Given that the charged entity’s name included “DeFi,” there was an inevitable flurry of news around last week’s SEC action against DeFi Money Market (“DMM”), including that it was the “first” enforcement action involving Decentralized Finance or DeFi. However, below are a few observations that, to our minds, make the DMM action less remarkable than its billing.
- In terms of violating Securities Act Section 5 through unregistered offerings, the March 2021 SEC Complaint against LBRY, Inc. was the first to concern a decentralized platform and its unregistered offering of an associated token. The still-unresolved LBRY action rests on the SEC’s conclusion that the LBRY platform was not truly as decentralized as was claimed, and the LBRY tokens it sold were thus unregistered securities. Rather than functioning autonomously and in distributed fashion, the SEC alleged: (i) the platform and its participants substantially relied on LBRY, Inc.’s managerial and operational control; (ii) LBRY, Inc.’s role involved controlling the supply of LBRY tokens to promote token price stability; and (iii) LBRY, Inc. had sole authority over the LBRY software code and the network’s functionality and expansion, including the allocation of capital raised in token sales. Some of these remaining vestiges of issuer control and participation were fairly intuitive as being hallmarks of persistent “security” status, but the SEC’s approach to analyzing decentralization in the Complaint provided a useful guide nonetheless. Resolution of the LBRY case thus continues to be noteworthy. As explained below, the basis for the DMM offering fraud action was mundane by comparison, with relatively little of future value from the perspective of guidance and signposts for DeFi entities.
- The DMM case was settled under Chair Gensler, but it was not “his case,” and it’s difficult to view it as such. The DMM action was filed August 6, 2021, after the platform announced back in February 2021 that it was shutting down due to regulatory inquiries, including an SEC subpoena received in December 2020. So while this action may play well as the “opening salvo” following Chair Gensler’s recent comments about ending the regulatory “wild west” in which he sees crypto and DeFi as operating, the seeds for the DMM action were planted on Chair Clayton’s watch. Indeed, to reach a settlement in August, settlement negotiations would have likely been ongoing since at least the beginning of the summer, only about six weeks into Chair Gensler’s tenure (following his April 2021 swearing in).
- In addition to violating Section 5, the DMM action involved a classic offering fraud — an issuer raised money based on false statements as to how the money would be used and how investors would profit. SEC Director of Enforcement Gurbir Grewal noted in the SEC release that an offering’s involvement of novel technology did not alter the requirements imposed on it by the securities laws. Director Grewal’s comments echo language from the July 2017 DAO Report, which essentially says that if you issue an instrument that has the characteristics of a security, it will be treated as such regardless of its technological underpinnings. Under the analysis from SEC v. Howey, a token is likely an investment contract (a type of security) if part of the reason purchasers might buy that token is they expect to financially benefit from actions the token’s issuer is taking or has stated it will take (such as technological development, release of additional features, seeking exchange listings for the token, etc.). But the SEC has indicated that a token’s network and functionality can become so decentralized that it ceases to be a security because actions taken by its issuer / promoter are no longer driving investors’ expectations (Bitcoin and Ether are prime examples of this).
The DMM action was notable because the charged fraud occurred in the context of a DeFi platform, which the SEC said had developed the technological infrastructure described in its White Paper. Indeed, it appears the token sales that underlay the Section 5 charges were executed by smart contracts that received investor funds and automatically minted new tokens for disbursement. So the case can be seen as making a pronouncement like the DAO Report’s, i.e., the securities laws are technology-agnostic and will 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 actually being generated in the manner the White Paper had described, including that human intervention and the undisclosed involvement of a related company featured heavily in DMM’s actual operation. In reality, DMM and its founders used investor funds for personal and other uses not described in the White Paper. Hence, the fraud charge (based on misstatements in offering documents) and the Section 5 charge (based on factors like the issuer’s ongoing role in providing investor returns).
Had the DMM platform functioned and generated profits as it was designed to do, if its promoters had to expend no further efforts after issuance, and if investors would have thus expected that the platform’s truly decentralized and autonomous functioning could be relied upon to generate future returns (rather than any future actions by the issuer or the founders), there would have been no fraud and there arguably might not have been a “security” on which the SEC could base an enforcement action. Analysis of such a platform would have provided a window to the SEC’s thinking on treatment of autonomous actions in context of the Howey analysis, culpability of founders and funders when their technology autonomously takes actions typically requiring registration, involvement of smart contracts and token minting in securities issuance, and the elements the SEC views as necessary for tipping the balance toward decentralization that would make a token no longer a security. That would have been momentous and would have offered a blueprint for other DeFi entities going forward. Sadly, that was not the DMM case.
* * *
There will be more DeFi guidance and enforcement actions to come, both in the securities space and other critical areas like financial crime and tax treatment. And a key regulatory question hanging over all of DeFi remains unresolved: Namely, how will administrative agencies and courts treat truly decentralized DeFi platforms that operate autonomously, and whose promoters have long ceased to have any active, necessary, or visible roles. Money can obviously be seized from smart contracts, but will the SEC and other agencies be satisfied with purely financial enforcement outcomes that hold no individuals or entities responsible?