As discussed in Part 1 of this post, on September 1st, the SEC issued a Cease and Desist Order (“Order”) against Blockchain Credit Partners d/b/a DeFi Money Market (“DMM”) and two of its founders for the unregistered offer and sale of $30 million of securities using smart contracts and decentralized finance (“DeFi”) technology. It found that the tokens issued by DMM, including “mTokens” which were marketed as paying principal and 6.25% interest, were securities because they were investment contracts pursuant to the Howey test.
Additionally, the SEC found that the mTokens were securities because they qualified as notes that are securities, under the test set forth in Reves v. Ernst & Young. The Securities Exchange Act provides that “notes” are securities. In Reves the Supreme Court held that the statute should not be read literally. Rather, a note is only a security of it falls outside specified categories of financial instruments that are not securities, or resembles an instrument in one of those categories pursuant to a four-part “family resemblance” test.
Surprisingly, the Order contains no analysis or explanation of the SEC’s conclusion on the threshold question of whether the mTokens are notes. The Supreme Court in Reves evaluated “whether an instrument denominated a ‘note’ is a ‘security.’” In the Order, the SEC simply asserts that the mTokens are notes, and then applies a Reves analysis to them.
Pursuant to Reves, notes with a commercial or consumer purpose, rather than an investment purpose, are generally outside the definition of a security. Notes that are not securities include:
• Notes delivered in consumer financing,
• Notes secured by a mortgage on a home,
• Short-term notes secured by a lien on a small business or some of its assets,
• Notes evidencing a character' loan to a bank customer,
• Short-term notes secured by an assignment of accounts receivable,
• Notes that formalize an open-account debt incurred in the ordinary course of business, and
• Notes evidencing loans by commercial banks for current operations.
The family resemblance test, which is applied to determine when a note has a “family resemblance” to notes that are not securities, has four prongs. Each of the first three is designed to capture notes that are for consumer or commercial purposes and not investment purposes. The fourth considers whether an instrument is subject to another regulatory scheme (such as the federal banking laws).
• The “motivations that would prompt a reasonable seller and buyer to enter into [the transaction]”;
• The “plan of distribution of the instrument”;
• The “reasonable expectations of the investing public”; and
• The “existence of another regulatory scheme [that reduces] the risk of the instrument, thereby rendering application of the Securities Act unnecessary.”
The SEC found that the mTokens were a security pursuant to the Reves test, because the mTokens were raised for general use of DMM, offered and sold to the general public, promoted as an investment with a rate of return, and not governed by an alternative regulatory scheme (and not possessing other risk reducing factors).
The order contains several curious features in addition to the absent analysis of whether the mTokens are notes at all. First, if the SEC is attempting to regulate nascent DeFi businesses by enforcement, DMM is a surprising target. Although it may be an unregistered issuer of securities, and although it and its owners may have misrepresented the assets of the business, as the Order indicates, nothing about DMM’s business model (other than its name) appears to be related to DeFi.
Second, assuming the SEC is confident in its position that the mTokens were notes, it is curious that the Howey test needed to be applied at all. If a note is a security pursuant to Reves, there is no need to consider whether the instrument would be an investment contract under Howey. This may be a belt-and-suspenders approach only—or the SEC may be announcing that it will use a Reves analysis in future enforcement actions if a Howey analysis would not apply. If the SEC’s definition of a “note” includes the mTokens, the only facts the SEC might need to define a note is an instrument involving an algorithm or smart contract pays principal and a fixed rate of interest.
What implication aggressive application of the Reves analysis have for other blockchain-based tokens is unclear. But many tokens could be characterized as notes under the SEC’s approach in the Order. For example, liquidity tokens represent interests in a pool of assets, such as BTC, that are paired with a pool of other assets, such as ETH. An investor who contributes digital currency on one side of the pool receives a token representing a pro rata share of the pool’s assets. When a user uses the pool to exchange BTC for ETH for a fee, holders of liquidity tokens are entitled to “principal”—their pro rata share of their side of the pool—and “interest”—their pro rata shares of the user fees. If such arrangements mean that liquidity tokens are “notes,” they are at least potentially securities under Reves— even if they would not be under Howey.
Postscript: Since we wrote this blog post, it has become public knowledge that the SEC seems to consider potentially bringing some action against Uniswap, and Coinbase tweeted about the resistance exhibited by SEC staff with respect to a potential “lend” program by Coinbase. We would not be surprised if the Reves— precedent plays a big role in these cases. Stay tuned.