GUEST BLOG: Beta Blockers by Aegis Frumento Esq

December 13, 2018

More and more, as I read of the SEC's dealings in the blockchain world, I am reminded of parents trying to control their young-adult offspring. Literature is rife with tales of parents foolishly interfering in their kids' efforts to hook up. Most (maybe all) of Shakespeare's comedies are about horny kids outwitting their elders to have their way. This year's hit movie Blockers tells the same old story. In Blockers -- the title is superimposed on a profile of a rooster to suggest what oughtn't be raised in public -- blockhead parents try to foil their daughters' pact to lose their virginity on prom night. As you might expect, things go awry. It still got decent reviews; see

A perverse sense of entitlement permeates all these parental plots. Why parents would think their kids would behave differently -- or better -- than they did at their age is a mystery of aging. For all the phony pieties that parents often voice to justify their meddling, it's really all about power. Young children naturally treat their parents as gods; problems arise when parents start to believe it.

That's the backdrop to this story of Blockvest and the SEC. Blockvest set out to woo investors into consummating an initial coin offering. Its whitepaper described its venture as the "First Licensed and Regulated Tokenized Crypto Currency Exchange and Index Fund in the US." It "pre-sold" 9 million blockchained tokens, called "BLVs," to 32 buyers for something like $180,000. However, Blockvest and its BLVs were neither licensed nor regulated, and many of the statements it made were so false they were funny. Like its claim to be under the jurisdiction of a fake regulatory agency, the "Blockchain Exchange Commission," or BEC for short, having a similar logo and the same address as the SEC's.

Now, I'm a veteran securities lawyer. I've spent years dealing with the SEC, both defending clients in enforcement actions and shepherding various ventures through the agency. I know enough to know that, with all the bullshit in Blockvest's whitepaper, the SEC just couldn't wait to burst in and rooster-block its ICO. So, of course the SEC sued for an injunction. Its case was simplicity itself: Blockvest admitted receiving money for its unregistered BLVs from 32 investors. And also, even if unsaid, the SEC had never before failed to get an injunction against an unregistered securities offering. Talk about feeling entitled!

But all that depended on the BLVs being securities. If they weren't, then Blockvest's shenanigans didn't violate any securities laws, whatever else they may have done, and the SEC would have no basis for its injunction. I don't think it ever dawned on the SEC that the BLVs might not be securities, and that's why this is interesting.
The Supreme Court defined what was a "security" over 70 years ago in SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
Howey has been cited more in the past year than in all of the prior half-century, because the SEC has spent much of the year explaining that blockchained coins or tokens were securities if they met the Howey test. See The Howey test is simply stated: A security is a thing that someone buys expecting to turn a profit solely from other people's work. Blockvest's whitepaper described the BLV as representing a passive interest in a profit-making enterprise. So of course, the SEC likely thought, the BLVs were securities.

Ah, but wait! Blockvest argued that, appearances notwithstanding, the BLVs it had issued were not securities, because the 32 buyers did not expect to make a profit. Huh? Why would anyone buy a passive interest in a business except to make a profit? Securities law does not recognize a non-profit interest in a for-profit enterprise. That is a logical contradiction -- in traditional securities law theory, an impossibility. 

But a coin issued on a blockchain is not a traditional security, and there's the rub. 

Blockvest's BLV embodied a smart contract that would execute automatically through the blockchain. Therefore, the BLVs did not merely certify ownership in a business; they were themselves operational pieces of computer software. Any software developer will tell you that before widely distributing a new application -- like the BLVs would have been in an ICO -- one must test it to make sure it works properly. Moreover, best practices in the software industry require that new software be tested in its actual operating environment, by actual users. That is called a beta test. See For Blockvest, beta testing meant the BLVs had to be bought by real people using real money. To the outside world, those purchases would be indistinguishable from investments, except for the mental expectations of the purchasers.

So Blockvest argued that the BLVs it pre-sold were not bought by investors looking to make a profit, but by a select group intending to test the Blockvest system. Without a profit expectation, the BLVs would fail the Howey test. 

That caught the SEC completely flat-footed. It had not set out to prove that the buyers of the BLVs intended to make a profit; it assumed it from the mere fact that they bought the BLVs whose whitepaper described a profit-making venture. But Blockvest came up with evidence that the actual buyers understood full well that they were only testing and not expecting to make a profit. So the SEC argued that the buyers necessarily expected to profit, and Blockvest argued that they actually didn't. This "yes they did; no they didn't" argument could have gone on forever.

Sometimes, a plot gets so out of hand that supernatural help is needed to untangle it. In Shakespeare's As You Like It, the god of wedded bliss, Hymen himself, "who peoples every town," arrives to force four squabbling couples to shut up and get it on. But perhaps more apt here is Aeschylus's Eumenides. In this, the last of the Oresteia trilogy, the hero Orestes is tormented by the avenging furies because he killed his mother for killing his father for sacrificing their daughter so his fleet could sail to Troy to avenge the abduction of his brother's wife. The goddess Athena, evidently bored by it all, comes down on stage and invents the judicial system, so that henceforth litigation would displace blood vengeance as the way to settle disputes once and for all.

And that's why, several thousand years later, Blockvest's fate ended in the hands of Judge Gonzalo Curiel of the United States District Court for the Southern District of California. Judge Curiel ruled that to get an injunction, a party -- even the SEC -- first has to prove its case. Duh! And yet, the SEC did not prove the most fundamental element of its case, that the BLVs were securities, because it did not prove that the BLVs were bought with the intent to make a profit rather than as part of a beta test. So far as we can tell from the decision, it never even occurred to the SEC that it had to. So, for the first time in memory, the SEC, on November 27, 2018, lost an application to enjoin an unregistered sale of securities.  
Mark your calendars.

Cryptosecurities are both securities and software, and as software they must be beta tested before an ICO. That means they must be "sold," before being registered, to "investors" who are not expecting to make a profit.The SEC set out to block Blockvest's ICO and unwittingly blocked its beta test instead. None of that computes under our current securities laws, because one doesn't beta test traditional securities. Contradictions like these will continue to give the SEC heart palpitations. A BEC, better rooted in the realities of cryptosecurities, is starting to sound like a good idea.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.