Recently, the Securities and Exchange Commission (the “Commission”) issued an enforcement order finding that the founder of EtherDelta had operated an unregistered national securities exchange for the trading of digital security tokens in violation of the federal securities laws (the “EtherDelta Order” or the “Order”). See In the Matter of Zachery Coburn, Release 34-84553 (Nov. 8, 2016). The EtherDelta Order is consistent with the public guidance issued by the Commission’s Divisions of Enforcement and Trading and Markets on March 7, 2018 (the “Online Platform Statement” or the “Statement”) and the guidance issued by the Divisions of Corporation Finance, Investment Management, and Trading and Markets on November 16, 2018. See, respectively, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets, Divisions of Enforcement and Trading and Markets (Mar. 7, 2018) and Statement on Digital Asset Securities Issuance and Trading, Division of Corporation Finance, Division of Investment Management, and Division of Trading and Market (Nov. 16, 2018).

Both the EtherDelta Order and the Online Platform Statement allow for the possibility that an online platform for trading digital assets involving the possible interaction of orders of multiple buyers and sellers may, in theory, operate pursuant to an appropriate exemption from exchange registration. Neither the Order nor the Statement, however, acknowledges any real possibility other than that such trading must take place on registered national securities exchanges and/or alternate trading systems (“ATSs”) operated by registered broker-dealers that have filed Form ATS with the SEC and otherwise obtained FINRA’s approval.

A POSSIBLE PATH FORWARD THAT DOES NOT REQUIRE EXCHANGE REGISTRATION OR USE OF AN ATS

Notwithstanding this narrow focus on registered exchanges and/or ATSs, a well-established line of no-action letters issued by the Commission’s Divisions of Corporation Finance and Trading and Markets allows issuers to establish and operate passive electronic bulletin boards capable of bringing together the interests of multiple buyers and sellers without requiring them to register as national securities exchanges. These no-action letters offer a realistic path forward for digital asset trading platforms that do not wish to register as an exchange or ATS, provided the platforms are limited to issuers that are registered with the SEC pursuant to Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”), and file the information required by Section 13(a) of the Exchange Act.

EXISTING NO-ACTION LETTERS PERTAINING TO PASSIVE BULLETIN BOARDS

In 1996, the Commission’s Division of Market Regulation (now known as the “Division of Trading and Markets”) issued three no-action letters that allowed issuers that had securities listed on an exchange to set up a passive electronic bulletin board to facilitate shareholder liquidity in the listed securities without registration as a national securities exchange, a broker-dealer, an investment adviser, or the registration of the offers and sales made through such platform under the Securities Act of 1933. See Real Goods Trading Corporation, SEC No Act. LEXIS 566 (June 24, 1996); PerfectData Corporation, SEC No-Act. LEXIS 700 (Aug. 5, 1996); and Flamemaster Corporation, SEC No-Act. LEXIS 972 (Oct. 29, 1996). In connection with the foregoing, the Division stated that it would not issue further no-action letters with respect to electronic bulletin boards unless the request raised new or novel issues.

Subsequently, the Division issued an additional no-action letter to Portland Brewing Company (“PBA”) (the “PBA No-Action Letter”). See Portland Brewing Co., Federal Securities Law Reporter – Transfer Binders (1993-2001) 77,664 (Dec. 14, 1999). In its request, PBA raised the novel issue of whether the passive electronic bulletin board line of no-action letters should apply to a stock (the “Covered Security”) that was registered under Section 12(g) of the Exchange Act but was not listed on an exchange and did not trade over the counter.

The PBA No-Action Letter request related to a trading platform that could be accessed by participants directly through PBA’s web site and would include (i) the names, addresses and telephone numbers (or other contact mechanisms, such as electronic mail addresses) of interested buyers and sellers; (ii) the number of shares or units of the Covered Security being offered for sale or desired to be purchased; (iii) the price offered or desired; and (iv) the date on which the information was entered into the trading platform. Once entered, the information would remain displayed on the platform until the earlier of the time a participant indicated that a transaction had been completed, a participant canceled any entry, or a stated time period set by the platform expired. Quotes on the platform would not be firm, i.e., binding, and participants would not be allowed to enter two-side quotes, i.e., a co-existing buy and a sell quote.

Significantly, the trading platforms covered by the PBA No-Action Letter as well as the earlier no-action letters did not allow transactions to be effected on the trading platform (the “System”) itself. Rather, any transaction had to be effected directly between the participants.

THE PBA NO-ACTION RELIEF

In response to PBA’s request, and subject to the conditions discussed below, the Division of Market Regulation granted no-action relief to PBA and its personnel with respect to the broker and dealer registration provisions under Section 15(a) of the Exchange Act and the Commission’s Division of Corporation Finance granted no-action relief with respect to registration of the offers and sales in the Covered Security made through the platform under the Securities Act of 1933.

Although the PBA No-Action Letter does not specifically grant no-action relief from the exchange registration provisions of the Exchange Act, that relief was granted in the prior no-action letters referenced above and would appear to apply equally to PBA and, therefore, anyone that relied upon that letter.

The PBA No-Action Relief includes the following additional conditions.

First, the Covered Security must be registered with the Commission as a class of securities pursuant to Section 12 of the Exchange Act and, should such status cease, the issuer will otherwise continue to make publicly available the information required by Section 13(a) of the Exchange Act in the same manner that participants will obtain access to the System.

Second, certain described notices regarding operation of and participation on the System will be provided to System participants both on the System itself and with any hard copy information that is provided to participants.

Third, the issuer is required to maintain records of all quotes entered into the System for at least three years and make those records available to the Commission, FINRA and any market on which the Covered Security becomes listed.

Fourth, any advertising by the issuer must comply with the requirements of the No-Action Letter.

Fifth, neither the issuer nor its affiliates may use the System, directly, or indirectly, to offer to or buy or sell securities, except in compliance with the securities laws, including any applicable requirements related to offers, purchases and sales by issuers and/or affiliates.

Sixth, neither the issuer nor its affiliates will receive any compensation for creating or maintaining the System or for the use of the System; be involved in any purchase or sale negotiations arising from the System; provide information regarding the advisability of buying or selling the Covered Security or any other security; or receive, transfer, or hold funds or securities as a result or incident of operating the System.

The no-action response also contained a requirement that the issuer’s transfer agent, which in the case of PBA was not a bank or a registered broker-dealer, would not take in funds as escrow agent or handle funds on behalf of the System participants. Presumably, this requirement would not apply where the transfer agent was either a bank or a registered broker-dealer.

USE OF SMART CONTRACTS AND POSSIBLE BROKER-DEALER REGISTRATION REQUIREMENTS

While the PBA No-Action Relief was granted with a conventional equity security in mind and did not contemplate the existence of digital securities such as securitized tokens, the PBA No-Action Relief would on its face appear to apply with equal force in the digital context. Of course, since smart contracts did not exist when the PBA No-Action Relief was granted, the PBA no-action letter is silent on the implications of using a smart contract to settle any agreed-upon trade. Nevertheless, use of a smart contract should not raise exchange registration issues because the execution through a smart contract would not involve the interaction of multiple buyers and sellers, which is a necessary requirement for exchange status. Use of a smart contract may, however, raise issues regarding broker-dealer registration requirements.

Section 3(a)(4) of the Exchange Act defines the term “broker” to mean “any person engaged in effecting transactions in securities for the accounts of others.” Because use of a smart contract to execute or settle a trade could be considered to be “effecting” the underlying securities transaction, use of a smart contract raises the issue of whether the sponsor or provider of the smart contract might be required to register as a broker-dealer or, at the least, whether it might be necessary for the smart contract to “insert” a broker-dealer in the transaction such that the transaction could be said to flow through a registered broker.

While the Commission’s existing guidance would probably support arguments pro and con on the issue of broker registration in the context of a smart contract, there are several reasons the Commission might be likely to require that a broker be involved in a smart contract execution. Most significantly, since brokers are required to report to FINRA all off exchange securities trades in which they are involved, inclusion of a broker on a trade executed through a smart contract ensures that the trade would be reported to FINRA. Trade reporting is important to regulators as it allows surveillance for manipulative trades. From the Commission’s perspective, involvement of a broker has the additional benefit that it would require each of the parties to the trade to have a brokerage account with a broker, which means that each party’s broker-dealer, as part of the account onboarding process, would be required to verify the participant’s identify, as required under anti-money laundering rules. Of course, involvement of a broker means that it is also likely that the broker-dealer would require a payment of a commission or other charge for “effecting” the transaction.

SMART CONTRACT DESIGN

Assuming a requirement that brokers be “involved” in an execution through a smart contract, issuers of digital assets could design a smart contract to allow for the participation of multiple brokers or only brokers or even a single broker selected and approved by the issuer. The smart contract would have to have a means of verifying both that a broker has been “approved” by the issuer or, at the very least, is a member of FINRA, and that the participants in trade are customers of the participating broker or brokers. The smart contract would also have to ensure that all information necessary for the trade report, e.g., time, price, buyer and seller, is made available to the broker on an almost immediate basis so that the broker can fulfil its reporting obligation.

The smart contract could also be designed to assist with the capture by the issuer’s registered transfer agent of the information necessary to maintain the issuer’s stock ledger, i.e., to largely automate the transfer agent function, which would also help automate the process of communicating with investors.

CONCLUSION

In summary, existing no-action precedents issued by the Commission’s Division of Trading and Markets with respect to passive bulletin boards offer a model that, in the case of reporting companies, may allow posting of indicative, i.e., non-binding, quotes relating to digital securities by multiple buyers and sellers without the need to comply with the exchange or ATS registration requirements. While these no-action precedents require settlement of any agreed-upon trade to be handled directly by the contracting parties, i.e., the buyer and seller, the use of a smart contract for this purpose would seem to significantly ease any inconvenience or difficulty caused by this requirement. There may, however, be a question as to whether the smart contract must insert a registered broker-dealer in the trade execution process. In addition, the smart contract may also be used to assist the issuer’s registered transfer agent by automating the collection of the information necessary to maintain the issuer’s stock ledger.