Analyzing the SEC Charges Against EtherDelta

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On November 8th, 2018, the SEC announced that they had formally charged crypto exchange, EtherDelta, with operating an unregistered securities exchange.

 

The official announcement by the SEC can be found here:

 

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

The reason why we are covering this announcement is because these charges could have some serious implications for the crypto space in the not-so-distant future and these charges could be indicative of other impending consequences for other similar exchanges.

Before going on though, it is worth noting that the charges have been settled at this point in time, and that the founder of EtherDelta, Zachary Coburn, was able to settle those charges with the SEC without admitting any wrongdoing. This is fairly standard procedure for those that cooperate with the SEC.

 

However, there are two major reasons why this is a big deal:

  1. EtherDelta bills itself as a ‘decentralized’ exchange. Many in the space have touted decentralized exchanges (commonly abbreviated as DEX) to be the ultimate workaround for potential regulatory action of the nature that the SEC is currently imposing against EtherDelta. This incident, however, appears to contradict that logic to a great extent and it may have greater implications for the crypto space in a number of ways that we will discuss in our article below.
  2. The SEC specifically stated that the ‘unregistered securities’ that were being traded on the exchange were ERC20 tokens. From this, we could extrapolate that the SEC essentially viewed at least some of the ERC20 tokens to be securities on their exchange.

Without further ado, let’s go ahead and look at the actual situation that transpired on the protocol.

 

 

Summarizing the SEC Announcement of Charges Against EtherDelta

As noted above, the announcement was released today — November 8th, 2018, on the SEC website


Announcement Begins by Defining EtherDelta

The announcement begins by providing basic background information about EtherDelta (in the SEC’s words).

They described it as, “An online platform for secondary market trading of ERC20 tokens, a type of blockchain-based token commodity issued in Initial Coin Offerings (ICOs).”

Then, the announcement states that, “The order found that Coburn caused EtherDelta to operate as an unregistered national securities exchange.”

In more detail, they stated that the EtherDelta platform possessed certain key elements that qualified it as an exchange (and thus, provided a premise for them to form the charges). Those characteristics were as follows:

A) “A marketplace for bringing together buyers and sellers”

Combined with

B) “The use of an order book”

C) “A website that displayed orders”

D) “A ‘smart contract’ run on the Ethereum blockchain”

By mentioning the integration of smart contracts into the platform itself, it the SEC appears well-aware of the decentralized nature of the EtherDelta platform.

They further confirm this by stating that, “EtherDelta’s smart contract was coded to validate the order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade.”

 

SEC Then Outlines the Circumstances That Put EtherDelta in Violation of Securities Laws

The report goes on to note that EtherDelta’s users had executed more than 3.6 million orders for ERC20 tokens over an 18-month period.

They also specifically state that these trades were, “Including tokens that are securities under the federal securities laws”, but the report fails to mention which specific tokens on the exchange were in violation.

 

Another important sentence to take note of in the announcement is the following, where they state:

“Almost all of the orders placed through EtherDelta’s platform were traded after the Commission issued its 2017 DAO Report, which concluded that certain digital assets, such as DAO tokens, were securities and that platforms that offered trading of these digital asset securities would be subject to the SEC’s requirement that exchanges register or operate pursuant to an exemption.”

We’ll go ahead and break that down after we finish summarizing the SEC announcement, but readers should keep in mind that this is one of, if not the most important sentence in the entire announcement.

 

The SEC Announcement Then Specifically States How EtherDelta Was in Violation

The SEC is blunt and unequivocal in describing how it saw EtherDelta in violation of securities laws by stating that, “EtherDelta offered trading of various digital asset securities and failed to register as an exchange or operate pursuant to an exemption.”

They also provide a quote from the Co-Director of the SEC’s Enforcement Division, which mentions that EtherDelta fit the SEC’s definition of an exchange/online broker and the SEC had also deemed (at least some) of the tokens on the exchange to be securities. Therefore, EtherDelta was charged with running an unregistered securities exchange because they were ‘required to register with the SEC or qualify an exemption’, and they had failed to do so.

The SEC further justifies its imposition of enforcement action against the owner of the EtherDelta exchange by citing precendent in the following statement:

The SEC has previously brought enforcement actions relating to unregistered broker-dealers and unregistered ICOs, including some of the tokens traded on EtherDelta.”

 

 

EtherDelta’s Penalty

The announcement concisely states that EtherDelta’s founder, Andrew Coburn, was required to do the following in order to resolve the charges (which are now currently resolved):

“ Without admitting or denying the findings, Coburn consented to the order and agreed to pay $300,000 in disgorgement plus $13,000 in prejudgment interest and a $75,000 penalty. The Commission’s order recognizes Coburn’s cooperation, which the Commission considered in determining not to impose a greater penalty.”

However, at the very end of the SEC Announcement, it is stated that, “The SEC’s investigation, which is continuing…”, without any further details as to what the nature of this investigation is, if it pertains to EtherDelta or just the crypto sphere in general, or what the nature of the investigation itself is. Thus, we won’t put too much stock into that statement for the time being.

 

 

Analyzing the Letter by the SEC

So now that we have identified the letter, the issues that the SEC had with EtherDelta, and the resulting punitive action for Andrew Coburn, founder of the EtherDelta exchange, we must unpack what this announcement means because there is a lot of misinformation spreading throughout the space with regards to this SEC announcement.

This must be done because, while the announcement by the SEC may seem straightforward in nature, it provides numerous implications for the crypto sphere that cannot be ignored. Therefore, we must carefully extract the language of the announcement and decipher this for ourselves. We have to remember, many of the individuals in leadership at the SEC were lawyers before joining the enforcement agency. So, the language that is used in these announcements is usually meticulously specific and carefully selected.

Below, the analysis of the letter will be presented on a point by point basis.

 

 

#1 — The SEC Charged Andrew Coburn, not EtherDelta

This is a fact that a few in the community have mentioned in an attempt to mitigate any and all ‘fears’ following the announcement.

While it is true that the charges were against Andrew Coburn and not EtherDelta itself, that is more than likely because of the legal structure of the exchange’s owner. If Andrew Coborn did not register EtherDelta is a corporation or corporate entity, then he as its owner would (and must) be on the receiving end of any punitive measures by the SEC or other regulatory bodies (as well as civil suits from customers should any crop up).

Since EtherDelta is a decentralized exchange, this is more than likely the case.

It also bears mentioning that the charges against Andrew Coburn were brought specifically because the SEC had deemed that EtherDelta (his creation) was in violation of securities laws in the United States.

 

 

#2 — Being an Exchange was a Crucial Component in the SEC’s decision to charge Coburn

As the SEC mentioned several times throughout, the fact that EtherDelta functioned as an exchange (with an order book, active trading, etc.; the characteristics that we listed above) made it eligible for such regulation.

This is not a major point, but something to keep in mind.

 

#3 — The Setup of the Exchange May Have Led to This Enforcement Action

Specifically, the SEC stated that, “The order found that Coburn caused EtherDelta to operate as an unregistered national securities exchange.”

The language that the SEC uses here is interesting, because they state that “Coburn caused” the exchange to operate in such a fashion.

When juxtaposing the language in the statement above with the fact that EtherDelta is a decentralized exchange, it seems that the SEC is stating that Coburn himself may not have been responsible for the addition of ERC20 tokens that the SEC considered to be in violation of federal securities laws, but it faulted Coburn anyway because the design of the platform (smart contracts) allowed for such tokens to be added to the exchange.

It is important to note that this is not a tacit condemnation of all decentralized exchanges, but it does show that DEX platform owners will essentially be held responsible for any and all tokens that are listed on their platform.

 

Thus, DEX owners face two choices:

  1. Attempt to launch these DEX platforms in an anonymous fashion so that there is no way for the SEC to apprehend them for securities being listed on the exchange.
  2. Compromise the decentralization of the exchange to an extent by creating a vetting process for the tokens being listed on there.
  3. Simply ignore the SEC (if they are charged), and proceed forward with operations as usual regardless of potential impending consequences.

Obviously, out of the options presented above, #1 is probably the most favorable for DEX developers and thus one of the ones that will be selected the most.

 

 

#4 — The SEC Has a Pretty Clear Understanding of How DEX Platforms Work

This is a major fact because it shows that the SEC has finally ‘caught up’ with the space in terms of understanding its various facets, like decentralized exchanges.

If readers remember some of the congressional hearings that were held in the United States to discuss cryptocurrencies, regulation, and its implications, the vast majority of individuals in those hearings (apart from experts called to testify before Congress) were somewhat clueless to how the space functioned.

However, the language in this announcement appears to indicate that this is no longer the case. While they may not be experts by any means, the SEC certainly knows enough about the space to understand how it functions on a basic level, and to know about various facets of the cryptosphere.

 

#5 — Certain ERC20 Tokens Put the Exchange in Violation

As mentioned above in the summary portion of this article, one of the most important statements that was made in the announcement was the following,

“Over an 18-month period, EtherDelta’s users executed more than 3.6 million orders for ERC20 tokens, including tokens that are securities under the federal securities laws.”

The most important part of the statement above is the bit at the end where it states, ‘including tokens that are securities under the federal securities laws’.

This means a couple of things:

  1. The SEC must have combed through all of the tokens being listed on the exchange. It would be nonsensical to assume that this was not the case.
  2. By examining all the tokens on the exchange, there were some that they deemed to be a security, but not all. This is made clear by the word ‘including’. The sentence is phrased in such a way where it is made clear that the tokens that are in violation of U.S. securities laws are a subset of the total number of tokens that the exchange offers, period.
  3. It appears that our original assumption that a token will no longer being deemed a security after moving past its ICO-phase is no longer valid. This is because generally, tokens are only listed on exchanges after the ICO is over. Therefore, if the SEC is deeming tokens that were listed on the EtherDelta exchange to be securities, then there are at least some ERC20 tokens that the SEC firmly believes are securities.
  4. The sentence makes it clear that not only will project owners face punitive measures from the SEC for listing securities, but exchange owners will as well.

For some reason, the report does not mention the specific tokens that the SEC deemed were in violation of securities laws. So, its anyone’s guess as to which specific tokens triggered this regulatory action.

However, we can surmise from the last statement posted above that there were at least a few tokens that the SEC had deemed to be securities.

 

#6 — The SEC Unequivocally States that DAO Tokens Are Securities

In what may have been the most important sentence in the entire announcement, the SEC stated the following:

“Almost all of the orders placed through EtherDelta’s platform were traded after the Commission issued its 2017 DAO Report, which concluded that certain digital assets, such as DAO tokens, were securities and that platforms that offered trading of these digital asset securities would be subject to the SEC’s requirement that exchanges register or operate pursuant to an exemption.”

 

Let’s break down the important takeaways from that statement in a few points:

  1. The 2017 DAO Report [super important] that the SEC cited in their announcement was released on July 25th, 2017. Therefore, whatever violations that EtherDelta committed that warranted scrutiny and regulatory action (in the SEC’s opinion), must have occurred after that date.
  2. They used the phrase “certain digital assets, such as DAO tokens” very specifically, and this is what should command the most attention.

Looking Back at That 2017 Report on DAO Tokens

This report hasn’t been spoken on in quite a while, but it must be analyzed (briefly) once more, because it is very relevant to the source of EtherDelta’s issues with the SEC.

In that report, the SEC combed through the DAO. For those that don’t know, the DAO was an ambitious project that was launched on the Ethereum blockchain for the purpose of revolutionizing crowd funding on the platform. It raised a significant amount of Ether, but was hacked shortly thereafter, effectively ruining/ending the project. Vitalik Buterin and several other developers decided to ‘roll back’ the chain in order to amend this hack, which led to controversy, a split in the blockchain protocol and several other things that we’re not going to dig into at the current moment.

The crux of the report was that the DAO was a security offering and that any and all subsequent tokens that were issued would be deemed to be a security that needed to be registered with the SEC.

One specific statement that the SEC made in that announcement that deserves special attention is this one:

“The Commission deems it appropriate and in the public interest to issue this report of investigation (“Report”) pursuant to Section 21(a) of the Exchange Act to advise those who would use a Decentralized Autonomous Organization (“DAO Entity”), or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”

Thus, it can be deemed that virtually any and all tokens/coins that were birthed via ICOs following this announcement, will be deemed a security.

 

Why Must it Be Following This Announcement in July 2017?

Because the language in the SEC’s announcement concerning the founder of EtherDelta specifically states that EtherDelta was in violation for actions that they committed after the release of this investigative report.

This would also explain why Ethereum was deemed to not be a security despite the fact that it also held a crowdsale.

 

Implications/Takeaways

If you’ve been in the crypto community after the release of this announcement by the SEC, you’ve probably heard a number of different theories as well as conflicting information about the announcement.

However, after taking some time to thoroughly analyze the report by the SEC, we believe that the follow takeaways would be most appropriate for users to extract:

  1. Merely operating a DEX will not put one above the purview of the SEC. If the operator of a DEX is an identifiable individual, they will be held liable for the tokens/coins listed on that DEX.
  2. The SEC seems to be giving projects and entities a ‘pass’ on anything that occurred before the release of that announcement in July 2017.
  3. Any and all tokens or coins that had an ICO after that announcement in July 2017 are unequivocally, securities. There is no room in the SEC’s purview for the creation of ‘utility’ tokens. This is the least restrictive definition that one could draw for tokens in this space at this very moment. It is very possible that the definition of what qualifies as a security is expanded slightly beyond this, but this is the fairest and most evidence-backed assumption regarding ICO tokens that we could come to.
  4. This announcement established that exchange owners will face penalties for listing unregistered securities on their exchange. So, it is not just the founders/devs themselves that will be charged by the SEC.
  5. The licenses that the exchange itself has is not a sufficient guard against SEC action. Exchanges in the United States must also be sure to not list projects that are in violation of the SEC’s guidelines regarding securities.

Overall, it’s not the death penalty for ERC20 tokens, but this will put a LOT of projects in jeopardy, which would effectively depress/destroy another segment of the crypto ecosystem.

In either case, the impact on Ethereum will probably fairly significant as well since any and all tokens that are looking to hold an ICO will be considered securities, thus restricting their options for exchange additions.

 

Security Token Offerings

The use case for Security Token Offerings just went through the roof, honestly. Especially if the SEC plans on ramping up their regulatory efforts in the space at any point in the near future.

 

This is Not an Efficient Use of the SEC’s Time

It goes without saying that the SEC has been extremely ineffective in their overall goal of encouraging projects to register as securities.

Their efforts have only resulted in projects obfuscating more information about their operations in an effort to avoid SEC regulation. Thus, increased SEC regulations have had the opposite of the intended impact of the securities laws in the United States — to create investor transparency and make the entities issuing them more transparent.

As many have noted, it would be more logical if the SEC considered reforming its registration process to make it more streamlined and also to reduce necessary requirements (such as mandating that all investors be accredited). Perhaps the SEC could compensate for this ‘loosening’ of the criteria for registered securities by placing a ‘cap’ on the amount that could be fundraised (we know that this exists already) in addition to creating stringent, space-specific rules that would promote greater transparency.

Conclusion

Crypto exchanges as well as those considering Initial Coin Offerings must be very careful in the future.

The SEC must also consider a different and more effective means of regulation in order to reach their end goal as well, because it is highly doubtful that this will prove sufficient. 

 

 

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