Part I
On August 6, 2021, the Securities and Exchange Commission issued a Cease and Desist Order (“Order”) against Blockchain Credit Partners d/b/a DeFi Money Market (“DMM”) and two of its founders, Gregory Keough and Derek Acree (collectively, “Respondents”), for the unregistered offer and sale of $30 million of securities using smart contracts and decentralized finance (“DeFi”) technology. The Order also charged the Respondents with fraud. Although the Order primarily sounds in fraud and misrepresentation, it is the first enforcement proceeding involving a platform characterized by the SEC as a DeFi platform, signaling that the agency intends to increase policing in the space, as was previously noted in remarks by Chairman Gary Gensler last week. In this Part 1, we summarize the order and the underlying facts and address the SEC’s analysis under the Howey test. In Part 2, which we will post in a few days, we will address the SEC’s application of the Reves test to find a blockchain-based token to be a security subject to the federal securities laws, and the implications of this development.
According to the SEC’s Order, DMM represented to investors that they would earn 6.25% interest plus additional profits on digital assets through DMM’s purchase of “real world” assets. DMM offered two types of tokens: (1) mTokens, which Respondents said accrued interest and could be redeemed at any time, and (2) DMG tokens, which they said were “governance tokens” that gave holders certain voting rights, a share of excess profits, and the ability to profit from DMG resales in the secondary market. No efforts were made to limit sales of either token to only accredited investors. In connection with offer and sale of these tokens, Respondents represented that they had obtained income-generating assets in the form of car loans and listed more than 100 specific loans on their website as purportedly acquired. However, according to the Order, in reality another company controlled by Respondents owned those assets. Respondents never transferred ownership to DMM and DMM officers directed that lien documents be altered to conceal ownership.
DMM represented that its investments protected against losses and ensured surplus income. When investors redeemed their mTokens, they were paid all promised principal and interest, though some of this funding was drawn not from DMM, but from the company holding the car loans and from the officers’ personal funds, giving the appearance that the asset had functioned as advertised.
The Order finds that both tokens were securities because they were investment contracts (and notes, as will be discussed in Part 2). In examining the DMG tokens, the Order applied the test articulated in Howey and Gary Plastic, which has often been used to analyze token offerings and defines an investment contract as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The Order states that the voting rights granted to investors in connection with the DMG tokens did not preclude the asset from being deemed a security because holders had no role in running DMM’s core business of identifying, buying and servicing loans, and then using the proceeds to pay mToken holders. The Order reasons that the definition of a security does not depend on labelling an asset as a “governance token” but requires examination of the economic realities underlying a transaction.
The Order charged Respondents with violating Sections 5(a) and 5(c) of the Securities Act of 1933, as amended, for the offer and sale of an unregistered securities. The Order further charged violations Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act, for materially false and misleading statements and other deceptive acts. Respondents were ordered to pay $12,849,354 disgorgement plus $258,052 pre-judgment interest, with approximately $7.3 million of that amount owed on a joint and several basis, and Keough and Acree liable each individually liable for a portion of the remainder. Additionally, Keough and Acree were each ordered to pay a civil penalty in the amount of $125,000. In addition, DMM is to refrain from participating, directly or indirectly, in any offering of a digital asset security. The two officers are to refrain for five years, but are permitted to buy and sell digital assets from their personal accounts during the time of the ban.
The findings in the Order are made without Respondents admitting or denying the allegations. The Order is not binding on nonparties to the proceeding but indicates the position that the SEC will take in future enforcement actions. Also of note is that the case was brought by the Complex Financial Instruments Unit, meaning there are now at least two of the Enforcement Division’s specialized units looking at token or DeFi offerings, the other being the Cyber Unit. The full text of the Order is available at https://www.sec.gov/litigation/admin/2021/33-10961.pdf.