What happened?
On December 22, 2023, decentralized autonomous organization (DAO) BarnBridge and its founders reached a settlement with the U.S. Securities and Exchange Commission (SEC) regarding allegations of violating U.S. securities laws. The settlement agreement includes the return of nearly $1.5 million from the sale of digital assets by the DAO, ceasing the offering of “unregistered securities,” discontinuing the “development, maintenance, and use of BarnBridge websites, applications, and protocols,” ceasing operations of the SMART Yield contract, and taking action to prevent investors from making new deposits to BarnBridge-related crypto addresses. Additionally, each founder is subject to a civil penalty of $125,000.
According to the SEC’s order, BarnBridge users were able to directly invest in or purchase “SMART Yield Bonds” within the SMART Yield pool, which provided returns to users. The SMART Yield contract pooled users’ assets to exchange for interest-bearing crypto assets issued by third-party lending platforms. The profits from interest income were distributed based on the type of SMART Yield bond held by the user: senior bonds (fixed income) or junior bonds (variable income). If the interest income profits in the pool did not meet the guaranteed returns of senior bondholders, capital from junior bondholders would be used to make up the difference. Conversely, if the interest income profits in the pool exceeded the guaranteed returns of senior bondholders, junior bondholders would receive additional profits.
The order includes two main allegations:
(1) BarnBridge DAO issued unregistered “SMART Yield Securities,” violating Section 5 of the Securities Act;
(2) The DAO “caused” the Pools to violate the Investment Company Act because the Pools sold SMART Yield bonds, which were unregistered investment companies.
This article provides a detailed analysis of the issues raised in the order and its implications for the future development of DeFi.
What is a “security”?
The U.S. Securities and Exchange Commission (SEC) considers SMART Yield bonds (“publicly-offered structured crypto asset securities”) to be unregistered securities in the form of fixed-income notes. The SEC relies on the “family resemblance test” from Reves v. Ernst & Young, 494 U.S. 56 (1990), which is used to determine whether an asset is a note-form security, but it does not provide a comprehensive analysis of the Reves factors. Under the Reves test, the presumption is that a note is a security, and this presumption is overcome if the note resembles one of the categories listed in judicially-created exceptions. To evaluate whether a note has this “family resemblance test” that is similar to non-security, the legal analysis focuses on four factors: (1) the motivations of the seller and the buyer, (2) the plan of distribution, (3) the reasonable expectations of the investing public, and (4) the existence of another regulatory scheme that would reduce the risk of ongoing fraud with the instrument. The SEC does not explicitly state in its order which facts it believes satisfy which factors.
Furthermore, the SEC does not mention which digital assets are included in the pool or analyze whether the digital assets in the pool themselves are securities. Instead, the SEC relies on the statement that “the only asset held within the SMART Yield pool is investment securities,” without specifying any particular digital asset in the pool.
Who is an “investment company”?
For the second allegation, the SEC determines that the Pools themselves (not the DAO or any group) are “investment companies” as defined under Section 3(a)(1)(C) of the Investment Company Act. The provision defines “investment company” as “issuer engaging or proposing to engage in the business of investing, reinvesting, owning, holding, or trading in securities and owning or proposing to acquire investment securities having a value exceeding 40% (exclusive of government securities and cash items) of the value of such issuer’s total assets.” Essentially, if over 40% of the assets in the pool are securities, the “investment company” must be registered with the SEC.
The SEC alleges that BarnBridge Pools are “investment companies” because “the only asset held within the SMART Yield Pools are investment securities, held with the purpose of generating returns to be paid to SMART Yield Pool investors, representing more than 40% of the value of each Pool’s total assets.” Section 3(a)(2) of the Investment Company Act defines “investment securities” as “all securities except government securities, securities issued by employees’ securities companies, and securities issued by non-investment companies, and does not depend on the definition of an investment company.” The order also states that the Pools violated the Investment Company Act because “the SMART Yield Pools sell newly issued SMART Yield bonds to investors, which themselves function as fixed-income debt securities in the form of redeemable notes, promising fixed or variable returns based on performance.”
What does the SEC’s approach to DAOs mean?
This is the SEC’s first action against a DAO, as the DAO introduced products like SMART Yield Pools that the SEC deemed to be “investment companies” themselves. The SEC is also taking a new stance that “SMART Yield smart contracts issue their own crypto assets to investors as evidence of debt.”
First, the SEC simply states that the digital assets in the pool are “investment securities” without further analysis or specifying which digital assets are included in the pool. Despite the lack of formal regulation or congressional direction granting the SEC jurisdiction over digital assets, the SEC is using the order to apply the Reves test to new DeFi activities.
Second, the lack of transparency regarding the types of digital assets in the pool perpetuates the SEC’s pattern of simply asserting that all digital assets are securities. The SEC does not apply the test described in SEC v. WJ Howey Co., 328 US 293 (1946), to any digital assets in this case to claim that they are securities. Additionally, the SEC’s analysis of whether a digital asset is a “security” is not transparent, which creates confusion for digital asset issuers and buyers. For example, BarnBridge DAO’s white paper cites DAI as an asset type that can be borrowed into the pool, but does that mean the SEC would consider DAI to be a security? The SEC’s refusal to explain which digital assets are included in the pool and why they are “investment securities” limits the guidance the order provides to the industry.
The SEC may have previously avoided issuing guidance or enforcement actions regarding DAO protocols because the legal treatment of DAOs at the federal level was unclear. However, some states have delved into DAOs and smart contract functionality under corporate law standards. For example, Vermont recognizes a legal entity called a “blockchain-based limited liability company” (BBLLC). Utah and Tennessee allow DAOs to legally register as limited liability companies (LLCs) in their respective states. More recently, Wyoming allows DAOs to operate as either limited liability companies or decentralized autonomous non-person legal entities (DUNAs). Under these frameworks, DAOs must comply with certain legal standards and obligations to operate as entities in these states. However, there is no similar federal law defining the responsibilities of DAOs.
Another interesting aspect of the order is the described remedies: the DAO agrees to cease paying for the “development, maintenance, and use of smart contracts that include BarnBridge websites, applications, and protocols” and to “cease operating the SMART Yield contract and take necessary steps to reprogram the controllers to prevent investors from making new deposits to BarnBridge-related crypto addresses.” While BarnBridge agrees to these remedies, it raises an interesting question of what happens if the DAO is technologically unable to take such actions.
The BarnBridge case may indicate that the SEC may shift its focus to other smart contract-based functionalities like DAOs and use the Reves standard as support. Without a clear congressional directive defining the SEC’s jurisdiction over digital assets, the SEC is leveraging every argument and “seeing what sticks” to determine what will be ultimately supported in court.
