LGO Markets Regulatory Update — Week of November 12, 2018

In this update, we talk about the EtherDelta settlement, the SEC’s promise to deliver ‘Plain English’ ICO guidelines, and ISDA’s latest whitepaper on smart derivatives contracts.

SEC Targets Decentralized Exchange EtherDelta in Latest Enforcement Action

In the first enforcement action of its kind, the SEC announced chargesThursday against EtherDelta founder, Zachary Coburn, for securities laws violations in operating an unregistered securities exchange. It alleged that EtherDelta embodied “both the user interface and underlying functionality of an online national securities exchange” in matching buyers and sellers of “digital asset securities” without SEC registration or qualifying for an exception.

The SEC described 3.6 million transactions occurring on the decentralized platform, which utilizes smart contract code deployed on the Ethereum blockchain to provide a secondary market for ICO products and any ERC-20 token with no closing hours or geographical restrictions. The transactions occurred over an 18-month period from July 12, 2016, to December 17, 2017, which is around the time Coburn sold EtherDelta to foreign investors. The agency highlighted that most of the transactions occurred after its highly-publicized July 2017 DAO Report.

Notably, the agency failed to call out any particular tokens of the 500 officially listed during the relevant period but simply stated that the tokens traded on EtherDelta included security tokens without providing any deeper insight regarding the specific qualifying characteristics.

This action comes in line with the SEC’s broad market warning it released back in March in which it emphasized that many “exchanges” hosting token products are doing so outside the confines of securities laws without registering as a national securities exchange (NSE), alternative trading systems (ATS), or broker-dealer with the SEC. It also comes just one month after the joint SEC and CFTC charges against foreign swap dealer, 1 broker, for failing to register as a dealer in connection with its security-based swaps funded with bitcoin.

Without admitting fault, Coburn cooperated with the SEC and entered into a settlement, agreeing to pay close to $400,000, including civil penalties, disgorgement, and prejudgment interest. This likely marks the beginning of similar SEC enforcement actions.

SEC to Provide ‘Plain English’ ICO Guidelines

SEC Director William Hinman announced at D.C. Fintech Week that the agency was preparing “a plain English instrument” to help token issuers more clearly decipher their status under federal securities laws. The announcement comes on the heels of the SEC Division of Enforcement’s 2018 annual reportin which it listed ICOs as a top enforcement priority.

Hinman said that the ICO guidance would elaborate on the analysis provided in his “When Howey Met Gary (Plastic)” Speech back in June. In that speech, he discussed the application of two prominent securities law cases–the seminal SEC v. Howey Supreme Court case from 1946 and the Second Circuit’s Gary Plastic decision from 1985. These cases, he reasoned, provide a basis for finding that digital assets can originally be sold in a security offering and later be sold in a manner that does not constitute a security offering. By focusing on the circumstances surrounding the sale and not the digital assets themselves, he provided some key questions token issuers should consider when analyzing their sale under securities laws:

  • Do the token promoters play a significant role in the development of the digital asset?
  • Have such promoters retained a motivating stake?
  • Is the primary motivation for purchase use or speculation?Does application of the Securities Act make sense?
  • Is there an informational asymmetry between promoters and purchasers?

This announcement comes in addition to the SEC’s October launch of FinHub, a “Strategic Hub for Innovation and Financial Technology.” FinHub aims to bridge the communication gap between entrepreneurs, developers, their advisors, and regulators by providing an avenue of open dialogue, information sharing, and cross-border communication.

ISDA Publishes Whitepaper on Smart Derivatives Contracts

In the latest installment of its smart contracts series, the International Swaps and Derivatives Association, Inc. (ISDA) issued an October 2018 whitepaperdiscussing the significant efficiencies smart contracts could provide in derivatives markets, such as automating the performance of certain events and obligations.

It described a smart contract as “an automatable and enforceable agreement…although some parts may require human input and control.” They are enforceable “either by legal enforcement of rights and obligations or via tamper-proof execution of computer code.” It distinguished smart contract code from smart legal contracts, focusing on the latter in the paper.

The paper paid considerable attention to the legal, technological, and operational challenges involved with deploying smart derivatives contracts in practice. It highlighted the compatibility issue, namely that they must comply with complex pre-existing regulatory, legal, commercial, and technological standards.

As a potential solution, the paper suggests use of a modified version of its Common Domain Model (CDM). The first draft of ISDA’s CDM was published in October 2017, offering a “standardized model for post-execution trade lifestyle.” It described certain “events” in the life of a derivative transaction, dividing such events into “dependent events,” those “contingent on the economics of a derivatives contract,” and “independent events,” those that change the nature of the contract, like the termination or amendment of a transaction.

The paper goes on to detail lawyers’ roles in focusing on the dependent events as they are the more automatable of the two. It describes how the industry can work together to forward a single “library” of functions that can be used to construct the template for many different financial products.

While noting that implementing smart derivatives contracts in the marketplace will be a complex task, the paper provides a practical step forward from a legal perspective, encouraging collaboration between lawyers, technologists and market participants.

The information provided is for informational purposes only. It does not constitute legal or investment advice.

Sources used in this article:

https://www.sec.gov/news/press-release/2018-258

https://www.sec.gov/litigation/investreport/34-81207.pdf

https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading

https://www.sec.gov/news/press-release/2018-218

https://www.sec.gov/files/enforcement-annual-report-2018.pdf

https://www.sec.gov/news/speech/speech-hinman-061418

https://www.isda.org/a/cHvEE/Smart-Derivatives-Contracts-From-Concept-to-Construction-Oct-2018.pdf


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