#198 Nick Morgan: The DAO, the SEC and the ICO Boom

Transcript

[Music] 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 double X Co and embrace the future of cryptocurrency wallets and by shapeshift IO the easiest fastest and most secure way to swap their digital assets don't run the risk of linear funds on a centralized exchange because it's shapeshifter 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 would you and my name is Baron Fabian we're 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 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 he gonna do what action are they gonna take recently they put out a 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 the speak a bit about you know 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 he 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 y SEC and what did what is its mandate so the SEC is a US 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

halation 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 it 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 works for

fraud and requires disclosure and what is the reach of the effort of the SEC what is its jurisdiction well a threshold issue which I'm sure 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 it's obviously focused primarily on US 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 SE C'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 with this but 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 in 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 let's move to years specifically sampling sit down then

maybe you can come back a little bit to SEC enforcement and and what this could look like in this industry too so of course the dollar many people will be familiar if it but I'll just get a little bit of background for those who aren't so the Dow was this decentralized autonomous organization which was proposed that the DEFCON 1 first in London by this German companies locket and slock it of course was trying to do these IOT devices it's here my ot devices and sort of in essence they try 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 a hundred fifty million dollars and and their idea was that you would make proposals to this

dau people could token all this could vote on it from different projects and then they would hopefully generate a return and give back money to these token holders and the idea was that the Dow's lock in 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 dated about ten days before he 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 it's got exploded so this was posted by a canal professor I mean cancer and then they got hacked and about a third was stolen which was around 50 million

dollars 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 heart 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 a theorem classic was born which of course still is around so it was a big huge effect huge event in the history of aetherium and now yeah now you have this report by yes you see 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 everyone was sort of waiting to see what the sec would take on these types 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 long-standing 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 you know a good place where as the SE she's fully aware that people want to know what does the SEC think about these kinds of fundraising technologies and it went to me when I read the report and obviously this is the first time that I've read such a report it the tone is is quite accuses slock it and it's its co-founders of illegally selling a security or at least it makes that claim it doesn't place guilt upon them but you know 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 you know their their side of the story in 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 yes he sees to do it 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 involve the security and 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 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 securities 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 they 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 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 there 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 aetherium 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 and I also think that the way the Dow principles marketed or promoted to Dow made it a fairly easy cage 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 I think that those probably all wait into their selection of this case to use as its vehicle well let's go into a little bit of the details of the argument here of course they're the standard criterion that the SEC you serious is being called

the Howey test many people will have heard about this so how he test I'll just read kind of there's a 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 about investment of money common enterprise expectation for office and entrepreneurial effort of others and then they just kind of apply that to the Dow right in so the 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 cryptocurrencies here money was that surprising to you or no that's

a pretty straightforward application not not too much to talk about there actually what was interesting is that when they use that in the first finger said you know this was they they gave it a Bitcoin or the gave ether and this was an investment of money into a common enterprise now in the second thing the common enterprise they don't actually talk about it much they don't justify why they consider this a common enterprise now and just sort of gloss it over which surprised me a little bit so can you elaborate on that is 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 I didn't view the SEC report as Sir 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 this particular application involved a common enterprise that almost sounds like any crowdfunding campaign would be into common enterprise tiger I agree yeah if people are going to design their their enterprise so that it

doesn't qualify as security common Enterprise is not is not where you're gonna win that battle so it's it's it's it's sort of inherent in the nature of a crowdfunding arrangement and 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 dog because they said it's a for-profit and it's gonna pay out basically a dividend so every war it's right so this is straight forward in that case but it's interesting to think about or to to understand exactly to what extent is depended on what the people marketing the Dow said as opposed to you know the

expectation of people participating in that how does the SEC look at that so the expectation is the investors expectation so if the promoter said for example we don't you should not expect any profits from this enterprise but the SEC was able to find evidence that the investor 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 investors 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 the gloss that's put on it by the promoters let's take a short break to talk about Jax Jax is your wallet your complete user interface to cover all your blocks your needs I've been using it not been loving and jock supports a lot of different cryptocurrencies suppose Bitcoin Easter like corn if you're in class say Kazee cash or Karev they're adding many more keep responding to users needs now if Jax the nice thing is that you manage all of those coins within single wallet and you are in control of your own private keys they're not on their server and there's a single 12 vert seat that you can use to back up your wallet all your coins and sync them across different devices talk about devices

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Jack's for their support of epicenter how easy is it to prove that investors had an expectation of profit you know when you're talking about thousands of investors how do they make that well so it's interesting this issue has come up most recently there's a 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 US 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 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 investment 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 that's how they would go about it that's interesting and it's interesting also it

it relates in this case to certain icos and one could argue that i ceos that sell tokens that have a utility value within the application that the developers are creating that these tokens you know have some value and that investors may in fact not have an expectation of profit but have an expectation to people use the future app the application in the future would you see that as perhaps a point upon which the the sec would have a hard time proving this this point right now 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 it's 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 the security and during the investigation there would be an opportunity to talk with the staff members who are 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 IC o---- 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 that's diminished I guess there is also kind of degrees here right and two different extend and and if you have ten thousand investors and for five hundred you can kind of demonstrate okay they say they clearly did expect that and and some other part you know had maybe more mixed motivations does it matter like you know what percentage of investor I know there's no sort of hardline 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 and then you're you know 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 it yes he spent the most time on and I think it is also the most tricky one because you know even if you have to the other one reasonable expectation of profit I think people today investing and putting money into these crypto

crowdfunding campaigns unless expectation of profit is certainly a very prominent or you know 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 argue against but I think there'll always be a plausible case to make that that was the case so maybe last one is the most interesting one so this derived from many cheerily effort of others the SEC clearly are used that this was the case here that people basically relied on the shlocker team and the founders to to make this profit do you feel this was a a clear-cut in in your in your view Qi

think one could make a good argument that this wasn't the case here so yeah I think I agree with you this is the element of the Howey 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 Howey test the Howey test came from the 1940s and 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 earth worm 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 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 yes as they cited a lot of examples here they said they clearly had a case I mean I think one could make the opposite case you and you know if you look at this

let's say we looked 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 DA was that this wasn't the case right so you can of course say in the reality in this beginning there was many K in many aspects in which you still relied on the efforts of all this and and the founding team and stuff but yeah I mean the whole idea of it was that it's with a decentralized fund that decisions will be made in a decentralized way and the the money will be managed in the SunTrust way so it's interesting that they you know so focus 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 some promise and that's why it is a security I agree with your interpretation I they 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 why 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 ICC'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 the SEC describes the activities of SLOC it and its co-founders so as being authors of the white paper as write as being authors of the code for the do 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 the DAO as a product and as descent 5vc fund but they also state that and I'm quoting here that SLOC had deployed the DAO code on the a theorem blockchain however this is can't really be verified I mean of course it's it's quite possible that schlock it did in fact deploy the code but let's say we live in a world where one you know we can't verify that it's my feeling that in the community and it's or 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 I 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 to the Howey tests they're trying to see whether the investors the people putting the money in are passive in turn of where the expectation of profits so I think the deployment of the code is certainly eight one data point but if there are other aspects like what's

cited in the GAO report of managerial efforts certainly deploying the code is one of them but I don't think it's tells the whole story like let's 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 they're the cursor stands there where the SEC might not consider you know SLOC it to be responsible for for this Dow well so it's going to be a collective test or a sort of a test in the aggregate what were all the efforts that the stock at or its equivalent in the next IC o---- what were all of their managerial efforts and the I don't 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 it will choose cases that where 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 a it's not a passive investment if that's what someone's relying on to not come under the SE C's jurisdiction I'd be very cautious about about trying to sort of position it

solely based on that kind of a thinking if we if you look at the DA right and if you kind of say okay let's let's apply this sort of reasoning to some other examples you know exactly let's let's you see if your example how do you think this report would fall in the case of ethereum well they could have brought they could have issued a twenty one a report about aetherium I think that has many aspects that don't look like a security and so if the theory am wouldn't make an ideal example for this kind of a 21 a report they wanted to pick a relatively legally easy case to make their point so I don't think they're gonna bring a case against

aetherium mark my words maybe I'll be wrong but so we could analyze aetherium and I'm not I'm not familiar enough with how its structured to apply each of the Howey elements but I think the fact that the SEC hasn't brought a case yet and chose to bring this 21:8 report on the DAO and not on the theory of large I think that says something I think they're probably not going to bring one Ben I sort of run through these 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 a theorem wasn't marketed in the same way as Lockett and you know ether said III as gas and sort of usage so that one is less clear and then on the forefront actually I think a theorem is going to be clearer that it is derived from an ethereal 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 dow but so I think if you look at this argument and they did the same thing on here I'm a Fink well we could do it of course too although if the big difference that yeah the Dow is a dead project and

there's nobody's gonna stand up and defend it and that would be much harder if a theorem for Summa Blee true and I agree with you that the expectation of profits elements would be the difficult one to 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 the profit you're it's it's more akin to hope 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 two enforcement so let's say I have a great idea for a Dow and I I

launched an IC o---- I sell a token that tokens is deemed by the SEC to pass the Howey test and is considered to be a security and they decide to enforce and practice 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 ICC's office would first catch wind of viewer 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 sense the penis to the principal's the organizers and gather information and a threshold issue is going to be does this enterprise meet the Howey test assuming there is no suggestion of fraud happening in other words 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 it's you've organized your your Dao just like the idea oh and it's cup 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 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 administrative li 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 it so that's a public process but now they're in front of a judge and the thing the 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 SCC's allegations or denying them we agree to settle and the SE C'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 disgorgement of any ill-gotten gains is the way they would phrase it so money me that you had the benefit of that was a 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 as appropriate under the facts of 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 he applied this to do example like there was no fault there I think that's nobody really argues that and so there's also no ill-gotten gains because in the end yeah they didn't make any money from this thing so is that why they didn't do this because okay the case it's it's just not interesting enough that the

will be too low there would be some kind of fine against maybe this locket found this 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 it's the first time yes she 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 J 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 coin desk recently just touching on your your description earlier of how an enforcement action would go would go through by a gentleman of by the name of Jason Simon Sato of morva lo LLP and I'll link to the show notes where he describes from his point of view as as a lawyer defending companies and violations of securities law I guess first limit Ruth do you what you do he describes you know what what that looks like and and as 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 it's not gonna look good for you because this 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 IC o---- they run a risk of being targeted by the SEC

ending up in the SCC's crosshairs in in a potential in a lawsuit or having to settle for admission of guilt for having violated securities law so it to me it sort of acts as a pretty good deterrent for anyone that wants to I was thinking of doing an IC o---- well what are your thoughts on that yeah a couple of thoughts so first of all I would never advise someone to structure an IC o---- that was close to the line of being a security or not if that if the intent was to avoid the federal securities laws but a couple of things you said one I want to correct one one point which is the requirement and a settlement that a defendant admit the violations of the law the SEC has on occasion required

settling defendants to make admissions but by and large most SEC settlements involve but 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 SE C's allegations what the world sees is the SE C'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

reputationally 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 it's 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 is that why most people settle because they 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 it's expensive to lynnie 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 who can't you know 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 in this example in particular because a lot of projects that are now raising money through these cryptic are funding campaigns are raising large amounts and 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 gonna be one factor that they all try to go after projects that they don't think have the 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 you know we said we were going to spend the money on something and we spent it on something else that's 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 raise money and and then people lose money and they they're unhappy and they complain and and that's really when we will see there's you see mostly taking action yeah you think again go back to the position of the staff attorney at the SEC in one of the regional offices or even in the home office in DC 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 we're 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 fact scenarios they're going to get a staff attorney incentivize to so you know go and the institution of the sec has a whole incentivize to go after something now you layer on so disgruntled investors will probably be the source of one of the next cases another possible source though is the BSE she'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 an 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 as I mean if you're if you ran an SEO and you raised your three hundred four hundred five hundred

million dollars and you know you're offered some you know like it's a fifty thousand dollar bounty you you're not really incentivized to do that so the bounties that have been awarded have arranged the way they're calculated is if the SEC brings a case and if the SEC obtains a monetary recovery 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 if you're an insider

and you're you're you have information suggesting that money is being misused in one of these icos and there's a million dollars 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 if I see a case comes out of a whistleblower seeking a bounty this episode is brought to you by shape-shift the world's leading trustless digital assets change quickly swap between dozens of fleeting cryptocurrencies including Bitcoin ethers e cash gnosis manera golem or cur and so many more when you go to

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support of epicenter but also the kind of implications from what you're saying is that this is like literally zero probability is zero chance because right now you know we are seeing 20 30 of these ICO so crowdfunding campaigns a month 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 yes you know some kind of blanket you know going after everybody like that's not gonna happen right absolutely they don't have the resources you know they have to pay attention to you know the rest of what they do on a day-to-day basis

investment advisers publicly traded companies brokers auditors all that other stuff 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 gonna bring will involve fraud because they can't possibly go after all of the purveyors of icos it just they don't have the resources to do that yeah cuz I was thinking before okay so from an ICC perspective how would you go about it sir I will what are your options and then I can I can see sort of two two possibilities right one is to say we are going after the ones are

really scam so really sketchy this you know the case is clear and they have done that to some extent right they had they went after this thing called pay coin which everybody agreed in in the crypto space this was a fraud the guy was some sort of had done previous falls 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 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 we if you are looking at this as a gigantic you know trend and wave that's becoming very dominant that is not gonna do anything to slow down this trend in movement

because people will say yeah of course they should go after those people but we're not gonna do fraud and so we're fine alright so and the only other option I would see is that they go after to 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 a secure you know they they didn't like promoted in dubious ways they didn't misuse their funds and 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 do you think that's the possibility to us oh 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 a hypothetical staff attorney in some office look to bring an enforcement matter and that's 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 say 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 more you know particularly following this report on the DAO so that you can get some more feedback from the SEC short of an enforcement action and 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 the 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 for the fraud case example that I described in that example let's say they 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 as security but we're not enforcing anything what would would I have any practical implications what say they data about the theorem they wrote they wrote this report saying we think it's your missus security meant then what well I think if if the if a division decide the division of corporation finance for example decided that there was an IC o---- that involved a security and violated the registration provisions an on 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 IC o---- involves a security that by itself has

no impact on the outside world it's 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 or take where that impacts coming from is that the report says it changed as a platforms where those tokens tokens were tradable they are also you know violence violating securities law and now we have seen bit fan access announced that they will to list some tokens that were basically created through these IPOs and shapeshifters also announced that they will use the how it has themselves apply to the tokens that they support trading for and

then delist the ones that if we fail this is this something common that the SEC tries to kind of enact its power by my exchanges or these intermediaries yes absolutely and I would not be surprised to see a case against a platform or an exchange and the reason if we go back 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 it's a it's a

sort of easier target if you will to go after an exchange than it is to go after the 12i cos that are being exchanged on that platform so yeah I think that's that's from a resource allocation perspective and and other sort of policy reasons I think in exchange would likely get some attention before Nathan I see oh 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 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 it's desirable and creates potentially jobs and and all this sort of things so you know given given the industry 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 out reports like this and and and pursue enforcement I kill off the block

chain 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 of our industry so I agree with you that that this 21a report has the potential to chill like a positive helpful good economic activity and that would be but I don't think we should extrapolate too far from the 21 a report I think they chose the DAO because it was a relatively straightforward application that I could send a message so that's I think one 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 and US markets that he attributes to over-regulation and so I think we'll see some reluctance but some cautious thoughtful approaches from the SEC not to overdo this not to expand the GAO conclusions too far what one opportunity that I see here and

I think something that might be this horrible was would be to sort of leverage this this this innovation you know that we've 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 in a in a company you have to be an accredited investor which means you have to have certain amount of capital or certain amount of revenue what are your thoughts on you know allowing smaller investors to take part and large funding projects without you know this criteria and and blockchain technologies allow and being

being the mechanism and sort of the technology and the the ecosystem through its this could this could occur so you bring up a good point about accredited investors and obviously the issue of credit investors is assuming you're dealing with the security and you're trying to fit that offering of securities into an exemption from registration that's where the subject if 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 you may 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 have to apply here if that perform takes takes hold yeah I mean expanding opportunities is I guess where where there's there's a lot of potential I mean just look at you know the JOBS Act and and the provisions in there for crowdfunding and just the entire industry that that that that blossomed from that it would I think definitely a step in the right direction if you similarly with icos we could open up this this this capital to you know just

non-accredited investors or people that just don't want to invest you know it's 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 look either way the ICO market is going to involve 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 market 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 GAO 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 the day in terms of resource allocation and the incentive there is to have these se owes I think they're going to happen one way or the other and so the SEC should find ways to to enable a market to happen in ways that will protect investors did not squelch the innovation so the last podcast episode we did was with with Donna Larimer who's the CTO of Yass Yass is is the project that has raised like

gear flags raised 300 million dollars 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 the token has no features no value no functionalities no rights no basically that the 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 their money for building the thing and so that this sort of this disassociation I guess I don't

know if this was actually a clear the people who put in money I didn't follow it to closely what do you think of that kind of argument do you think we will see these I don't know to it to me they feel somewhat bizarre twists 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 yes you would ever say that I added they will shy away from a hard case particularly if there's fraud involved but the way you describe the EOS tank sounds very novel frankly it sounds like a charitable enterprise I mean you're you're donating money for what purpose it sounds like for anybody exactly it's

a for-profit right so it's actually right in terms of the investors expectations the way you described it makes it sound like the investors should be 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 diminishing any expectations of profits right but of course this is this is in the terms and conditions sort of hidden away you know this yeah I think the expectation of most people when putting money into this is that there is an expectation of profits whether or not they read the Terms of Service right and and that gets back to sort of what we talked about before about the SEC will 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 the SEC could could make a case there particularly if they're raising large amounts of money if that is the kind of thing that would give the SEC attention I mean maybe one question just look we haven't really covered it but like what from from your standpoint and where you stand as a securities lawyer what is your impression and about what's happening in the blockchain space right now and just the massive amounts of money that are being raised and very short amount of times for projects that very much are in the seed stage or not even in the seed stage I think it's fantastic I think that the more

opportunities there are for investors to engage with investments particularly that involve new technology I think it's fantastic it's 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 yeah absolutely that's a a great perspective so yeah Nick thanks so much for coming on that

was super interesting super valuable I also personally to just learn so much about the SEC how they how they will think about this stuff how they will go about this I think a lot of people will will find this very very illuminating so thanks so much for joining us today and thanks so much for a listener for once again and tuning in to be a part of less topical Network even on this show and other shows and less topical comp 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