‘Back to the basics’: What the SEC’s ruling on DAO tokens mean for the industry

In a ruling issued Tuesday, the U.S. Securities and Exchange Commission finally came out and said what the blockchain community has known all along: DAO tokens are securities and are “subject to the requirements of the federal securities law.”

The DAO, which stands for Decentralized Autonomous Organization, was the automated, leaderless ethereum-based funding vehicle that suffered a massive hack last year after raising millions of dollars from investors in the token sale. This ruling could be “the end of the beginning phase for blockchain,” said Emin Gun Sirer, associate professor at Cornell University and co-director of the Initiative for Cryptocurrencies and Smart Contracts.

“What we were beginning to see with the ICO craze was every Jack and Jill coming up with an old idea, wrapping it up in a token and issuing securities in a virtual company of some kind,” Sirer said. “I hope we will see a return back to the basics. There’s a lot of infrastructure work to be done. People will start to take a close look at their own ICOs and quite a few will fail these rules the SEC applied.”

The rules follow a three-pronged test known as the Howey Test. A token is a security if they’re selling something for money; are they promising future profits; and the future profits predicated on the efforts of other people and third parties.

Here are three key takeaways from the ruling.

This doesn’t change much
If anything, the ruling was “a reminder” of something people already knew was coming and maybe were surprised was taking so long, according to Angela Walch, an associate professor at St. Mary’s University School of Law and research fellow at the Centre for Blockchain Technologies at University College London.

“It’s not like they came out with a new conclusion of law or policy, they reminded us that the existing policy applies to these new forms of fundraising,” she said. “The only difference is that we’re doing it in a technological way and calling it something different.”

The SEC tends not to give guidance on whether something is a security or not so as not to discourage innovation. In the guidance it didn’t even define what a security is or isn’t. The fact that the DAO tokens are treated in the eyes of the SEC as legal securities doesn’t mean the market is going to suddenly shut down. People that want to continue with their ICO plans can probably do so — in a way that’s compliant with U.S. securities laws.

There is some uncertainty as to what will happen to token sales that will happen in the interim, Walch said. Those that occur after this point are clearly on notice and need to figure out how to comply with securities law. But there’s some ambiguity among people that launched their token sales between the the time of the DAO and now. They’re not necessarily off the hook.

“I think the future is bright for non-securities tokens,” said Marco Santori, a partner at law firm Cooley LLP, tweeted Wednesday. “This is the first step in a critical maturation process.”

This isn’t the end of ICOs
If anything, the guidance could slow down the pace a little bit, according to David Lucking, a partner at law firm Allen & Overy. There has been a lot of focus on ICOs in the last year, and many people have set them up without really considering the legal ramifications.

“The SEC is sort of putting the market back on notice: the tokens themselves can be treated as securities, and the platforms on which these tokens trade may be treated as securities exchanges. Both things are regulated in the U.S.,” he said.

Of course, not all tokens are securities. The SEC was pretty clear it would take a case by case approach to this kind of activity, “depending on the particular facts and circumstances,” making it a nice time to be a lawyer versed in crypto.

“It will bring back to the forefront the need to involve lawyers, which for so many people is not that desirable because obviously, the beauty of blockchain and distributed ledger technology is somewhat to disintermediate established ways of doing things and established market participants,” Lucking said. “This reins that in a little bit.”

Sirer highlighted the quick emotional reaction by many in the blockchain community — some gloated about having seen this coming, some worried all tokens were securities and that this might affect their ICOs — to guidance on a narrow class of activity pretty specific to the DAO. The SEC could issue other findings — that will inevitably come later, but for now, not just any ICO is binding by the SECs recent findings.

“We’re living through a time of ICO mania,” he said. “There are worthless ICOs, there are scam ICOs and all sort of other rogue ICOs that shouldn’t exist. But this ruling doesn’t say anything about them — this is a ruling on the DAO and things like the DAO.”

Implications for bitcoin and ethereum
Many people that read that guidance couldn’t help but notice the SEC’s choice identifier of ethereum as a “virtual currency” as opposed to a virtual “token” or “coin.”

“My reading of this is it has no implications for the underlying infrastructure,” Sirer said. “Currencies themselves are not regulated by the SEC, securities are regulated by the SEC.”

Plus virtual currencies in the U.S. got their ruling in March 2013. It’s legal to own and transfer them without a license (although the exchange doing the actual transferring may need one).

Excessive fees plague fund reporting; will new rules fix the problem?

changing mutual fund reporting

An Investment Company Institute (ICI) survey found that funds pay 120 percent more to deliver shareholder reports to investors that own funds through brokerage accounts than those who bought funds directly from fund companies. Adoption of digital delivery methods and updated regulation should increase efficiency and transparency in the reporting process, and also lower costs.

Under the current system, funds — and, by extension, their shareholders — pay an estimated $100 million each year for shareholder reports to broker-held accounts.

Currently, brokers are tasked with handling the shareholder reports, and funds reimburse the brokers for the delivery costs. Most brokers use a single delivery vendor, Broadridge Financial Solutions. While the brokers and Broadridge negotiate the fee, the funds pay the bill. Under this system, there is no incentive to negotiate the fee lower than the maximum fee permitted.

The analysis by the ICI was conducted amid the backdrop of the SEC’s modernization of the Investment Company Act of 1940, as a request to tweak the regulatory and fee structure for mutual fund shareholder reports.

“Under Broadridge’s interpretation of applicable NYSE processing fees, ICI estimates that funds would realize no net savings in NYSE processing fees from proposed rule 30e-3,” the ICI stated in a May 23, 2016 meeting with SEC officials discussing the proposed rules.

Rule 30e-3 is the clause addressing shareholder reports in the SEC’s proposed set of changes.

Table
from the SEC

Updating a process from the ‘40s

The Investment Company Reporting Modernization, Proposed Rule is a set of proposed rules under the Investment Company Act of 1940 which would significantly expand the information reported by registered investment companies.

Among the proposed rules are changes to the structure of the data the SEC receives from mutual fund companies. More structured data will allow the SEC to better analyze funds’ compliance and exposure to risk. In addition, the proposed rules call for publishing shareholder reports online rather than printing it on paper.

According to PwC, the SEC’s proposed rule constitutes its most significant change to the reporting regime for registered investment companies in at least a decade.

Challenges ahead

Complying with the proposed rules will not be easy for investment companies. Therein lies an opportunity, though.

“The most difficult part of compliance will be the development of appropriate technology, processes, and procedures,” noted Nathan McConarty, assistant vice president, investor services at Browns Brothers Harriman in a market commentary.

According to a Deloitte report, among the challenges investment companies face when trying to adjust to the proposed changes are interpreting inconsistencies between the current and proposed rules, developing appropriate data sourcing and aggregation processes, and increasing resources to accommodate compressed and increased filing timelines.

Deloitte asserts that while the challenges might be daunting, the proposed rule offers an opportunity to create centralized databases, automate reporting and increase internal and external oversight. Capitalizing on these opportunities will provide funds with long term benefits and ultimately make investing cheaper to the end investor.

Photo credit: crazyoctopus via VisualHunt / CC BY-ND

Insider Trading Dashboard: Everything you need to know

With the daily news of hedge funds being raided and expert networks being investigated, I wanted to put together a resource sheet for those looking to delve a bit further into the insider trading game.

Research

Decoding Insider Trading (Cohen): This new paper looks at a methodology to isolate insider traders acting on good information from noisy trades.  By looking at individual trades — versus looking at all insider activity — investors can mimic better-performing trades, boosting performance of insider trading strategies.

Law and Economics of Insider Trading: A Comprehesive Primer (Bainbridge) 84 pages of insider trading awesomeness.  This 2001 paper deals with everything from the origins of current laws prohibiting insider trading to defining an insider to making a case for and against regulating insider trading. For a smaller, more concise paper on insider trading, see Bainbridge’s Insider Trading: An Overview

Stock Market Anomalies: What can we learn from repurchases and insider trading (Core, Guay, Richardson, Verdi)

How Informative are Analyst Recommendations and Insider Trading (Hsieh, Ng, and Wang) Evidence points to insider trading and analyst recommendations giving conflicting signals.  This paper documents that and provides theory why this may be the case.

What Insiders Know about Future Earnings and How They Use It: Evidence from Insider Trades (Ke, Huddart, Petroni) Insiders do trade on this stuff up to 2 years before public release.

Do Insider Trades Reflect Superior Knowledge About Future Cash Flow Realizations (Piotroski, Roulstone) Short answer: yes.

Insider Trade Disclosure, Market Efficiency, and Liquidity (Buffa): Policy implications after finding that informational efficiency and liquidity are lower in more transparent markets

Institutional Investors and Insider Trading Profitability (Markarian, Bricker) Insider profits are inversely related to presence of institutional ownership.  Hedge funds/mutual funds may provide monitoring effect.

MSM (Mainstream Media) on Insider Trading

WSJ on Insider Trading (sub. req’d)

Bloomberg.com: Insider Trading

Google fastflip on Insider Trading

Tradestreaming on Insider Trading

Dealbreaker’s Insider Trading Fest(ivus)

NYT on Insider Trading

Dealbook on Insider Trading

Books on Insider Trading Strategies

Investment Intelligence from Insider Trading: If this book is the bible of insider trading strategies and research, its author, Professor Seyhun is Moses.  Great research into strategies for following insiders.

Profit from Legal Insider Trading: Invest Today on Tomorrow’s News

The Vital Few vs. the Trivial Many : Invest with the Insiders, Not the Masses

Videos on Insider Trading