” has been achieved and thus whether mutation of the token from security to non-security has occurred.
At the time, this speech was HUGE: The head of one of the most important SEC divisions was specifically confirming that he did not view ETH as a security. And he was doing so as part of enunciating a broader doctrine of “sufficient decentralization” or “mutability” stating that a token that initially represents a security can mutate into a non-security.
Much buzz and gossip instantly ensued, mixed with considerable optimism and relief. Upon reflection, Hinman’s speech appeared astonishing — because it was more cypherpunk than the prior positions of most cryptolawyers! Here was a U.S. regulator, a normie among normies, a buttoned-up securities attorney, who was saying that technologies and the people working on them will receive an extra privilege in the form of lighter regulation if they do what blockchains are supposed to do — decentralize power. No one expected such an anarchist-friendly result to emanate from the SEC!
In the coming days, weeks and months, much speculation ensued regarding whether or to what extent the SEC officially embraced Hinman’s speech. The first confirmatory evidence came in the form of rumors that the SEC staff was asking token issuers to provide memos explaining how a given token fared under the Hinman Factors. Then on March 17, 2019, additional confirmation appeared in a letter from SEC Chairman Jay Clayton to U.S. House Representative Ted Budd, stating in relevant part as follows:
Your letter also asks whether I agree with certain statements concerning digital tokens in Director Hinman’s June 2018 speech. I agree that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument. A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition. I agree with Director Hinman’s explanation of how a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.
Finally, Hinman’s stance was further confirmed and clarified in the SEC’s official Framework for “Investment Contract” Analysis of Digital Assets published on April 3, 2019. Similarly to Clayton’s letter, the Framework clarified that the “sufficiently decentralized” test is not a rewrite of the Howey test, but merely a gloss on the Howey test. The level of decentralization of a network or its technology leadership was relevant to determining whether whether the fourth prong of the Howey test was met in the context of open network tokens initially sold as investments.
With that added context, Hinman’s approach looked less like the radical new “mutability doctrine” that some had feared and others craved, and more like a sensible extension of the Howey test and fundamental principles of securities laws, but tailored to the somewhat unusual context of tokenized open blockchain networks.
Basically, what the SEC is saying is this: In order to determine whether there is reliance on the efforts of others and whether the token is thus an investment contract and a security, one must also ask what kind of others are contemplated to be making these efforts, and what kind of efforts those others are making. Only, says the SEC (repeating case law), if the efforts of others are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise, as opposed to efforts that are more ministerial in nature,” will the token be an investment contract and thus a security.
When there is “sufficient decentralization,” with multiple unaffiliated persons/groups adding value to the project, and the network and software operating without a central authority, there no longer are such “others” and they are no longer making such “efforts.” A token then cease to be an investment in some group of affiliated people or an entity — it becomes an investment in a kind of live, ever-evolving, community-run enterprise that is owned by no one and dependent on nothing other than incentives and game theory. Therefore, it no longer make sense for the securities laws to apply.
The remainder of this article will be an attempt to flesh out what “sufficient decentralization” really means in more detail, and to propose a “safe harbor” the SEC could approve to clarify the doctrine more.
PowerCoin. Two Years Later
NOTE: This section can be skipped or skimmed. It is intended to provide some details that flesh out when I think I a token project could become “sufficiently decentralized,” but not every detail is important.
Let’s check in with our favorite project, PowerCoin. You will recall from Part 3 that PowerCoin was designed by a “prototypical blockchain foundation”, the Power Foundation. As we concluded then, around the time of the token sale and network launch, PowerCoins should be viewed as representing securities (specifically, investment contracts) and the Power Foundation should be viewed as a “reporting company” under Section 12(g) of the Exchange Act.
Let’s assume the Power Foundation has a smart and handsome protocol droid like lex_node as a lawyer, gets good advice and does the right thing —converts to PowerCorp (a public benefit corporation expressly permitted to make decisions for the benefit of not just its stockholders but also PowerCoin holders and other community participants). PowerCorp registers as a reporting company and files all its 10-Qs, 10-Ks, 8-Ks, 14-As, etc. on time.
Now what? Let’s fast-forward two years in time:
- all of the advertised features of PowerCoin and PowerChain referred to in the ICO Whitepaper have at least arguably been completed — in particular, the hotly anticipated “DAPP-mining” feature is in full swing and has been accompanied by a steady rise in PowerCoin price as more and more DAPPs choose PowerChain
- however, there are rumors of potential future upgrades and many ideas for what those upgrades might look like — PowerCorp contributes to those discussions and is starting some research into the possibilities, but many others are also doing so on an independent basis
- PowerCoin now trades on a many exchanges, including mainstream exchanges like CoinbaseSTONKS (for securities coins)
- PowerCoin is widely distributed among many types of holders (speculators, users, institutional investors, mom & pops) and is a top 15 coin by market cap
- PowerCorp has burned through its original $50M raise and continues to fund itself through sales of its treasury PowerCoins (either in unregistered private placements or pursuant to SEC-registered or SEC-qualified offerings — remember, PowerCoins are securities!)
- MegaZord continues to be the most popular PowerChain network client, but several other good clients written in different languages — ViperZord (Python), NinjaZord (Rust) and FrappucinoZord (Javascript)— now exist and are gaining traction; MegaZord’s “market share” (percentage of nodes on the network) has declined from 100% to an average of about 60%; all the code of all of these clients is open-source
- MegaZord is now maintained by a team of 30 developers, 20 of which are directly employed full-time by PowerChain, and the rest of which are comprised of a mix of independent contractors who receive periodic grants from PowerCorp, and volunteers who work on the client out of interest and to gain experience
- about six months after the PowerChain launch, several early investors and employees of PowerCorp split off from PowerCorp and started Ranger Inc.
- Ranger is a “RedHat for PowerChain”: it developed and maintains the second most popular PowerChain network client, ViperZord, does enterprise consulting work for bigger companies interested in building on PowerChain, and supplies important infrastructure boosters and tools for the PowerChain community, like testing suites, powerful network nodes that can be accessed for a fee, etc.;
- the current tokenomics are as follows:
- — ->PowerCorp and its “insiders” (more on definition below) own 5% of currently existing PowerCoins
- — →Ranger and its “insiders” own 3% of currently existing PowerCoins
- — ->the rest of tokens are dispersed among the public
- the operations of the network are widely decentralized; many unaffiliated DAPP teams are contributing to the new DAPP-mining process; in addition, GPU-based PoW mining continues as a backstop and such mining can be done by any recently manufactured GPU; it is believed that miners are widely geographically distributed, though professional GPU-based mining operations have started clustering in regions with cheap energy and/or tax breaks
Is PowerCoin Still a Security?
So, this is the big question. I have designed the above facts to not be completely clear about the answer but still clear enough that I would be pretty confident that the PowerChain ecosystem has become “sufficiently decentralized” such that PowerCoin should no longer be considered a security. Part of the reason for any hesitation at all, I think, is just the fact that no set of hypothetical facts written down in bullet points can match the richness of reality, and I could imagine supplemental facts that could change my mind: For example, if all of the equityholders of PowerCorp and Ranger Inc. are secretly tightly affiliated so that effectively PowerCorp and Ranger Inc. are functioning as one entity disguised as two.
That being said, I want to explain what mental models and implicit tests I am using to decide that PowerCoin is no longer a security. I believe they are the same tests that are being used (or should be used) by the SEC or any judge to decide this issue.
There are really two tests, working together:
- a doctrinal test, rooted in the Howey test, that shows the investment contract has been performed and has thus expired in accordance with its terms, so PowerCoins should no longer be regulated as securities
- a policy-driven test, rooted in the fundamentals of corporate law, agency law and securities law principles, that shows there is no longer a separation between ownership of the PowerCoin network and control of the PowerCoin network, so from a policy perspective applying the securities laws no longer makes sense
These tests are premised on slightly different — but potentially compatible — theories of what “sufficient decentralization” means and why it is important.
Test 1 — Sufficient Decentralization Is Simply Completion of the Original Investment Contract, Which Then Ceases to Exist
- Summary of Test
Here is a doctrinal, Howey-based argument for why PowerCoins have stopped being securities:
- PowerCoins were securities (to be more precise, securities instruments) because they represented investment contracts
- When an investment contract is fully performed by the seller, it expires
- When a contract expires, any transferable instruments that used to represent that contract cease to do so
- The investment contract formed at the time of the PowerCoin token sale and any subsequent sales has been fully performed by PowerCorp
- Therefore, the investment contract has expired
- Therefore, PowerCoins no longer represent that investment contract — there is no investment contract to represent
- Therefore, PowerCoins are no longer securities (to be more precise, securities instruments)
2. What is an “Investment Contract,” Really?
What is an “investment contract”? Let’s really think about this. It is a source of frequent confusion.
It’s theoretically possible, though virtually never happens in practice, that two parties could purposefully write down and sign an explicit, purposeful investment contract. In the case of a very simple token sale arrangement where the investment contract was to be fully performed at the time of the initial network launch, a cartoon sketch of an explicit investment contract would read sort of like this:
Token-Seller hereby covenants and agrees, to and for the benefit of Token-Buyer, to use reasonable best efforts to, as promptly as reasonably practicable: (a) develop a fully functioning blockchain technology network complying with the specifications set forth on Exhibit A; and (b) cause Token-Buyer’s designated blockchain address on such network to be pre-populated with 1,000,000 of the native protocol token for such blockchain technology network. Without limiting the generality of the foregoing, Token-Seller hereby acknowledges and agrees that Token-Purchaser is entering into this contract with the understanding and expectation that the the Token-Seller’s efforts hereunder will cause the value of the tokens to be received by Token-Buyer to potentially substantially exceed the price Token-Buyer is paying to purchase such tokens hereunder. Token-Seller hereby agrees that such expectations on the part of Token-Buyer are reasonable.
If the above contract seems slightly comical, it should — no one actually does that. Indeed, as with most ICOs, it is rare that there is an explicit contract involved in most “investment contract” transactions at all. When there is one, it usually seeks to obfuscate the investment intent and the true terms of the deal rather than clarify them.
For example, the few ICOs that had explicit contracts typically specified the opposite of what was happening. The “Purchase Agreements” would often say that the tokens were being acquired solely to be “consumed” or “used” like products, with no investment intent whatsoever, and with the seller expressly disclaiming any obligations to build or deliver anything or use any particular efforts to help the buyer achieve profits. The same is true for non-token “investment contracts” — for example, Howey featured a hybrid lease/services contract meant to look like a person was just leasing a plot of land and hiring someone to help grow oranges on it, but it was really an investment contract and hence a securities transaction.
Thus, what “investment contracts” really are, almost always, is contracts created by the application of a legal rule. Lawyers usually describe this, more confusingly, as “contracts implied as a matter of law”. These are the same thing. When the law implies that a contract exists even though the parties have not observed the requisite formalities, the law is essentially saying that it would be unjust if there were no contract, so a contract is legally deemed or legally required to exist. The contract is a sort of virtual legal object.
Implied contracts are well known and generally understood in commercial law, and in that context they are relatively intuitive for a non-lawyer to understand. For example, if you and I have a history where I mow your lawn every Saturday, and you give me $20 afterwards, that is a contract implied as a mater of law by course of performance — if one day when I show up and mow the lawn, you do not pay me the $20, I can go to court and prove you breached out contract and I am entitled to $20 in damages. You never said to me “every Saturday that you come and mow my lawn, I’ll pay you $20 in return” and I never said “I accept your offer”, but we didn’t need to: it’s what I understood, and the basis of my understanding was reasonable, so to protect me against injustice the law says that we had a contract, even though we didn’t observe the typical formalities of contract formation like hiring lawyers and writing the terms down. This should seem fair and logical to anyone.
In the case of an investment contract, its existence and terms are implied as a matter of law from: (1) the general understanding of the buyer (that the buyer reasonably expects profits due to the entrepreneurial efforts of the seller as part of a common enterprise) and (2) the fact that securities laws in the U.S. are non-waivable.
What “(2)” means is that, under circumstance “(1),” even if you and I enter into a written contract, signed in our blood, that says in all-caps, bold letters, WE HEREBY AGREE, ON PAIN OF DEATH, TO WAIVE ALL THE PROTECTIONS WE OTHERWISE WOULD HAVE UNDER THE SECURITIES LAWS, AND ASSUME ALL RISKS OF THE RESULTS OF NOT HAVING THOSE PROTECTIONS,” the arrangement will still be an “investment contract. Our attempt at agreeing to the contrary will be unenforceable. Thus, in every situation where “(1)” is true, the law creates an investment contract between the parties.
3. What is the Relationship Between a Token and an Investment Contract?
I hear some really weird things said about securities laws by non-lawyers, and even sometimes lawyers, who are trying to understand how securities laws apply to tokens. One can end up falling down some very dark and twisted rabbit holes, such as a recent discussion I had with some non-lawyers about ‘whether ASICs are securities’. Even the SEC does this: in various reports, settlement announcements and complaints, the SEC has occasionally said words to the effect that “tokens are investment contracts.”
But what does that mean? How can some of kind of tangible or intangible thing — like an ASIC, an orange, a bottle of whiskey or a token— be a contract? Contracts are not things, they are legal abstractions — agreements, understandings.
Answer: it can’t be.
Saying that a token is an investment contract, or that a token is a security, is at best an imprecise shorthand, and at worst a category mistake. Yes, I realize I’ve done it too — especially in this article. But that is partly because the actual relationship of tokens to securities has been widely misunderstood, so I’ve had to use the same imprecise shorthands while I work my way to this point, where I can finally try to clarify things.
Legal abstractions, like all abstractions, have the property that they can be represented in various ways. For example, shares of stock in a corporation can be represented as book entries on a ledger maintained by the corporation, or they can be represented via paper stock certificates; in the latter case, they become more easily transferable on a peer-to-peer basis, without involving the issuer. Similarly, debt arrangements can be represented as promissory notes.
When a security — which is always a contract (whether express or implied) — is represented via a transferable instrument, we generally call that a securities instrument: stock certificates and promissory notes are examples of securities instruments. The hallmark of a securities instrument is this: by transferring the instrument, one also, as a matter of law, transfers/assigns one’s rights under the relevant contract.
I contend, then, that the most precise way of understanding the relationship between an open network token and the related investment contract is this: the token represents the investment contract the same way a stock certificate represents a share of stock. For a very comprehensive overview of how blockchain tokens can function the same way as securities instruments like stock certificates, see Tokenizing Corporate Capital Stock by Gabriel Shapiro.
From now on, every time you read a statement by the SEC, a judge or someone else saying something along the lines of “tokens are investment contracts” or “tokens are securities,” what you should be hearing is “tokens are transferable securities instruments representing the holder’s rights under an investment contract.” That is quite a mouthful! Hence, I suppose, it is understandable why we all tend to use less precise descriptions most of the time.
4. When Can a Token-Related Investment Contract Consider to Have Been Fully Performed?
This is a tricky question.
When contracts are done the right way — written down in nice clear language and signed by the parties — it is easy to tell what the parties’ respective rights and obligations are. If a party does not perform its obligations, it is easy to tell that the contract has been breached; conversely, when all of the parties’ obligations have been fully performed it is easy to tell that the contract has been fulfilled and expired in accordance with its terms.
But what about contracts created by law, like investment contracts? What are their terms and conditions? What are each parties’ rights and obligations, and when do they terminate? These questions can be tough to answer because the parties did not observe the typical formalities and spell out all these matters in detail — therefore, it can be hard to determine what the terms and conditions of an investment contract really are.
Let’s first thing about this in the context of our example — PowerCoin.
As stipulated in our hypothetical fact set, one of the biggest reasons why people bought PowerCoin is they expected that its value would increase when each step of the whitepaper roadmap was completed — a little bit when privacy features were added to PowerCoin, and then a whole lot more when the new DApp-mining feature was added to PowerChain and its network effects might increase dramatically.
Therefore, at a minimum, PowerCorp’s obligations under the investment contract certainly include pursuing the completion of that roadmap.
In addition to completing the technology development roadmap, it might also be inferred that PowerCorp had some obligations to do other things contemplated in the whitepaper, such as promoting and marketing PowerCoin/PowerChain and encouraging decentralization through grant rewards, hack-a-thons, etc., and that it would do these things at least until a kind of critical mass was achieved such that the network is truly open, censorship-resistant and privacy-preserving as contemplated by the network.
Beyond that, we don’t really know a whole lot about the terms of the investment contract — the law does not imply more terms than it needs to. In particular, we don’t know what level of efforts PowerCorp needs to use to fulfill the roadmap — best efforts? reasonable best efforts? commercially reasonable efforts? The parties have not agreed to a specific dispute resolution mechanism such as going to a Delaware court or seeking binding arbitration. This lack of specificity is suboptimal, but it doesn’t mean there isn’t a contract — it just means there is a very poorly specified contract that is silent on many terms.
Nevertheless, we do know enough about the investment contract to know that PowerCorp has substantially performed all of its obligations under it. At the network level, PowerChain is thriving and the operation of PowerChain is highly decentralized. At the software development level, everything PowerCorp promised to do has been achieved, and although further improvements could be made, there are independent organizations and individuals that are both incented and empowered to deliver them, either with or without the assistance of PowerCorp.
To couch this in even more Howey-like terms, the entrepreneurial efforts of PowerCorp are no longer the essential efforts contributing to success of the PowerChain/PowerCoin enterprise, and thus the fourth prong of the Howey test is no longer satisfied. To couch this in the language of tokenomics — further dramatic increases in the value of the tokens as shares of network equity are no longer expected to be driven by PowerCorp or any other particular group of affiliated persons. Both the operation of the network and efforts to increase the value of the network equity have become “sufficiently decentralized”.
Based on all these facts, it would now be reasonable to conclude that PowerCorp has performed all of its obligations under the investment contract, and that unless PowerCorp starts selling additional PowerCoins with a new roadmap in place that would create new expectations, there is no investment contract and PowerCoins should not be regulated as securities instruments any longer.
5. “Sufficient Decentralization” is Inherently Necessary to Complete an Open Tokenized Network Roadmap
It just so happens that tokenized open blockchain networks are the kind of thing that, in order to really work and be valuable, must be decentralized.
Is it really a coincidence, then, that the point at which the investment contract would be complete (and thus expire) would also be the point at which the network is “sufficiently decentralized”?
I think not.
The SEC is correctly perceiving that tokens cease to be securities when the network has become “sufficiently decentralized,” but this in itself does not mean the SEC is enunciating a radical new securities law doctrine. What the SEC is doing — or at least from a doctrinal perspective should be doing — is focusing on whether the investment contract has been fully performed and thus the “efforts of others” are no longer being relied upon sot hat Howey is no longer met. That typically will be the case when the network is “sufficiently decentralized” — or, in any event, it cannot be the case unless the network is sufficiently decentralized. Because the terms of the investment contract require the token seller to try its best create a decentralized network.
When you think about it, it’s actually quite logical and elegant.
Test 2 — Sufficient Decentralization Occurs When There is No Longer a Separation Between Ownership and Control of the Network
We have talked about what “sufficient decentralization” means as a matter of current legal doctrine —i.e., under the Howey test. But what about policy concerns? Normatively, does the mutation process we talked about map onto sound policy goals? Is it consistent with the way we think about securities laws at a deeper level?
I would argue yes. The easiest way I can explain this is by centering the discussion on one of the deepest and most fundamental principles of corporate and securities laws, which is that such laws exist to help deal with the structural conflicts of interest and other policy concerns arising from the “separation of ownership and control” typical of large-scale modern enterprises.
What is the separation of ownership and control? Here is a nice concise summary from an article by Stephen G. Marks:
The separation of ownership and control refers to the phenomenon associated with publicly held business corporations in which the shareholders (the residual claimants) possess little or no direct control over management decisions. This separation is generally attributed to collective action problems associated with dispersed share ownership. The separation of ownership and control permits hierarchical decision making which, for some types of decisions, is superior to the market. The separation of ownership and control creates costs due to adverse selection and moral hazard. These costs are potentially mitigated by a number of mechanisms including business failure, the market for corporate control, the enforcement of fiduciary duties, corporate governance oversight, managerial financial incentives and institutional shareholder activism
If we go back to our construct that tokens represent shares of network equity, then we can easily see a similar dynamic applying to tokenized open networks. Let’s think about this in the context of our hypothetical PowerChain and PowerCoin.
Ownership of PowerChain is widely dispersed among many people— likely tens or hundreds of thousands. Thus, PowerChain is very similar to a “publicly held business corporation”. In the early days, though, any dispersal of network ownership is not mirrored by similarly wide dispersal of network control. The network effects are thin and immature, and both ownership of PowerCoins — the network equity — and power over the protocol development process is highly concentrated in PowerCorp. Essentially, PowerCorp is playing a role very similar to the board of directors and executive officers — the management — of a corporation, except it is a network that is being “controlled” rather than a company.
The separation between ownership control creates many issues, which can necessitate legal or other mechanisms to realign incentives. One does not want the management to entrench itself and extract rent endlessly or unfairly, with no accountability. Of course, in many ways cryptoeconomics exist to replace regulations with technological mechanisms, but, for now, cryptoeconomics apply in-network and are not particularly well suited to govern the relationship between the network and protocol developers, people who hold or trade tokens for profit, etc. Thus, laws and/or contractual mechanisms remain relevant — at least for a time.
As the network evolved, PowerCorp starts to lose control of PowerChain and PowerCoin. PowerCorp’s ownership of PowerCoin starts out as a majority, and eventually dips below the 10% level. PowerCorp’s control over the software development process for the protocol also diminishes as more independent people and businesses step up to the plate and start contributing.
Eventually, one reaches the point where PowerCorp is no longer in control, and arguably not even especially influential, over the network — and at that point there is no longer a “separation of ownership and control,” because there is no control, and thus many of the traditional mechanisms like securities regulations, non-waivable fiduciary duties, etc. should be deemed irrelevant or of vastly diminished importance. Essentially, at this point of “sufficient decentralization,” the PowerChain network can be compared to a corporation that is owned by its stockholders and has no management.
To put it another way: Essentially, the SEC is saying that the same rule applies to sufficiently decentralized open networks as to general partnerships. It is an axiom of securities laws that interests in general partnerships are presumed not to be securities because no one is depending on anyone else, everyone represents himself in the venture, and there are no inherent information or control asymmetries.
A Possible Safe Harbor for Measuring “Sufficient Decentralization”
In the realm of securities laws, the SEC has been a driver of “safe harbors” which do not change the law in substance, but provide clarity regarding specific fact patterns that the SEC regards as obviously complying with the law. Regulation D — including the notorious “accredited investor” rule — is actually an example of this and improved upon more general rules like “sales by an issuer not involving any public offering,” which were unclear and subject to frequent litigation.
This brings us to our next question: Can we propose a “safe harbor” that would provide clarity on when “sufficient decentralization” has been achieved — a hypothetical “Regulation Crypto” or “Reg C”? I believe we can.
Let’s explore what this might look like:
(a) Safe Harbor. Any Open Network Token representing an investment contract shall be deemed to no longer represent a security within the meaning of section 2(a)(1) of the Act if it satisfies the conditions in paragraph (b) of this section.
(b) Conditions to be met.
(i) less than 10% of the Circulating Token Supply is directly or indirectly owned beneficially by the following persons (individually or collectively): the issuer of such Open Network Token, affiliates of the issuer, persons who are directly or indirectly the beneficial owners of more than 10 percent of any class of any equity security of the issuer or any affiliate of the issuer, and persons who are directors or officers of the issuer or any affiliate of the issuer;
(ii) prior to commencing sales of the Open Network Token, the issuer filed with the Commission an Open Network Token Offering Statement with respect thereto;
(iii) the issuer has filed with the Commission a Form C Termination Statement certifying that all of the investment contract performance conditions set forth in the Open Network Token Offering Statement have been satisfied (or, if applicable, waived by action of the holders of the Open Network Token);
(iv) the Open Network Token does not represent another security within the meaning of Section 2(a)(1) of the Act ; and
(v) the issuer has not committed any uncured or continuing material violation of securities laws in connection with the Open Network Token
Keep in mind, this is just a draft. I have tried to dress this up in language that could plausibly be further massaged into an actual SEC rule. In doing so , I have cut some corners, and not defined every relevant term. Believe me, I realize it’s not there yet — it’s meant as a promising starting point.
For greater clarity and readability, here is a summary of how I see a safe harbor like this working:
- token issuers who wish to take advantage of the safe harbor will have to first file with the SEC an “Open Network Token Offering Statement”
- I envision an Open Network Token Offering Statement would have a level of detail and formality ranging somewhere in between that of a traditional ICO whitepaper and that of a a traditional Private Placement Memorandum
- we could debate whether the Open Network Token Offering Statement should be subject to an SEC qualification requirement (SEC reviews, comments and qualifies the statement) or just a filing requirement (the statement is filed with the SEC, but does not have to be in any way signed off on by the SEC before the token sale commences) — I have deliberately left this point undecided
- the Open Network Token Offering Statement would include a statement of conditions that essentially specifies the roadmap for tech development, marketing, and other relevant factors, and thus determines when the underlying investment contract has been fully performed
- when the investment contract has been fully performed, the issuer must file a termination statement certifying the same
- alternatively, if the issuer originally set up a governance process whereby the token holders could waive any of the performance conditions and this was described in the Open Network Token Offering Statement, then the issuer can also file a termination statement based on such a waiver, or a mix of performances and waivers
- the issuer, its affiliates, and their respective “insiders” (10%+ equity holders or directors and officers) must collectively own less than 10% of the Open Network Token
This safe harbor achieves three objectives:
- it incents token sellers to set very explicit investment contract terms, rather than having the terms implied by law and leaving them potentially ambiguous and open-ended
- it ensures the Howey test is no longer satisfied by ensuring that the investment contract has been fully performed
- it ensures that many of the policy concerns underlying the securities laws are mitigated because the issuer (and any related group) now hold less than 10% of the ‘network equity’ in the form of tokens
Conclusion
We have come a long way. Now is probably a good time recap everything:
- Tokens are primarily shares of network equity; we should expect them to be regulated as representing investment contracts and thus securities, up to a point.
- In some cases, such regulation might mean that the issuer has extensive public reporting obligations — however, these may be beneficial, not only from an investment perspective, but also for the development of the open network.
- Over time, the issuer of the token should be able to fulfill the terms of the investment contract represented by the network tokens — when it does, the fourth prong of the Howey test will no longer be met, the tokens will cease being securities and the issuer can terminate its SEC reporting obligations.
- Additionally, the issuer’s stake in the network will decline — when it declines sufficiently, this is independently a good index of when securities laws should cease to apply, since there is no longer an economic “controller” of the network value.
- The SEC should consider enshrining these principles in a formal safe harbor along the lines I have proposed.
Well, that is it — for now. If you are a lawyer or dev interested in helping advance the ideas set forth in this series of articles — particularly if you can help encourage the SEC to start thinking seriously about a similar safe harbor — you can feel free to contact me on ye olde Twitter, where I am lex_node
I am also a practicing California attorney who can be hired if you know the right Jawas — bring me your blockchain projects or other corporate / securities law projects, and perhaps we can work together — you don’t know the power of the dark side of the force! *evil laugh*
