DAOsing Rods and the Power of Enforcement Prediction
Thoughts on Recent SEC statements and Action on Enforcement Related to Decentralized Autonomous Organizations (DAO)
On November 10, 2021 the US Securities and Exchange Commission (the SEC) announced that it had halted the first ever attempt to register digital tokens issued by a decentralized autonomous organization (DAO) under the US federal securities laws. American CryptoFed – also the first DAO to take advantage of Wyoming’s new “DAO Law” that attempts to give DAOs legal status – filed Form 10 and subsequently filed a Form S-1 in an effort to register its digitals assets in the form of two coins designed to operate in tandem issued under the names Locke and Ducat.
A DAO is an organization encoded as a transparent computer program, controlled by the organization members and not by a central corporate entity, often through a governance token utilized on a blockchain.
In the SEC’s announcement, they alleged that the registration statement filed by American CryptoFed contained a number of deficiencies, including purportedly misleading statements such as claims that the tokens were not intended to be securities and may be distributed on the form of registration statement used for registration of securities under an employee benefit plan. Perhaps just as importantly, the registration statement failed to provide substantive information about the issuer as is required to be disclosed in the form, such as information regarding its business, management, and financial condition. One telling example of the deficient information concerns the issuer’s ownership structure, which a pure DAO would be unable to produce by its very nature of being a DAO.
This highlights several issues with being able to register DAO-issued tokens under the current regulatory framework. The SEC disclosure forms rightly require financial statements and business information regarding the issuer. That said, a DAO is not really an entity. There often is a supporting entity in place alongside a DAO, and in some instances an organization that isn’t really decentralized may be mislabeled as a DAO, but the DAO itself in almost all circumstances would not be able to produce financial statements prepared in accordance with generally accepted accounting principles. If the DAO does not have a definable business and truly is decentralized, then there may not be a management structure for which information can be provided. Further, depending on the circumstances, the financial condition of a DAO may be of limited relevance to holders of the tokens, particularly if there truly is a level of decentralization that would allow the project to move forward even if the ‘entity’ sponsoring the token were to collapse (or the financial statements of the issuer could be looking at the wrong thing if the treasury of the DAO is not housed in that entity). Simply put, this action implies that it will be difficult if not impossible for true a DAO to register its tokens under the current regulatory framework, even if it sets itself up in a way to attempt robust compliance.
Avoiding the Line and Counsel?
Any spurt of innovation, particularly the one we are experiencing now with decentralized finance and DAOs, will test the boundaries of existing regulation and hopefully lead to regulatory flexibility and updated regulations. For this reason, a recent statement by SEC Chair Gensler could use additional clarification. On November 4,, 2021, a few days before the American CryptoFed halt, at the first SEC Enforcement Forum since he became Chair, Gensler laid out a number of enforcement directives of the SEC, putting an emphasis on a the economic reality of a transaction regardless of what form it is in. In particular, he emphasized that terms such as “decentralized finance” (DeFi), “currency,” or “peer-to-peer lending” should not be taken at face value without looking at what the transaction is really doing.
While it is important to understand the spirit of the law and never act fraudulently regardless of the law, the role of legal counsel is to help clients work within the law, even if it is near the boundary of the law. Gensler’s statement - “if you’re asking a lawyer, accountant, or adviser if something is over the line, maybe it’s time to step back from the line” – has the potential to deter entrepreneurs from seeking counsel and encourage haphazard action. While a measure of caution is not undue, it does have the potential to stifle innovation. This is after all a new frontier of finance where advances are made in the margins often by those who get there first. Consulting with responsible counsel is something that any innovator should be encouraged to do. Seemingly discouraging innovators from seeking counsel, and asking those who are trying to be responsible and comply with the law to not even attempt to do so, would only increase the prevalence of bad actors, exposing all parties - including investors - to the very risks that regulators are trying to avoid.
Rulemaking Under Any Other Name…
A few days after Chair Gensler’s statement, Gurbir Gruwal, the new Director of the Division of Enforcement gave prepared remarks discussing the role of that Division. The remarks were largely a defense against the assertion that, with respect to the crypto industry, the SEC has been “regulating by enforcement” rather than creating new regulation. Mr. Gruwal gave three examples to show how the Division’s Cyber Unit’s enforcement of digital assets actions are enforcing existing laws and not creating new law. The first example he gave was the Kik ICO, followed by a recent Ponzi scheme that claimed to use DeFi but did not actually support a DeFi network and, last, the BitConnect project that also was long thought to be a Ponzi scheme. While there was not complete consensus within the digital asset legal community about how Kik’s KIN token would be treated for federal securities law purposes, the latter two were blatant frauds of what would have obviously been securities, had they existed at all. Selecting those straightforward examples out of hundreds does not mean that there haven’t been other enforcement actions in areas where the law was quite unsettled.
While the Division of Enforcement is doing a lot of great work, the speech shows that there is a fundamental misunderstanding of the industry’s frustration over “rulemaking by enforcement.”
Rather than coming out with new regulations that provide somewhat bright lines, one must wade through a gallimaufry of enforcement actions, press releases, risk alerts, and speeches to determine the current state of the law. Even then, there is a wide gulf between what the SEC has endorsed and publicly warned against with any level of specificity. In the nearly 10 months since the current administration took office, there have only been a small handful of new proposed rules and only in the last week have any new substantive regulations been approved. “Rulemaking by enforcement” is really shorthand for the lack of clear, concise guidance needed for those who want to comply with the law to actually comply with the law. This particularly rings true for aspects of many blockchain technologies that are fundamentally incompatible with existing regulations, even if they are compatible with the spirit of the law. The SEC Staff has announced that it will try to tackle this problem with respect to the Advisers Act “Custody Rule” by modernizing it, but it does not appear that any other meaningful regulation relating to digital assets or decentralized finance is on the horizon.
Maybe the SEC should also consider a framework under which a DAO or a supporting organization of a DAO can register securities, particularly as the discussion regarding regulation of stablecoins and DeFi starts to heat up.
The prepared remarks close out as follows:
“This is not “regulation by enforcement.”
This is not “regulation by enforcement.”
This is not “regulation by enforcement.”
There. I have said it thrice and what I tell you three times is true.”
This is (not) regulation by speechmaking at its finest.