Much Ado About DeFi – Corporate/Commercial Law

United States:

Much ado about DeFi

17th August 2021

Bryan Cave Leighton Paisner LLP

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Given the accused company’s name included “DeFi,” there was an inevitable spate of news surrounding the SEC’s action against DeFi Money Market (“DMM”) over the past week, including the fact that it was the “first” enforcement action related to Decentralized Finance or DeFi was. However, below are a few observations that we believe make the DMM action less noticeable than its billing.

1. Regarding the violation of Section 5 of the Securities Act by unregistered offers, the March 2021 SEC filing against LBRY, Inc. first concerned a decentralized platform and its unregistered offer of an associated token. The pending LBRY lawsuit is based on the SEC’s conclusion that the LBRY platform was not really as decentralized as it was claimed, and the LBRY tokens sold were therefore unregistered securities. Rather than functioning autonomously and distributed, the SEC claimed: (i) the platform and its participants essentially relied on management and operational control from LBRY, Inc .; (ii) the role of LBRY, Inc. included controlling the delivery of LBRY tokens in order to promote the price stability of the tokens; and (iii) LBRY, Inc. had sole authority over the LBRY software code and the functionality and expansion of the network, including the allocation of funds raised in token sales. Some of these remaining vestiges of issuer control and participation were fairly intuitive as indicative of persistent “security” status, but the SEC’s approach to decentralization analysis in the complaint provided useful guidance nonetheless. The resolution of the LBRY case therefore continues to be remarkable. As explained below, the basis for the fraudulent actions of the DMM offering was mundane by comparison, with relatively little future value from the point of view of guidelines and signposts for DeFi companies.
2. The DMM case was settled under the presidency of Gensler, but it was not “his case” and it is difficult to view it as such. The DMM lawsuit was filed on August 6, 2021, after the platform announced back in February 2021 that it would be closing due to regulatory inquiries, including a subpoena received from the SEC in December 2020. So this lawsuit could well play as an “opening salvo”. After Chair Gensler’s recent comments on ending the regulatory “Wild West” in which he sees Krypto and DeFi as active, the seeds for the DMM action were planted on Chair Clayton’s watch. To reach an agreement in August, agreement negotiations would likely have been underway at least since the beginning of summer, just about six weeks after Chairman Gensler’s term in office (after he was sworn in in April 2021).
3. In addition to violating Section 5, the DMM action was a classic offering fraud – an issuer raised money based on false information about how the money would be used and how investors would benefit from it. Gurbir Grewal, SEC’s director of enforcement, stated in the SEC’s press release that including novel technologies in an offering does not change the requirements of securities laws. Director Grewal’s comments echo the language of the July 2017 DAO report, which essentially states that an instrument that exhibits the characteristics of a security will be treated as such regardless of its technological basis. According to the analysis by SEC v. Howey is a token, probably an investment contract (a type of security) if buyers could buy this token because they expect to benefit financially from, or have announced, the measures taken by the issuer of the token (e.g. technological development, release of additional Functions, search for stock exchange listings for the token, etc.). However, the SEC has indicated that the network and functionality of a token can be decentralized so that it is no longer a security, as the actions of its issuer / promoter no longer drive investor expectations (Bitcoin and Ether are prime examples of this) .

The DMM action was noteworthy as the fraud accused took place in connection with a DeFi platform that, according to the SEC, had developed the technological infrastructure described in its white paper. In fact, it appears that the token sales underlying the fees of Section 5 were carried out through smart contracts that received investor funds and automatically minted new tokens for payout. So the case can be viewed as a statement like the one in the DAO report, meaning the securities laws are technology independent and apply to securities issued by DeFi platforms when Howey’s elements are met. The problem highlighted by the SEC was that investor returns were not being achieved in the manner described in the White Paper, including the fact that human interference and undisclosed affiliate involvement were heavily involved in the actual operation of DMM. In reality, DMM and its founders have used investor funds for personal and other purposes not described in the White Paper. Hence the Fraud Fee (based on misrepresentation in Offer Documents) and Section 5 Fee (based on factors such as the issuer’s continuing role in generating investor returns).

If the DMM platform had worked and generated profits as it was intended, if their promoters hadn’t had to put in any further efforts after issuance, and if investors had therefore expected that the platform’s truly decentralized and autonomous functioning could be reliable for future returns (in lieu of future action by the issuer or founders), there would have been no fraud, and there probably would not have been any “security” on which the SEC could base an enforcement action. Analysis of such a platform would have insight into the SEC’s considerations on handling autonomous acts related to Howey’s analysis, the guilt of founders and financiers if their technology autonomously takes actions that normally require registration, the inclusion of smart contracts and the minting of tokens in securities opens up issuance and the elements the SEC deems necessary to tip the balance towards decentralization that would turn a token no longer a security. That would have been significant and would have provided a blueprint for other DeFi units in the future. Unfortunately, that wasn’t the DMM case.

* * *

There will be further DeFi guidance and enforcement actions, both in the securities area and in other critical areas such as financial crime and tax treatment. And a central regulatory question that affects the entire DeFi remains unresolved: namely, how will administrative authorities and courts handle really decentralized DeFi platforms that work autonomously and whose promoters have long since ceased to have an active, necessary or visible role. Money can obviously be seized from smart contracts, but will the SEC and other agencies be satisfied with purely financial enforcement results that do not hold individuals or organizations accountable?

The content of this article is intended to provide general guidance on the subject. Expert advice should be sought regarding your specific circumstances.

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