Epicenter - Learn about Crypto, Blockchain, Ethereum, Bitcoin and Distributed Technologies - Nick Morgan: The DAO, the SEC and the ICO Boom

Episode Date: August 29, 2017

Nick Morgan, a former attorney at the SEC, joined us to discuss their recent report on the DAO and what it means for the ICO boom. Topics covered in this episode: The history and mandate of the SEC Nick’s years as a trial attorney at the SEC How the Howey Test is used to determine if something is a security The application of the Howey Test to the DAO case The weaknesses in their argument that token holders relied on the effort of others Why the SEC did not prosecute the Slock.it founders Why the SEC will likely focus on token sales involving fraud How the SEC’s limited resources will make it hard for it to impact the ICO boom The implications of the SEC report for cryptocurrency exchanges Episode links: SEC Press Release on The DAO SEC Report on Investigation of The DAO Seven Takeaways from the DAO Report - Kyle Mitchell EB134 – Emin Gün Sirer And Vlad Zamfir: On A Rocky DAO Nicolas Morgan Website The DAO Report: Understanding the Risk of SEC Enforcement - CoinDesk This episode is hosted by Brian Fabian Crain and Sébastien Couture. Show notes and listening options: epicenter.tv/198

This is Epicenter, Episode 198 with guest Nick Morgan. This episode of Epicenter is brought to you by Jax. Jax is the user-friendly wallet that works across all your devices and handles both Bitcoin and Ether. Go to J-A-A-W-X.I.O and embrace the future of cryptocurrency wallets. And by Shapeshift.I.O. The easiest, fastest, and most secure way to swap your digital assets. Don't run the risk of leading your funds on a centralized exchange. Visit Shapeshift.io to get started.

Hi, welcome to Epicenter, the show which talks about the technologies, projects, and startups driving decentralization and the global blockchain revolution. My name is Sebastian Quirju. And my name is Brian Fabian Crane. We're here today with Nick Morgan. Nick is a partner at Paul Hastings, which is a law firm in Los Angeles. And he was also before in the enforcement division at the SEC for seven years, you know, pursuing various security cases. And of course, the SEC has been a sort of word and topic in the blockchain space for many, many years. People often thought, okay, what's the SEC going to do? What action are they going to take?

Recently, they put out the report on the Dow, which is a long report, very interesting report. So I'm super happy that we have Nick on today to speak about this report and to speak a bit about, how does the SEC look at these things, what kind of action can we expect from the SEC in the coming years and how is that going to impact the blockchain industry. So thanks so much for joining us today, Nick. Thank you for having me. Exciting topic. Yeah, absolutely.

So can you give us some background? A lot of people will have heard about the SEC, but not really be too familiar with the details. Like, what is the SEC and what is its mandate? So the SEC is a U.S. federal agency. It was created in the 1930s as a result of the stock crash in the late 1920s. And prior to its creation, there was very little federal regulation of the securities markets. And so there were two acts promulgated, the 1933 Securities Act and the 1934 Securities Exchange Act. And they each did different things.

The 34 Act created the SEC. And the mandate of the SEC is really twofold. Its disclosure of material information is required and has an anti-fraud backstop for that. So the original conception, and it's basically held true, is not to evaluate the merits of a particular investment, but to require disclosure of information and to prevent fraud in those disclosures. And that's carried through from the 1930s to today. That still is the mandate of the SEC. It looks for fraud and requires disclosure.

And what is the reach of the SEC? What is its jurisdiction? Well, a threshold issue, which I'm sure we're going to talk about today, is it's limited to securities. And so an obvious first question when the SEC seeks to assert jurisdiction is whether a security is involved. So that's a subject matter limitation. And then it has some geographical limitations as well. It's obviously focused primarily on U.S. investors, although not exclusively. And so at the fringes, where you see investors outside the United States involved in business enterprises outside the United States, the SEC's jurisdiction is not as strong as it is when

the businesses and investors are in the United States. And so you were in enforcement at the SEC. What does that job look like? What was your role there and what would you actually do day to day? So I was in the Los Angeles office and the SEC has offices all around the United States and the enforcement staff attorneys are looking for cases to bring. So they have lots of different ways they get information and some of those methods have changed as technology and statutes have been changed over the years.

But essentially, we would take an information from informants, disgruntled investors, employees, whatever the source, other regulators to see whether there was a securities law violation. And then we would investigate it. This is before there's any lawsuits involved, the staff has the power to send out subpoenas to require production of documents, to require witnesses to come in and give testimony. They gather those facts. They put them together and internally decide what to do. And that decision is made by five commissioners in Washington who are politically appointed.

And they have the decision-making authority about whether the SEC should file a lawsuit and pursue these violations. So the day-to-day job of a staff attorney is to collect information, organize the information, and then help make the recommendation about whether to do something about it. Cool. Well, let's move to a specific example of the DAO and then maybe we can come back a little bit to SEC enforcement and what this could look like in this industry too. So of course, the DAO many people will be familiar with it, but I'll just get a little bit of background for those who aren't. So the DAO was this decentralized autonomous organization, which was proposed at the DEF CON won first in London by this German company, SLOCIT. And Sloket, of course, was trying to do these IoT devices, Ethereum IOT devices. And sort of in essence, they tried to raise money for themselves by creating this VC fund, how they call it, kind of decentralized VC fund.

And they raised that 12 million ether, which was at the time about $150 million. And their idea was that you would make proposals to this Dow. People could token holders could vote on it, fund different projects. And then they would hopefully generate a return and give back money to these. token holders. And the idea was that the Dock itself would make one of those proposals. And then there was, this was quite rushed. It was quick. They raised a ton of money and it was not so well written code, for example. So there was a podcast which we did about 10 days before it got hacked about all the security flaws and what they were doing. And then right,

and actually one of the things we discussed there was what got exploded. So this was posted by Cornell professor, Emine Genssir, and then they got hacked and about a third was stolen, which was around $50 million. And then of course, there was a big disagreement about what to do. People ended up, the majority ended up deciding, okay, we're going to undo this hack, do a hard fork, take the money back, which is what happened. However, it was a hard fork and some people did not like this. And then they continued on the old chain. And this is also how Ethereum Classic was born, which of course still is. around. So it was a big, a huge event, a huge event in the history of Ethereum. And now, yeah,

now you have this report by the SEC on, on that and what they think about this. So with that background, what do you think about this report? How do you, what's your general impression? I think the report is really unremarkable. I mean, obviously, as you said, uh, everyone was sort of waiting to see what the SEC would, would, what the SEC's take on, uh, these types of of technologies would be, but anyone who's sort of a student of securities law wouldn't be surprised by anything that was in the Dow report. It appeared to apply longstanding law to a novel new area, which is what the SEC does. So I didn't think it was that remarkable. These 21A reports are not that common. They come out every once in a while on a variety of topics where the SEC wants

to make a pronouncement about something. And this looked like a good place. The SEC's fully aware that people want to know. What does the SEC think about these kinds of fundraising technologies? And to me when I read the report, and obviously this was the first time that I've read such a report, the tone is quite accuses Slocut and its co-founders of illegally selling a security.

or at least it makes that claim. It doesn't place guilt upon them, but it's quite clear that in their position there was wrongdoing, from their position, sorry, that there was wrongdoing. What would it take? I mean, what more do we need in order to have an enforcement of basically this report that just lays out their side of the story and their position? Right.

And that's one thing to keep in mind is when the SEC issues a report like this, you're getting a one-sided view. You're getting the SEC's view. We don't get to hear the other side's view. But to answer your question, this report dealt almost entirely with whether the Dow was a security or involved a security. And the importance of that issue, obviously, is if it's not a security, the SEC doesn't have jurisdiction and the federal securities laws don't apply. So it was important that they sort of stake out their ground and say this is a security. Several things flow from the conclusion that it's a security. The first one being every security's offering or sale has to be either registered or exempt from registration. So when you describe accurately that the report says the Dow principles had liability, they had broken the law, what the SEC really focused on was the fact that the Dow had not registered or qualified for an exemption from registration.

I think the case that the SEC will bring next against someone will involve the other aspect of the federal securities laws, the anti-fraud provisions. And I think the discussion about whether a security exists and whether registration was required will be included in that type of a case. But I don't think we'll see the next case be argued solely on the basis of whether it's a security and whether it should therefore have been registered. that will be an anti-fraud component to that. Why do you think that this report was written about the Dow and not some other decentralized autonomous organization, ICO, or even Ethereum itself? Well, this is me speculating, but I think the Dow was fairly high profile because of the hack. It got a lot of press. The amount of money raised was fairly significant.

So that's another factor in favor of choosing this one over another one. I also think that the way the Dow principles marketed or promoted the Dow made it a fairly easy case for the SEC. There are certainly more difficult legal cases where it would be harder for the SEC to make its point. So here they have a high profile, fairly large dollar amount, and legally a fairly simple straightforward analysis. So I think that those probably all weighed into their selection of this case to use as its vehicle.

Cool. Well, let's go into a little bit of the details of the argument here. Of course, the standard criterion that the SEC use here is being called the Howie Test, many people will have heard about this. So the Howie Test, I'll just read kind of the one sentence definition, actually, very short and simple. So it's an investment contract, or an investment contract is an investment of money into a common enterprise with an expectation of profit to be derived from the entrepreneurial effort of others. So basically four things, right, investment of money, common enterprise, expectation of profits and entrepreneurial effort of others.

And then they just kind of apply that to the DAO. Right. And so I mean, I guess even the first point is kind of interesting, right? So they say investment of money clearly it was. So they consider Bitcoin ether and cryptocurrency here money. Was that surprising to you or? No, that's like a pretty straightforward application. Not too much to talk about there.

Actually, what was interesting is. When they used that, in the first thing they said, you know, this was, they gave Bitcoin or they gave Ether and this was an investment of money into a common enterprise. Now, in the second thing, common enterprise, they don't actually talk about it much. They don't justify why they consider this common enterprise down, just sort of gloss it over, which surprised me a little bit. So can you elaborate on that? What is a common enterprise? Well, so it's a grouping of people who are going to act with a common purpose as opposed to individuals who are making individual investments that are unrelated to the other investors.

So here, all of the investors in the Dow had a common interest in that investment, as opposed to one person making an investment that's unrelated to the other investors. So I didn't view the SEC's report as sort of shying away from that issue. it just didn't seem that there was much to talk about there because it seemed pretty self-evident that this particular application involved a common enterprise. That almost sounds like any crowdfunding campaign would be into a common enterprise.

Do you think that's true? I agree. Yeah, if people are going to design their enterprise so that it doesn't qualify as security, common enterprise is not where you're going to win that battle. So it's sort of inherent in the nature of a crowdfunding arrangement. And then the next point was this expectation of profit. Of course, this was, as you point out, was easy to argue in the case of the dollar

because they said it's a for profit and it's going to pay out basically dividends or rewards. So this is straightforward in that case. But it's interesting to think about or to understand exactly to what extent is depended on what the people marketing the Dow said as opposed to the expectation of people participating in that. How does the SEC look at that? So the expectation is the investor's expectation. So if the promoter said, for example, we don't, you know, you. You should not expect any profits from this enterprise, but the SEC was able to find evidence that the investors still expected profits from the enterprise.

That would be an interesting, much closer case, and I wouldn't want to predict which way it would come out, but the investor's expectations are where the focus would be. So if the economic reality is different than the way the promoters characterize the investment, the SEC will look at the economic reality of the transaction rather than the label or the gloss that's put on it by the promoters. Let's take a short break to talk about Jacks. Jacks is your wallet, your complete user interface to cover all your blockchain needs. I've been using it and I've been loving.

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We'd like to thank Jax for their supportive epistans. How easy is it to prove that investors had an expectation of profit? You know, when you're talking about several thousands of investors, how do they make that? Well, so it's interesting. So this issue has come up most recently. There's a, I don't know if you're familiar with the EB-5 visa program, where people outside the United States are able to make investments in the United States and qualify for a visa if certain conditions are met.

So that's created a whole cottage industry where enterprises in the U.S. are selling interests to build a shopping mall or do whatever. And in that case, the people making the investments really could care, well, in many instances, could care less whether the shopping mall or the plant or whatever it is it's being built with the investor money, whether there's a profit. They're investing for the purpose of getting a visa. and so they have whether they have whether they actually make money on investment or not is irrelevant to them. And so there have been several cases brought where there was an argument that there was no security involved because there was no expectation of profits. And the issue hasn't been litigated to my knowledge in a very sort of satisfactory where you could pull it apart and see.

But the answer to how difficult it is to prove is the SEC would go and talk to investors and find out what their expectations were. That's how they would go about it. That's interesting. It's interesting also how it relates in this case to certain ICOs. I mean, one could argue that ICOs that sell tokens that have a utility value within the application that the developers are creating, that these tokens, you know, have some value in that investors may, in fact, not have an expectation of profit, but have an expectation to people to use the application in the future. Would you see that as perhaps a point upon which the SEC would have a hard time proving this point, right, about expectation of profit?

It is. That would be a good, if I were representing someone who had been sued by the SEC for a failure to register or be exempt, I would make that argument. And so what you, sort of a dose of reality here, the way this would come about is the SEC would investigate it. They would talk to investors. they would talk to the principals, the creators, and they would come to a determination of whether they thought it was a security. And during the investigation, there would be an opportunity to talk with the staff members who were doing the investigation and try to persuade them that this is not a security. On a fairly esoteric point like this, I can tell you the SEC would not necessarily be interested in the finer academic points, particularly if there is also a potential fraud being committed in connection with the offering. So it's a good defensive point to raise.

And if you're trying to organize an ICO in a way that's not a security, you'd want to obviously make it so that the expectation of profits is diminished. Yeah. Okay. That's diminished. I guess there is also kind of degrees here, right, and to different extent. And if you have 10,000 investors and for 500, you can kind of demonstrate, okay, they said they clearly did expect that. And some other part, you know, had maybe more mixed motivations. Does it matter?

Like, you know, what percentage of investor? I don't. There's no sort of hard line, bright line of percentage of investors and what their expectations are. The way these things normally play out is the SEC would gather information about investors who supported their case. They would present those. And if someone were actively defending, they would try to find investors who had a different conception of what the investment was. And then you're sort of at the mercy of a federal court judge or an administrative law judge to make the decision or potentially a jury. Okay, excellent.

And then the final point, which is actually where the SEC spent the most time on. And I think it is also the most tricky one because, you know, even if you have the other one, reasonable expectation of profit, I think people today investing and putting money into these crypto crowdfunding campaigns, and expectation of profit is certainly a very prominent, or you know, it's certainly what drives this in almost any token sale to a significant extent. So I think that one again is going to be less or more tricky depending on project to against, but I think there will always be a plausible case to make that that was the case. So maybe the last one is the most interesting one.

So this derived from miniature effort of others. The SEC clearly argues that this was the case here, that people basically relied on the Slocke team and the founders to make this profit. Do you feel this was a clear cut in your view? Do you think one could make a good argument that this wasn't the case here? So, yeah, I agree with you. This is the element of the Howie test that the SEC struggled the most with. And I do think this is the place where a fight could be won.

Really, the test of expectation of profits coming solely from the efforts of others. If you keep in mind sort of the history of the Howie Test, the Howie Test came from the 1940s and it involved citrus groves in Florida being sold to investors vacationing from New York. And so there's, you know, decades of experience of courts wrestling with novel arrangements and whether they arise solely from the efforts of others. There have been earthworm farms, chinchilla breeding programs. I mean, every possible way to raise and use money has been used. And this element gets a lot of attention.

And so here, yeah, I think they struggled a bit with this one. And ultimately, what they're trying to do is decide whether the investors are really passive investors or whether they're actively involved in creating the value. And they decided here that the investors were not actively involved, that they had to rely, as you say, on the curators and the socket principles for the investment to pay off. Yeah, so they cite a lot of examples here. So they clearly have a case. I mean, I think one could make the opposite case, too. And, you know, if you look at this, let's say we look at the reasonable expectation of profit, right? It's pretty clear.

This was structured in a way to make a profit for people. But at the same time, if we look at the other one, you know, derived from managerial effort of others. Actually, I think fundamentally the idea of the doubt was that this wasn't the case, right? So you can of course say in the reality in this beginning, there was many aspects in which you still relied on the efforts of all this and the founding team and stuff. But I mean, the whole idea of it was that it's with a decentralized fund, that decisions would be made in a decentralized way and the money would be managed in a decentralized way. So it's interesting that they, you know, so focused on that point and they clearly seem to think they have a strong argument there that it sort of almost didn't live up to its own promise.

And that's why it is a security. I agree with your interpretation. I would say, though, that I found their argument defensive. I thought they put a lot of effort on this element because it was the closest call, the closest to not being met. And so if I were a defense attorney arguing against the SEC on this element, that's where I would focus my energy because I think you're right. This sort of contradict, this argument by the SEC contradicts the whole conception of the decentralized investment like this. So it's a place where – so again, we're looking at a report that's just the SEC's point of view. If we were in court in front of a judge, we would be making the arguments that you're making to show that, in fact, this is about as decentralized as you can get, although I suppose you can structure it differently to be even more decentralized.

So what's interesting in this report is that the – so the SEC describes the activities of Slocut and its co-founders, so as being authors of the white paper. as being authors of the code for the DAO, as the administrators of the website, online forums, basically doing all the marketing, promotion, curation of content, responding to support tickets on forums and things like that. And so they were very actively involved in promoting the DAO as a product

and as a decentralized VC fund. But they also state that, and I'm quoting here, that Slocut deployed the DAO code on the Ethereum blockchain. However, this can't really be verified. I mean, of course, it's quite possible that Slocut did, in fact, deploy the code, but let's say we live in a world where we can't verify that.

It's my feeling that in the community, in sort of the blockchain space, there is this assumption that if you don't hit the deploy button on the smart contract, if you don't send that transaction that you're not responsible for the code. And it would appear by this report that that is, it's wrong to think that. Can people be protected if the contract is not actually deployed by them? Does that sort of fall to the wayside when all this other activity is being conducted? I don't think so. At least I don't think the SEC would see it that way. The SEC is just again getting back to the element of the Howie test. They're

trying to see whether the investors, the people putting the money in, are passive in terms of where the expectation of profits. So I think the deployment of the code is certainly one data point, but if there are other aspects like what's cited in the DAO report of managerial efforts, certainly deploying the code is one of them, but I don't think it tells the whole story. Let's imagine that they had written the white paper but had left it up to the community to write the code and deploy the code, right? Like, where do you think the cursor stands there where the SEC might not consider, you know, SLOC to be responsible for this Dow? Well, so it's going to be a collective test or sort of a test in the aggregate. What were all the efforts that the Slockeet,

or its equivalent in the next ICO, what were all of their managerial efforts? And the, I know we'll probably talk about this a little bit later, but I think that the finer points about where on the spectrum this particular issue lands is not going to be, is not going to be the determinant as to whether the SEC brings its next case. It will choose cases that when this particular element falls closer to the line of not involving expectation of profits solely from the efforts of others. but I wouldn't rely on, okay, we only did these things. And so it's not a passive investment. If that's what someone's relying on to not come under the SEC's jurisdiction,

I'd be very cautious about trying to sort of position it solely based on that kind of a thinking. If we look at the DA, right, and if you kind of say, okay, let's apply this sort of reasoning to some other examples. Let's use the Ethereum example. How do you think this report would fall in the case of Ethereum? Well, they could have issued a 21A report about Ethereum. I think that has many aspects that don't look like a security, and so the Ethereum wouldn't make an ideal example for this kind of a 21A report. They wanted to pick a relatively legally easy case to make their point.

So I don't think they're going to bring a case against Ethereum. Mark my words, maybe I'll be wrong. But so we could analyze Ethereum, and I'm not familiar enough with how it's structured to apply each of the Howe elements. But I think the fact that the SEC hasn't brought a case yet and chose to bring this 21A report on the DAO and not on Ethereum large, I think that says something. I think they're probably not going to bring one. When I sort of run through the same arguments and try to apply the money theorem, right? So we have the first two, we have this investment of money, which is the same. Common enterprise, I guess, is the same.

Then the reasonable expectation of profit, so that is going to be more ambiguous, right? Because Ethereum wasn't marketed in the same way as lock it and, you know, ether is gas and sort of usage. So that one is less clear. And then on the forefront, actually, I think Ethereum is going to be clearer. that it is derived from an material effort of others. Because you could say, okay, the funds went to a foundation that then, you know, there was kind of managed in some way.

And especially it was possible to just kind of buy ether, sit back and profit. Okay, you could do that too with the Tao. But so I think if you look at this argument and they did the same thing on Ethereum, I think one could do it, of course, too, although with the big difference that, yeah, the Tao is a dead thing. project and there's nobody's going to stand up and defend it. And that would be much harder with Ethereum, presumably. True. And I agree with you that the expectation of profits element would be the

difficult one for the SEC to meet here. I mean, it looks much more like a store of value than an enterprise that you're hoping will one day yield a profit. It's more akin to hoping you're buying a currency and hoping the value of the currency. will change in your favor. So I think it's a tougher call for the SEC on that element. So let's move on to enforcement. So let's say I have a great idea for a Dow. And I launch an I CO.

I sell a token. That token is deemed by the SEC to pass the Howie test and is considered to be a security. and they decide to enforce and prosecute myself and my company for having sold a security and not registered as a security and followed regulation. What would that look like for me as an entrepreneur and running a company and perhaps also to a lesser extent, what would that look like for the investors? Right. So keep in mind, the two types of cases, very generally speaking, that the SEC brings are fraud cases and non-fraud cases. So in your hypothetical, Brian, of a situation where it's a registration violation, that's a non-fraud violation. In other words, a person doesn't have to intend to be defrauding people to violate the law. So the way it would start is some staff attorney in one of the SEC's office would first catch wind of your DAO. and start investigating. So they get subpoena power.

At this point, there's no lawsuit been filed. No allegations have been made. The SEC hasn't reached any conclusions about whether a security exists or not. It's purely an information gathering process. So that staff attorney sends out subpoenas, picks up the phone, starts calling people, would call investors, would call or send subpoenas

to the principals, the organizers, and gather information. And a threshold issue is going to be, Does this enterprise meet the Howie test? Assuming there is no suggestion of fraud happening, in other words, a suggestion that someone is misusing the proceeds of the offering in a way they didn't say they were going to use them, I think the SEC would be very cautious in bringing an action. But let's say they find a blatant one.

You've organized your DAO, just like the DAO, and it meets all the elements, and there's no question, and they decide to bring a case to make an example. they would have a discussion with you and before filing a lawsuit, they would make the recommendation to the five commissioners in Washington to file a lawsuit, and then they would file a lawsuit. They can do that in federal court. I can do it administratively in front of an SEC administrative law judge. So essentially, when they file a complaint, they're starting a litigation. Now they're making accusations. It's a public process.

That's a press release. There would be lots of news stories. Your podcast would cover it. And, you know, so that's a public process. But now they're in front of a judge and the thing, the matter gets litigated. Almost everyone, because you're up against the federal government, tries to find a way to settle that litigation. And so if there's a settlement, that means that the judge never decides whether the SEC is correct about its legal arguments. You essentially say, without admitting the SEC's allegations or denying them, we agree to settle.

and the SEC's normal types of sanctions that it imposes are an injunction against future violations of the federal securities laws. So presumably not a big issue. Most people don't want to violate the federal securities laws. Discorgement of any ill-gotten gains is the way they would phrase it. So money that you had the benefit of, that was the result of the legal violations. In this kind of a case, that could mean if you had the benefit of the money, all of the money raised through the DAO, and then civil penalties of some dollar amount

to be determined as appropriate under the facts and circumstances. So that would be a typical sort of non-fraud judgment. There would be a federal court order imposing those types of things. It would be public, and presumably that would be the end of your DAO enterprise. Okay, that's super interesting. So if we apply this to the O example, right, there was no fraud there. I think that's nobody really argues that. And so there's also no ill-gotten gains because in the end,

they didn't make any money from this thing. So is that why they didn't do this? Because, okay, the case, it's just not interesting enough. The penalty will be too low. There would be some kind of fine against maybe the Slokk it found list, but that's it. Well, so they, I think the reason they didn't bring it is because the DAO was dead. It's not a functioning enterprise. it's the first time the SEC has spoken definitively on whether a security exists. And so

I think they chose this opportunity to send a message rather than bring a case. It may also be a reflection of the change in leadership at the SEC. We have a new SEC chair and he, Jay Clayton, I don't know. I wasn't privy to the internal discussions, but it would be consistent with his sort of outlook on markets to send a message first rather than have your opening salvo be an enforcement action in federal court. So I think probably a lot of different factors played into it, but I think those are probably the primary ones. So there was an interesting post in CoinDes recently just touching on your description earlier of how an enforcement action would go through by a gentleman of the name of Jason Samenzato of Morvillo LLP. And I'll link to the show notes. We're

He describes, from his point of view, as a lawyer defending companies and violations of securities law, I guess, very similar to what you do. He describes, you know, what that looks like. And as a company or an enterprise in the crosshairs of the SEC, you know, whether or not you're in violation of securities law, Okay, I guess not if there's fraud, but whether or not you're in violations of securities law, it's not going to look good for you because the SEC will never admit to having wrongfully accused or wrongfully taken to trial an enterprise. Any settlement would involve you having to make some statement admitting guilt, admitting that you did in fact violate securities law. So it seems that for anyone getting into this space and thinking of doing an ICO, they run a risk of being targeted

by the SEC, ending up in the SEC's crosshairs and in a potentially lawsuit, or having to settle for admission of guilt for having violated securities law. So to me, it sort of acts as a pretty good deterrent for anyone that wants to, or is thinking of doing an ICO. What are your thoughts on that? Yeah, a couple of thoughts. So, first of all, I would never advise someone to structure an ICO that was close to the line of being a security or not if the intent was to avoid the federal security laws. But a couple of things you said, one to want to correct one point, which is the requirement and a settlement that a defendant admit the violations of the law. The SEC has on an occasion required settling defendants to make admissions, but by and large, most SEC settlement.

involve the defendant not admitting to violations of the federal securities laws. That doesn't help you much reputationally once the SEC has filed a lawsuit in federal court and made this public display alleging that you violated the federal securities laws. And I think the point, I haven't read the post you referred to, but I think the point being made there was if you settle a case, even if you don't admit the SEC's allegations, what the world sees is the SEC's complaint making those allegations. There's no retraction of those allegations. And there's a federal court order imposing sanctions on you as a result of those allegations.

So reputationalally, you know, you're right. The SEC would never sort of retract what it said. The only way to get the SEC to acknowledge that its legal opinion is incorrect is to win and get the judge to adopt your legal arguments. And that means taking the case all the way through trial potentially. So that's a difficult process. So is that why most people settle because they don't want to go through this long process? They don't want to spend years fighting this.

In the vast majority of cases, yes. I mean, obviously there are cases where the defendant has no good legal or factual arguments to make, and it's in their best interest to settle for that reason. But for many defendants, I mean, it's expensive to litigate against the federal government with its infinite resources. It's a long, drawn-out process, distracting from your business activities, expensive. So most people settle for that reason, the ones who can't afford or don't want or choose not to be involved in litigation for years. So that's the vast majority of defendants.

Although I guess that is interesting in this example, in particular, because a lot of projects that are now raising money through these crypto crowdfunding campaigns are raising large amounts. and they presumably would have the resources to spend, you know, maybe many millions of dollars on, you know, fighting, something like that. Do you also think that's going to be one factor that they'll try to go after projects that they don't think have their resources to really fight? I don't think that's a big factor in case selection at the SEC. I think the case selection is how strong are the violations, what's the number of potential victims?

And I do think the next enforcement case that gets brought will involve not just the issue of whether it's a security, but whether there's fraud involved. And so the focus of that kind of case is much more on the fraud. We said we were going to spend the money on something and we spent it on something else. That's the kind of case that'll get the attention of the SEC. And then, of course, they'll sweep in these Howie type arguments and say that it was a security and needed to be registered and wasn't. But I think those, the arguments that were the focus of the DAO report will become secondary in any case that involves fraud. And I guess that mostly means that the risk is biggest for projects that raise money and then people lose money. And they're unhappy and they complain.

And that's really when we will see the SEC mostly taking action. Yeah. I mean, I think again, go back to the position of the staff attorney at the SEC in one of the, the regional offices or even in the home office in D.C., who's thinking about how much energy should I put into this investigation, how much energy should I put into putting together a case. The cases, the types of fact situations that will get the most attention are ones where disgruntled investors are coming in, very upset at, you know, I was told this, I was told X and what happened was not X. Those are the kinds of facts scenarios that are going to get a staff attorney

incentivized to, you know, go, and the institution of the SEC as a whole, incentivized to go after something. Now, later on, so disgruntled investors will probably be the source of one of the next cases. Another possible source, though, is the SEC's whistleblower program, which permits the SEC to award a bounty to someone who provides information about securities law violations. So we've seen lots of insiders who are coming forward. in an effort to get one of those bounties providing information. And so particularly here in the crypto crowdfunding area where enforcement may be very difficult,

the existence of a whistleblower who comes in and shares information that might otherwise be very difficult for the SEC to get, that might prompt a staff attorney to go after a case if there's particularly useful or damaging information from an insider. So, well, what are the, what are these bounties look like? I mean, if you're, if you run an SEO and, you know, you raised, 300, 400, 500 million dollars, and, you know, you're offered some, you know, like, say, $50,000 bounty. You're not really incentivized to do that. So, the bounties that have been awarded have ranged, the way they're calculated is if the SEC brings a case and if the SEC obtains a monetary recovery for, from a defendant, either in the form of penalties or disgorgement, then the whistleblower is entitled to a certain percentage of that bounty that, I mean, of the monetary remedies that are imposed

and collected. So in very different contexts, the dollar amounts of some of these bounties have been huge, you know, into the tens of millions of dollars. So if you're looking, you know, if you're an insider and you're, you have information suggesting that money is being misused in one of these ICOs, and there's $100 million raised and potentially that amount of a judgment to be imposed, the bounty could be significant. So I wouldn't be surprised, particularly given the difficult nature of enforcing the securities laws in this context,

wouldn't be surprised if an ICO case comes out of a whistleblower seeking a bounty. This episode is brought to you by ShapeShift, the world's leading trustless digital asset exchange, quickly swap between dozens of leading cryptocurrencies including Bitcoin, Ether, Zcash, Gnosis, Monaro, Golem, Auger, and so many more. When you go to Shapeshift.io, you simply select your currency pair, give them your receiving address, send the coins, and boom. ShapeShift is not your traditional cryptocurrency exchange. You don't need to create an account. You don't need to give them your personal information, and they don't hold your coins.

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And this is just going up and up and up. And so that the number is exploding. And it sounds like there's zero chance that we will see from the SEC, you know, some kind of blanket, going after everybody. Like that's not going to happen, right? Absolutely. They don't have the resources. You know, they have to pay attention to the rest of what they do on a day-to-day basis,

investment advisors, publicly traded companies, brokers, auditors, all that other stuff that they look at. They have to apply their resources to all of that in addition to looking at this relatively new, relatively small portion of the market compared to the rest of the things they look at. So they will be looking to deploy their resources, efficiently. And that's why I say, I think the next case they're going to bring will involve fraud because they can't possibly go after all of the purveyors of ICOs. It's just they don't have the resources to do that. Yeah. Because I was thinking before, okay, so from an ICC perspective,

how would you go about this? So what are your options? And then I can see sort of two possibilities, right? One is to say we are going after the ones that really scams, they're really sketchy, there's, you know, the case is clear. And they have done that to some extent, right? They went after this thing called pay coin, which everybody agreed in the crypto space. This was a fraud. The guy was some sort of had done previous frauds before.

He was doing all kinds of shady stuff, right? So nobody was, it was a clear case, and they went after that guy. And so that's, of course, one thing. And I guess that's also what you are pointing out here. Okay, they will go after fraud. But the thing is, if you are looking at this as a gigantic, you know, trend and wave that's becoming very dominant, that is not going to do anything to slow down this trend and movement. Because people will say, yeah, of course, they should go after those people,

but we're not going to do fraud. And so we're fine. Right. So, and the only other option I would see is that they go after the complete other end, right? they say we go after that project that is, you know, try to do everything right. And they, they were careful in what they said. They tried to structure it so it's not as secure. You know, they didn't like promoted in dubious ways.

They didn't misuse their funds. And of course, if they went after that, it would, it could really have an impact because they would be people, projects wouldn't feel safe and they wouldn't know how to position themselves in order to avoid that danger. Do you think that's a possibility, too? So I do. And so there are different constituencies within the SEC that will be looking at this issue and they'll treat it differently. I've been focusing on the hypothetical staff attorney in some office looking to bring an enforcement matter. And that certainly, I think, is probably going on right now. And they will naturally drift toward the cases that involve fraud.

There are other constituencies within the SEC that look at this from a much more analytical perspective, and they will be looking for a test case, and it won't necessarily be an enforcement case. I think there have been people who, so for example, a division of corporation finance will opine, will give an opinion on whether something is a security or not. And so lawyers on behalf of ICOs may write a letter to that division asking for an opinion, hey, we are structuring one in this way. Will you, the division of corporation finance, give us a no action letter saying that you will not recommend taking action in our specific context?

So you've got that sort of avenue of dialogue with the SEC, which I think people will take advantage of, particularly following this report on the DAO, so that you can get some more feedback from the SEC short of an enforcement action. And the people analyzing this issue from that point of view will keep their eyes out for another DAO example at the high end that's raising a lot of money that in the opinion of those SEC staff members involves a security, is not registered, doesn't qualify for an exemption from registration. And they will pick and choose, again, based on allocation of resources questions, pick and choose some cases at the higher end where there's no fraud involved, again, to make an example.

So I think we will see guidance come out from other divisions of the SEC, not the enforcement division. And I think we'll see some selective cases being brought against entities that don't involve fraud. But it will be more selective than the sort of staff attorney looking at. for the fraud case example that I described. But in that example, let's say they had a case, they had some example like that, and they wanted to say, okay, this isn't fraud, but we still think it's a security,

but we're not enforcing anything. Would I have any practical implications? Let's say they did that about Ethereum. They wrote this report saying, we think Ethereum is a security, and then what? Well, I think if the division decided, the division of corporation finance, for example, decided that there was an ICO that involved a security and violated the registration provisions, a non-fraud example, they would take that to the enforcement division and encourage the enforcement

division to investigate and bring a case. Then at that point, it becomes really a resource allocation issue. Is this example something where the SEC wants to litigate the case? And so they would take into account whether they want to expend the resources to do that, whether this is the best example of a case to bring to send a message to others and deter others from violating the same provisions. And then it would be up to the five commissioners, the politically appointed commissioners, whether to approve the case or not. So you're right, merely an internal determination that a particular ICO involves a security, that by itself has no impact on the outside world. It's really when the SEC decides to take action by filing a lawsuit. That's when you have the broader impacts.

So one area where we have already seen some impact from this SEC report, at least that's, I think, our take where that impact is coming from, is that the report says exchanges or platforms where those tokens, there are tokens, were tradable. They are also violating securities law. And now we have seen BitFinex as a side. announced that they will delist some tokens that were basically created through these ICOs. And ShapeShift has also announced that they will use the Howie Test themselves,

apply to the tokens that they support trading for, and then delist the ones that they think failed is. Is this something common that the SEC tries to kind of enact its power via via exchanges or these intermediaries? Yes, absolutely. And I would not be surprised. I see a case against a platform or an exchange. And the reason, again, if we go back to the idea of the SEC trying to allocate its resources in the most effective way possible, the exchanges are a nexus. You can effectively speak about a number of different ICOs at one time by going after an exchange. So it's a sort of easier target, if you will, to go after an exchange than it is to go after

the 12 ICOs that are being exchanged on that platform. So, yeah, I think that's from a resource allocation perspective and other sort of policy reasons. I think in exchange likely get some attention before an ICO that wasn't involving any fraud. The entire premise behind blockchain technologies are at least one of the ideas is this idea of permissionless innovation. And we have seen quite a lot of that. We've seen a lot of new types of application come out of.

this space, new types of fun, obviously types of funding mechanisms through these ICOs. And I think if you asked a lot of people in the community and a lot of people working in the community, entrepreneurs and people that have good intention, this is something that is valuable and is desirable and creates potentially jobs and all this sort of thing. So, you know, given the industry and where it's at today and where it's at today and where things are going in the industry. This sort of feels like, well, it sort of feels like the SEC is potentially, you know, if it continues to put up reports like this and pursue enforcement, kill off the blockchain industry potentially, right? Or stifle this type of innovation.

What are your thoughts on, you know, how the SEC is handling blockchain technologies and what this type of report means for the future of our industry. So I agree with you that this 21A report has the potential to chill positive, helpful, good economic activity, and that would be a shame. But I don't think we should extrapolate too far from the 21A report. I think they chose the DAO because it was a relatively straightforward application, and they could send a message. So that's, I think, one word of caution is it's not extrapolate too far out. The other thing is we have seen, I think, a movement in favor of relaxed capital-raising regulation requirements. So we've got the Jobs Act. The current chair of the SEC

has spoken publicly about the dwindling number of IPOs in U.S. markets that he attributed. to over-regulation. And so I think that we'll see some, not reluctance, but some cautious, thoughtful approaches from the SEC not to overdue, not to expand the GAO conclusions too far. One opportunity that I see here, and I think something that might be desirable,

would be to leverage this innovation, you know, that we've seen with this new type of funding mechanism to allow what I guess we would call today unaccredited investors to invest in projects up to a certain amount, right? I mean, at the moment, to be an accredited, to invest in a company, you have to be an accredited investor, which means you have to have a certain amount of capital or a certain amount of revenue. What are your thoughts on, you know, allowing smaller investors to take part in, you know, large funding projects without this criteria and blockchain technologies allow, being the mechanism and

sort of the technology and the ecosystem through which this could occur. So you bring up a good point about accredited investors. And obviously the issue of accredited investors is assuming you're dealing with a security and you're trying to fit that offering of securities into an exemption from registration, that's where the subject of accredited investors comes up. So if you limit your offering to certain types of investors, accredited investors, or if you limit your offering to certain geographies, then your offering may qualify for an exemption from the registration provision.

So the accredited investor threshold obviously keeps out of these offerings, lots of people who don't meet the income and net worth requirements. So there's a whole movement separate apart from the ICO movement to reform the accredited investor definition to, expand the opportunities available to investors who don't meet that threshold and certainly that would apply here if that perform takes hold. Yeah, I mean, expanding opportunities is I guess where where there's a lot of potential. I mean, just look at, you know, the Jobs Act and the provisions in there for crowdfunding and just

the entire industry that that blossomed from that. It would, I think definitely a step in the right direction. If similarly with ICOs, we could. open up this capital to, you know, just non-accredited investors or people that just, you know, want to invest, you know, small amounts of money in these projects. Right, right. So I think the accredited investor issue becomes an issue if your ICO is a security and you're trying to fit your ICO into a registration exemption.

You know, I think we can, if we're looking to see the way the ICO market's going to evolve, I think if we look at the private placement market, which happens right now every day where people are raising money through private placements of securities, I think you'll see some similarities in the ICO markets. I think people will continue, some people will continue to raise money through ICOs and not really pay much attention to the registration issue, the issue outlined in the DAO report. That's just going to happen. And some of those people will raise money.

Some of them will do good things. and some of them might get sued by the SEC, but for all the reasons we've talked about today in terms of resource allocation and the incentive there is to have these ICOs, they're going to happen one way or the other. And so the SEC should find ways to enable the market to happen in ways that will protect investors

but not squelch the innovation that's going on here. So the last podcast episode we did was with Dan Larimer, who's the CTO EOS. EOS is the project that has raised like GIFLAS raised $300 million so far. So I think it's the biggest ever at this point. And they have a very interesting legal structure. So what they in their term said was that token has no features, no value, no functionalities, no rights, no basically that people putting in money have no rights whatsoever.

And then the other thing they argued was that the money is not actually going towards building the thing, but it's just going to the company. And they already had the money for building the thing. And so that it's sort of this association, I guess. I don't know if this was actually clear to people who put in money. I didn't follow it too closely. What do you think of that kind of argument? Do you think we will see these?

I don't know, to me, they feel somewhat bizarre twists of, and is that something that the SEC will then say, okay, well, it's harder to go after these, so we will not do that? I don't think the SEC would ever say that. They won't shy away from a hard case, particularly if there's fraud involved. But the way you describe the Eos thing sounds very novel. Frankly, it sounds like a charitable enterprise. I mean, you're donating money for what purpose? It sounds like for any purpose. Except it's a for-profit, right?

So it's actually... Right. But in terms of the investor's expectations, the way you described it makes it sound like the investors should aren't being told they should have no expectations of anything profitable coming out of this. So even if it's structured as a for-profit, it sounds like companies trying to position itself as, you know, diminishing any expectations of profits.

Right. But, of course, this is in the terms and conditions sort of hidden away, I think the expectation of most people when putting money into this is that there is an expectation of profit, whether or not they read the terms of service. Right. And that gets back to sort of what we talked about before about the SEC. We'll look at the economic substance of the arrangement rather than the gloss that the promoter puts over it. So if, in fact, people are investing with the expectation of profits, you know, the SEC could make a case there, particularly if they're raising large amounts of money, that is the kind of thing that would get the SEC's attention.

Maybe one question just that we haven't really covered. From your standpoint and where you stand as a securities lawyer, what is your impression about what's happening in the blockchain space right now and just the massive amounts of money that are being raised in these very short amount of times for projects that very much are in the seat stage or not even in the seat stage? I think it's fantastic. I think that the more opportunities there are for investors to engage with investments, particularly investments that involve new technology, I think it's fantastic. I fear that a couple of bad apples will spoil the bunch, that it will be people who are not honorable, who are misusing the investors money. And when the SEC brings a fraud case against those people, it will give the impression. that there's something problematic with the entire market.

I think that's a shame because I think it's a great opportunity. Yeah, absolutely. That's a great perspective. So yeah, Nick, thanks so much for coming on. That was super interesting, super valuable. Also personally, to just learn so much about the SEC, how they will think about this stuff, how they will go about this. I think a lot of people will find this very, very illuminating.

So thanks so much for joining us today. It's my pleasure. It's been great talking about it. And thanks so much for a listener for once again, tuning in. So we are part of LessopiCone Network. You've been at this show and other shows on Lesstoppicone.com. If you want to support the show, then please leave us an iTunes review. It helps new people find the show.

Thanks so much. We look forward to being back next week.