Brian Farber is the General Counsel at Securitize, which delivers trusted global solutions for creating compliant digital securities. The Securitize compliance platform and protocol provide a proven, full-stack solution for issuing and managing digital securities (security tokens). Prior to joining Securitize, Brian was in-house counsel at ConsenSys and practiced law at Sullivan & Cromwell LLP.
In early April, Templum Markets filed a letter with the Securities and Exchange Commission requesting guidance on whether blockchain miners could be deemed unregistered broker-dealers under federal securities laws.
The filing has added a layer of confusion to the digital securities ecosystem and has caused some to jump to conclusions about the legality of issuing and trading digital securities on public blockchains.
It’s quite possible that the timing of Templum’s request was no coincidence. Around the same time, Templum publicly announced a significant pivot in its business model from facilitating digital securities offerings on public blockchains, to using a private blockchain it was building with Symbiont.
Regardless, it is critical that thoughtful analysis be given to new innovations without jumping to an immediate conclusion that they create issues under federal securities laws. A decision to classify miners as broker-dealers would have grave implications for innovation and growth in the industry.
What are Ethereum miners actually doing?
As the majority of digital securities offerings to date have utilized the public Ethereum blockchain, this analysis focuses specifically on activities of Ethereum miners on the public chain.
Ethereum, like other blockchains, is a digital ledger system that records the occurrence of events and certain identifying information about those events (e.g. its participants). While the events being recorded on the blockchain are colloquially referred to as “transactions”, it is important to note that not all of them involve the exchange of value.
Transactions, in this context, represent units of work performed by a computer system. A transaction might be a purchase or sale of cryptocurrency like Ether, but it also might be a record of title for a plot of land.
Prior to being recorded on the ledger, transactions are processed by a network of high-speed computers called “miners”. When a transaction is proposed on the Ethereum blockchain, it is randomly sent to miners for confirmation.
Miners then aggregate that transaction with other unrelated transactions into a “block” (i.e., a group of transactions) and are able to confirm those transactions by solving cryptographic equations that require significant computing power. The miner that solves the equation quickest confirms the transactions within the corresponding block and the transactions are then recorded on the blockchain.
The miner then finally receives payment from the network in the form of Ether for its efforts. The amount of Ether dispensed to a miner is determined by block without reference to the block’s contents. As of June 2019, Ethereum miners receive two Ether per confirmed block.
Do miners’ activities fit within the scope of broker-dealer regulation?
With limited exception, all persons who are deemed to be brokers or dealers are required to register with the SEC in accordance with the Securities Exchange Act of 1934. Registration can be time-consuming and creates onerous ongoing compliance requirements.
A “broker” is “any person engaged in the business of effecting transactions in securities for the account of others.” We will examine in more detail if miners act as brokers engaged in the business of effecting transactions in securities for the account of others, but first, let’s eliminate the idea that they are “dealers”.
A “dealer” is “any person engaged in the business of buying and selling securities for [its] own account, through a broker or otherwise.” Miners on the Ethereum blockchain do not purchase digital securities for their own account when processing and recording on-chain transactions, therefore they should not be considered” dealers” under SEC rules.
Are miners “brokers” that are in the “business of effecting transactions in securities”?
An entity effects transactions in securities if it participates in such transactions “at key points in the chain of distribution,” (BondGlobe, Inc., SEC No-Action Letter [pub. avail. Feb. 6, 2001]).
In assessing whether an entity performs activities at key points in the chain of distribution, the SEC and courts have considered, among other things, whether the entity is assisting an issuer to structure a securities transaction, helping an issuer identify prospective investors, soliciting transactions, and participating in the order-taking or order-routing process for transactions.
These factors are typically considered in tandem with the receipt of any transaction-based compensation (as discussed below). While miners do not perform the aforementioned functions, it is difficult to argue that they are not involved at a key point in a chain of distribution when they are required for issuances and trades of digital securities to be recorded on the blockchain.
However, the SEC has previously granted no-action relief to entities whose services are limited to clerical and ministerial activities within a chain of distribution (Universal Pensions, Inc., SEC Staff No-Action Letter [Jan. 30, 1998]).
The confirmatory activities of miners should fit within this exception, since they are “mechanical task[s]” akin to “bookkeeping and record-keeping.” The confirmation by a miner merely begets an on-chain record of the underlying transaction, but the miner is not otherwise involved in the transaction.
In the digital securities ecosystem, investor sourcing and deal structuring are still performed by traditional broker-dealers, just as other non-broker-dealers perform transfer agent and custodial services for digital securities.
It is more appropriate to view the blockchain as a decentralized clearinghouse (i.e., a decentralized version of DTCC and Euroclear/Clearstream), and miners as its participants, that, in conjunction with blockchain-based transfer agents, are tasked with recordkeeping responsibilities for the digital securities ecosystem.
Like miners, clearing agencies confirm and process trades but do not undertake any other activities at “key points in the chain of distribution” that might classify them as broker-dealers.
Is the miner’s block reward considered transaction-based compensation?
The SEC has also noted that “the receipt of transaction-based compensation often indicates that such a person is engaged in the business of effecting transactions in securities.” In certain situations, receipt of transaction-based compensation alone can be sufficient to trigger broker-dealer registration.
Typical transaction-based compensation includes commissions, mark-ups, mark-downs, sales loads or similar fees on specific transactions. However, courts and the SEC have routinely focused on entities having a “salesman’s stake”, where compensation is based on the size, value or completion of a securities transaction.
The Ether paid to Ethereum miners neither fluctuates with the size or value of the transactions in the block nor correlates to the categories of the transactions within the block.
The miner’s block might contain confirmation of a $400 million bond issuance, but that block might also include the on-chain issuance of a Cryptokitty (a popular Ethereum-based game where users breed digital cats) and an encrypted record of the ingredients in a Taco Bell burrito. The miner is oblivious to the block’s contents when it confirms the transactions within, and it remains so when it receives payment in Ether upon completion of the block.
Furthermore, the amount of Ether paid to miners is fixed per block. It does not, as an underwriting commission might, fluctuate in accordance with the size or value of an underlying transaction.
Miners have far more in common with administrative service providers than they do with those connecting buyers and sellers and having a “salesman’s stake” in transactions.
As recently noted by Steven Peikin, Co-Director of the SEC’s Division of Enforcement, “Companies do not face a binary choice between innovation and compliance with federal securities laws.”
A ruling by the SEC requiring blockchain miners to register as broker-dealers would, as Fluidity’s Jeff Amico presciently observed, “effectively cripple public blockchains like Ethereum, stifling innovation and imposing significant harm in exchange for very little, if any, benefit.”
Furthermore, such a ruling would contradict SEC and court precedent supporting the notion that administrative actors that do not receive transaction-based compensation, like blockchain miners, are not broker-dealers.
Of course, the speed at which the blockchain industry has developed has resulted in a number of instances when innovation has directly conflicted with federal securities laws, but after thoughtful analysis and a review of relevant precedent, it is our view that miners should not be required to register as broker-dealers.
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