Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The SEC and The DAO

The US SEC has published an Investigation Report concluding that crpyto-currency tokens issued by The DAO constitute securities under US law. I am not a lawyer, and it is not my intention in this post to dispute the SEC’s conclusion which is, on balance, probably correct. What bothers me is that some vital facts seem to me to have been suppressed and misrepresented in the report. In particular, several passages look like the kind of suppresio veri suggestio falsi that one does not expect from a top notch regulator like the SEC which commands global respect:

DAO Token holders’ votes were limited to proposals whitelisted by the Curators, and, although any DAO Token holder could put forth a proposal, each proposal would follow the same protocol, which included vetting and control by the current Curators. While DAO Token holders could put forth proposals to replace a Curator, such proposals were subject to control by the current Curators, including whitelisting and approval of the new address to which the tokens would be directed for such a proposal.

This ignores the ability to split The DAO and create a new “child” DAO with a new curator. The hacking of The DAO (which the SEC refers to as the Attack below) involved exactly this splitting.

Second, the pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control. … This was later demonstrated through the fact that DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others.

In reality, it is the DAO Attack that constitutes the biggest obstacle to the theory that The DAO tokens were securities. The tokens looked much more like securities when they were issued than they do in retrospect after the Attack:

  1. The only important events (“investments” in some sense) in the entire life of the DAO were the Dark DAO (the Attacker) and the Robin Hood Group or the DAO White Hat Team. Since neither of these were initiated by Slock.it, this completely demolishes the idea that Slock.it was in a position to control The DAO.

  2. I could not help laughing out loud on reading the sentence: “DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others”.
    • If the “others” refers to the Robin Hood Group (White Hat Team), this statement is factually incorrect: (a) the Robin Hood Group were also token holders (and not others) and (b) they were acting not on behalf of Slock.it, but in their individual capacity, struggling with “bad internet and family commitments”.

    • The major assistance that Slock.it provided in reversing the Attack was not in their role as developers of The DAO, but in their role as developers of Ethereum which was the platform on which The DAO ran. What the core developers did was to change the rules of Ethereum to undo the Attack.

      The right analogy is that of a company where the government has been outvoted in a shareholder’s meeting (because it has been reduced to a minority stake), and the government proceed to change the law and use its sovereign powers to get its way. This would establish not that the government still controls the company, but that it has lost control. The analogy is apt because Ethereum was the closest thing to the sovereign when it comes to The DAO.

    • Even this “assistance” (changing the rules of Ethereum) was well beyond the powers of Slock.it. Ethereum is far more decentralized than The DAO; even the SEC has not claimed that the Ethereum coin offering was a securities issue! The Ethereum community did not actually care much about the wishes of Slock.it. Whatever influence was there was the personal influence of Vitalik Buterin. (In much the same vein, the Ethereum community probably did not care much about Cornell University, but listened with respect to Emin Gun Sirer). Even Buterin’s enormous personal credibility could not prevent a split in Ethereum and the creation of the parallel coin, Ethereum Classic

In short, the Attack demonstrated that at truly important junctures, crypto communities are truly decentralized. The events in Bitcoin in the last few weeks provide additional corroboration of this.

These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.

The SEC forgets that The DAO did not have a Board or a Chief Executive who run the company on a day to day basis. In the case of The DAO, the day to day administration of the organization was in the hands of the token holders.

By contract and in reality, DAO Token holders relied on the significant managerial efforts provided by Slock.it and its co-founders, and The DAO’s Curators, as described above.

The claim “By contract” is very rich. The DAO was very clear in all its communications that it was governed by its code and repeatedly emphasized that all English language descriptions were subordinate to the smart contract embedded in the code: code is law. And, I am sorry, the code did not contain any promises by Slock.it to provide managerial efforts.

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3 responses to “The SEC and The DAO

  1. David C Fischer August 1, 2017 at 8:31 pm

    Seems that you might have strayed from your original declaration that you would not dispute the SEC’s conclusion (as opposed to pointing out deficiencies in the narrative). In the U.S., the Supreme Court’s “Howey” test is, as stated in the SEC’s release, whether there is a “common enterprise with a reasonable expectation of profits to be derived from entrepreneurial or managerial efforts of others.” In all cases I’ve seen, the test is applied to the ongoing operations of the enterprise, rather than who is in control during an emergency; and the language you quote from the release related to The DAO’s ordinary business, i.e., choosing “Contractors” to run “projects.” In this connection, the SEC’s discussion of the ADO Token holders’ reliance upon (or being subject to) the decisions of the Curators and Slock.it at least seems credible. Interestingly, albeit not entirely germane to the point of the release, the SEC neglected to mention that the Contractors could themselves be considered issuers of securities. In any case, from this perspective and notwithstanding the attention the release has received, the SEC’s conclusion is unremarkable, except, perhaps, for its tacit assumption that the Ethereum Blockchain currency is not a security .

    • Jayanth Varma August 2, 2017 at 11:46 am

      As I made it clear at the outset, I think the conclusion is probably correct and in any case, I am not disputing it. However, I believe the SEC has an obligation in a report of this kind to place opposing facts on the table, and then argue why these inconvenient facts do not change the conclusion. For example, your argument that “the test is applied to the ongoing operations of the enterprise” should have been made by the SEC after pointing out that the original curators completely lost control in the aftermath of the Attack.

      Also, I would like to point out that the Split DAO functionality was an integral part of the normal ongoing operations of the enterprise and the SEC should have mentioned it and explained why in their view, this did not change their conclusion. The Split ended up being used in unusual circumstances, but was intended to be used in normal circumstances (in fact, the entire DAO governance structure would have been untenable without the Split DAO functionality). Unfortunately, The DAO did not have any normal operations at all in its short life.

      The SEC’s suppression of material facts is what bothers me. Particularly because in emerging markets like mine, we all tend to look up to the SEC as an effective regulator.

  2. David C Fischer August 1, 2017 at 11:39 pm

    Correcting the second-to-last sentence, in a footnote, the SEC indirectly addressed the question that Contractors would be issuers of securities by referring to the Investment Company Act.

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