Amidst enforcement actions against crypto projects, Securities and Exchange Commission (SEC) Chair Gary Gensler likes to implore well-intentioned projects to come in and talk to the regulator about ways to become compliant with U.S. law. But there is no balloon ride to the safety of home at the end of this yellow brick road.
Polkadot, a Swiss-based blockchain project founded by the Web3 Foundation with an $8.1 billion market capitalization, took the SEC’s invitation at face value and commenced a three-year odyssey with its Strategic Hub for Innovation and Financial Technology (FinHub). Led by Valerie Szczepanik, FinHub engaged in more than 50 meetings with the project, ostensibly to provide guidance on ways that Polkadot’s native token, DOT, could escape its classification as a security and thus steer clear of the regulator.
But the project is left with little more clarity than when it started. On Nov. 4, a media company hired by the foundation sent out an email timed to the three-year anniversary of its engagement with the regulator saying, perhaps inadvertently, that “the Web3 Foundation is announcing [that] Polkadot blockchain’s native token (DOT) has morphed from a security to a software in the eyes of the U.S. Securities and Exchange Commission.”
This was not quite true, and in a follow up communications with Forbes the agency acknowledged that the descriptor used in the email included a “slight error” and the foundation made clear that it was issuing a “self-certification”.
It seemed unlikely given that the SEC’s Gensler has largely followed the path paved by his predecessor Jay Clayton in expressing a belief that nearly every crypto token in existence today, with the exception of bitcoin, is a security.
“We used the three-year anniversary of our first engagement to go with this [self-certification],” says Daniel Schoenberger, chief legal officer at Web3 said, referring to the announcement. “Obviously, communicating the issuance of a No-Action Letter would have been the stronger message. However, after our whole engagement, we were confident enough to make the statement [that we believe that DOT is no longer a security].” The SEC issues a No-Action Letter when it decides not to pursue an enforcement action against a specific project or company.
The lack of clarity is the problem. A prominent and well-intentioned project is trying to responsibly develop its token and avoid enforcement actions that have befallen Telegram and social network Kik, but because it has not yet received regulatory relief, it doesn’t really know what the SEC, especially its enforcement division, is ultimately thinking.
The second issue is that all of this confusion belies what appears to be a very detailed and fruitful engagement within Polkadot and FinHub, as well as occasional meetings with the SEC’s Division of Corporate Finance. Almost half of the 50 engagements over three years were formal gatherings. The substantive discussions, which were led on the SEC’s side by Szczepanik and 2-3 staffers, covered all aspects of Polkadot’s operations and ways that it could fall under U.S. securities laws. There are multiple methods used to determine whether a token is a security, but the most common is the Howey Test, which poses a series of questions stemming from a 1946 U.S. Supreme Court decision that specifies if a particular engagement constitutes an investment contract. It asks four simple questions. Was there an:
- Investment of money
- In a common enterprise
- With the expectation of profit
- Largely based on the efforts of others
If the answer to any of them is a ‘yes’, then the asset under question is a security.
The Howey Test constitutes the guts of the SEC’s 2019 Framework for “Investment Contract Analysis” of Digital Assets, and was a de facto roadmap for the discussions between the groups. When those conversations began, there was no question that DOT was a security. It was issued in 2017 under SEC Regulations D and S, which free issuers from adhering to securities laws by limiting to whom assets can be marketed, when the Web3 Foundation raised $145 million. In addition, when the tokens were actually released to purchasers in 2019, they were still considered to be securities by the team.
The discussions focused on two major topics. According to Schoenberger, the SEC wanted to first make sure that the technology was fully developed, meaning that the blockchain network was launched according to specifications outlined in the project’s white paper. This step is critical to proving that DOT, which is used to access the network, has real utility and is not seen as just an asset intended to be sold at a higher price in the future. Second, the SEC focused on ways that the Web3 Foundation divested itself from day-to-day control over the network.
“In working with the SEC, we found that while we impressed with our technology, in some ways it was even harder to orchestrate our ability to decentralize our business processes and set up communications and disclosure processes to show that we were no longer holding material non-public information.”
For instance, the foundation was asked to demonstrate how it set up service level agreements (SLAs) with Parity Technologies, a for-profit entity contracted to actually build the platform. The two parties entered three such agreements focused on developing the network, marketing and business development activities. This is an important point, as many decentralized projects use a similar construct where there is both a non-profit foundation and for-profit entity, which can employ the project’s founder, that actively works on the network. Sometimes these projects can even exercise supermajority voting power on networks, making decentralized governance nothing more than window dressing.
Polkadot launched on-chain governance in July 2020. The Web3 Foundation claims to control only 15% of DOT tokens and that Parity’s holdings are in the single digits, which suggests that the two parties by themselves could not unilaterally propose and pass governance proposals. Schoenberger claims that no supermajority voting power exists.
Other topics raised by the SEC focused on indicators of buyer intent, meaning whether DOT was being purchased for consumption or investment purposes. In the eyes of the SEC, buyer intent can matter just as much under securities laws as the means by which an asset is marketed. These questions included (not direct quotes):
- Did the respective amounts of DOT purchased by each purchaser generally appear to reflect that such purchasers were acquiring DOT with an intent to consumptively use DOT on the network?
- What kind of diligence was done on purchasers?
- Do you have any listing agreements with exchanges?
One area of operations that was of less concern to the SEC according to Schoenberger was its staking model. More than half of DOT in existence, 56%, is staked on the network, meaning that it is sent to the network as collateral in order to help secure it, an activity that currently offers an annual yield of 5.92%. This question is relevant for two reasons. First, because in an interview after the Ethereum Merge in September, which saw the network shift from a proof-of-work to a proof-of-stake transaction-validation model, Gensler raised questions about whether ether was now a security due to its concerns about staking concentration. For its part, Polkadot has 297 validators and a spokesperson tells Forbes that it is on track to reach 1,000. Validators on a proof-of-stake system are rewarded with new tokens for verifying transactions on the block chain; they must stake existing tokens to participate.
When it came to the question of yield, which can sound similar to the returns offered by centralized lenders such as Celsius, BlockFi and Voyager, all of which have either entered bankruptcy proceedings or been investigated by regulators for issuing unregistered securities, Schoenberger says that staking yield’s should be interpreted differently. “With DOT’s inflationary model if you don’t stake, then you lose over time.”
The SEC also did not seem to consider questions about Kusama, Polkadot’s testnet, where its token KSM was given out for free to DOT purchasers and currently has a market capitalization of $326 million. Schoenberger calls Kusama a “canary in the coal mine” and notes that since Kusama is technically in front of Polkadot on the development roadmap it is even less likely to be a security. It is worth pointing out that tokens and other assets can be seen as securities in the eyes of the law even if they are initially given out for free.
Additionally, Schoenberger noted that the SEC does not appear to hold the foundation responsible for the security status for the dozens of tokens that operate on parachains (independent blockchains that rely on Polkadot’s base layer for security and communication protocols). This could be similar to how the SEC does not hold Ethereum responsible for the status of decentralized application tokens on top of that network.
So what does all of this mean? The foundation says that it is going to continue engaging in dialogue with the SEC but with no promise of injunctive relief in the form of a No-Action Letter. To be clear, Schoenberger says that the foundation has had no interaction with the SEC’s enforcement arm and that all of its engagements with the agency have been voluntary. So it appears that the project could remain in a state of limbo. This certainly does not help during a time when crypto markets are suffering through a months-long bear market. Bitcoin is down 56% year to date as it straddles the $20,000 line, while DOT has fallen 73%.
Of course, with crypto being a hot-button issue in Washington, and other world capitals, the project is also staying abreast of other legislative and regulatory activities that could impact Polkadot’s future, such as the Lummis-Gillibrand Financial Innovation Act that would ostensibly favor the Commodity and Futures Trading Commission (CFTC) over the SEC as the prime U.S. crypto regulator
Schoenberger does not think the CFTC should regulate DOT. When asked who he thinks should be its overseer, he initially suggested that the product should not have one because it is software. However, in a follow-up conversation a spokesperson clarified, “We have done the hard work to go through the current process with the SEC, and we believe the current securities laws worked for us until now. We are similarly ready to comply with any new applicable laws and work with any new regulator claiming jurisdiction hereunder. Our goal has always been to be legally and regulatory compliant, as we believe strongly in the importance of achieving Web 3.0, and legal and, to do this, regulatory compliance remains our goal.” Web 3.0 refers to a decentralized version of the internet.
So it appears that Polkadot remains stuck, as will many other projects with similar levels of development until something shakes out. While it would be great to get a sign-off from the SEC, that was not the only reason why Polkadot went through the process.
“We hope that going through this whole process could inform others,” says Shoenberger.
The SEC declined to comment for this article.
Editor’s Note: The article has been amended to remove the reference that the Web3 Foundation operates Polkadot.