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What happened?
On December 22, 2023, the BarnBridge decentralized autonomous organization (DAO) and its founders agreed to cease-and-desist orders and settled charges brought by the Securities and Exchange Commission (SEC) for violations of U.S. securities laws. The settlements included a nearly $1.5 million disgorgement from the DAO’s sale of digital assets, an order to stop offering “unregistered securities,” to stop “making payments for the development, maintenance, and use of smart contracts that comprise the BarnBridge website, application, and protocols,” to “cease operation of SMART Yield contracts, and take actions to . . . prevent investors from making new deposits,” and a civil monetary penalty of $125,000 from each of the founders.
According to the Orders, BarnBridge users could “invest” directly in SMART Yield pools or purchase “SMART Yield bonds,” which paid yield to users. The SMART Yield contracts pooled users’ assets to be “exchanged for crypto assets issued by third-party lending platforms that generated interest income.” The profits from the interest income were divided and distributed to users according to the type of SMART Yield bond users held: Senior tranche holders (fixed return) or Junior tranche holders (variable return). On one hand, if the interest income profits of a pool did not meet the yield guaranteed to Senior bond holders, Junior bond holders’ capital would “be used to make up the difference.” On the other hand, if the interest income profits of a pool exceeded the yield guaranteed to Senior bond holders, then Junior bond holders would receive the additional profits.
There are two main allegations from the Order: (1) BarnBridge DAO violated Section 5 of the Securities Act by issuing unregistered “SMART yield securities” and (2) the DAO “caused” the Pools to violate the Investment Company Act because the Pools sold SMART Yield bonds and were unregistered investment companies.
In this blog post, we break down the issue with the Order and what it means for DeFi going forward.
What were the “securities?”
The SEC’s position was that the SMART Yield bonds (“public structured crypto asset securities”) were 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 security in the form of a note, however, they do not include comprehensive analysis of the Reves factors. The Reves analysis begins with a presumption that a note is a security unless it bears a “strong resemblance” to assets that are not securities. To assess whether a note bears such a “family resemblance” to a 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 that the instrument would be used to perpetuate fraud. The SEC does not make it clear in the Order which facts it believes satisfies each factor.
Moreover, the SEC does not address which digital assets were in the Pools and does not analyze whether the digital assets in the Pools were themselves securities. The SEC instead relies on an assertion that the “only assets held in the SMART Yield Pools were investment securities,” without identifying a single digital asset in the Pools.
Who was an “investment company?”
For its second claim, the SEC decided that the Pools themselves (not the DAO or any group of persons) were “investment companies as defined by Section 3(a)(1)(C) of the Investment Company Act.” This section defines “investment company” as any issuer which “engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 [percent] of the value of such issuer’s total assets…on an unconsolidated basis.” Essentially, if more than 40% of the assets in a pool are securities, the “investment company” must register with the SEC.
The SEC alleged that the BarnBridge Pools were “investment companies” because the “only assets held in the SMART Yield Pools were investment securities, held for the purpose of
generating the returns to pay SMART Yield Pool investors, and constituted more than 40 percent of the value of each Pool’s total assets.” Section 3(a)(2) of the Investment Companies Act (ICA) defines “investment securities” as “all securities except government securities, securities issued by employees’ securities companies, and securities issued by majority-owned subsidiaries of the owner which are not investment companies, and are not relying on the exception from the definition of investment company.” The Orders also say that the Pools violated the ICA because “The SMART Yield Pools sold investors newly minted SMART Yield bonds that themselves acted as fixed income debt securities in the form of a callable note by promising a fixed or variable return based on the performance of the Pools.”
What does this mean for the SEC’s strategy on DAOs?
This is the first time the SEC has brought an action against a DAO for launching a product like the SMART Yield Pools, which the SEC determined are themselves “investment companies.” The SEC also took the novel position that the “SMART Yield smart contracts issued their own crypto assets to investors as evidence of indebtedness.” (emphasis added).
For one, the Order is alarmingly ambiguous. It simply states that digital assets in the Pools were “investment securities” without further analysis or even naming which digital assets were in the pools. The Order also applies the Reves test to new DeFi activities, even though there has not been a formal rulemaking or congressional directive giving the SEC jurisdiction over digital assets.
The lack of transparency regarding what kinds of digital assets were in the Pools continues the SEC’s pattern of simply asserting all digital assets are securities. The SEC does not apply the test described by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) to any digital assets in this case in order to allege that they are securities. And the SEC has not been transparent in how it analyzes whether digital assets are “securities,”1 which creates confusion for digital asset issuers and purchasers. For instance, the BarnBridge DAO white paper used DAI as an example of the kind of asset that could be loaned into the Pools – was DAI in the Pools? Does this mean that the SEC would take the position that DAI is a security? Because the SEC refused to explain which digital assets were in the Pools and why they were “investment securities,” there is very limited guidance to the industry from this Order.
It is possible that the SEC has previously shied away from issuing guidance or enforcement regarding DAO protocols because the legal treatment of DAOs is unclear at the federal level. Several states have delved into DAOs and smart contract functions under corporate law standards, known as “legal wrappers.” For example, Vermont recognizes a corporate entity called a “blockchain-based legal liability company” (BBLLC). Utah and Tennessee allow DAOs to legally incorporate in their respective states as limited liability corporations (LLCs). And, most recently, Wyoming permits DAOs to operate as LLCs or Decentralized Unincorporated Nonprofit Associations (DUNAs). Under these frameworks, DAOs are held to certain legal standards and obligations to operate as businesses in those states. However, at the federal level, there is not a similar law defining DAO liability. Therefore, the Orders are another example of the SEC providing little guidance to the industry.
Another interesting part of the Orders is the remedies described: the DAO agreed to stop paying for “development, maintenance, and use of smart contracts that comprise the BarnBridge website, application, and protocols” and to “cease operation of SMART Yield contracts, and take actions necessary to reprogram controllers to prevent investors from making new deposits in BarnBridge-related crypto addresses.” While BarnBridge agreed to these remedies, they pose an interesting question of what would happen if the DAO was simply unable to take such actions from a technology standpoint.
The BarnBridge case could signal that the SEC may turn its focus to other smart contract-based functions like DAOs and use Reves for its support. Without a congressional directive outlining the SEC’s jurisdiction over digital assets, the SEC is taking advantage of throwing every argument at the wall and “seeing what sticks” for what will ultimately be upheld in the courts. Could this be, “Goodbye Howey, hello Reves?”
This piece was written by Kathryn Paravano, a legal intern with the DeFi Education Fund. Kathryn is currently a student at Georgetown University Law Center.
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