GUEST BLOG: [In]Securities: Puff!: The SEC Slays DRGN by Aegis Frumento Esq

August 26, 2022

a Guest Blog by

Puff!: The SEC Slays DRGN

It is fitting that the same week that dragons returned to HBO Max, the SEC would take on a dragon of its own.

On August 16, the Commission filed a complaint in federal court against Dragonchain, Inc. its affiliated companies and its founder, Joe Roets. The SEC alleged they sold unregistered securities. The securities in question was a token -- the Dragon (or DRGN) -- which the defendants sold beginning in 2017 to raise a total of $16.5 million and to pay for services.

According to the SEC's complaint, Dragonchain first raised $1.4 million in a "pre-sale" of DRGNs to 68 members of a crypto investment club, and in October and November 2017 raised $12.3 million from about 5,000 investors in an initial coin offering ("ICO"). It used the money "to develop its technology, market its services to businesses, and otherwise pay business expenditures."

Before the SEC enforcement staff seeks authority to start a lawsuit, it gives the target an opportunity to talk it out of it. It sends what is called a Wells Notice. Conventional wisdom is that responding to one is counterproductive, as that just educates the staff and allows it to draft a better complaint against you. But sometimes you have a client who insists they are smarter than you are. Enter Joe Roets. Roets wrote his own response to the SEC's Wells Notice -- and posted it on Dragonchain's website for all to see.

Roets introduces himself in the first paragraph: "I am Joe Roets. I am not a lawyer nor venture capitalist. I am a software engineer, businessman, entrepreneur, husband, father, and patriot." You can already see where this is going.

Roets traces the history of DRGN from an open source blockchain platform developed by the Walt Disney Company, then goes deep into how it works and how great it is, sprinkled through and through with bon mots like "Blockchain is liberty encapsulated in software" and quotes of Thomas Paine on triumphing over tyranny. His "legal" argument starts out with a constitutional appeal to the First, Fifth and Fourteenth Amendments, invoking freedom of speech and due process of law, then careens into an attack on the SEC's ethics in trying to regulate something it doesn't understand. A recurring theme is how stupid we all are. Take this, for example:

Dragonchain has spent millions of dollars on legal fees to comply. This process has represented a significant cost to the project and platform, as the team has been required to communicate advanced and often abstract technology to lawyers and bureaucrats, many without sufficient technical background. Many actions and processes had been assumed from within false contexts, and we spent considerable time educating our attorneys and the SEC. Often, we have later found that information provided to our attorneys material to the case were not conveyed or were misinterpreted by one or the other side. This is understandable given the complexity of advanced blockchain technology patterns and use cases. We're essentially being regulated by lawyers that don't have adequate understanding of the technology or its intended use.

Reading between the lines, Roets is essentially saying: (1) lawyers are too expensive; so (2) I fired my lawyers and I'm writing this myself; because (3) my lawyers and the SEC bureaucrats don't understand "the complexity of advanced blockchain technology patterns and use cases."

Needless to say, this effort to dissuade the SEC from proceeding failed spectacularly.

Roets' response fails because, like most non-lawyers (and all too many lawyers), he doesn't separate what matters from what doesn't. Roets thinks what matters is that his business is both too awesome and too complex for mere mortals to grasp. 

It isn't. Basically, DRGN is the entry key into a blockchain. A blockchain is no more than an electronic ledger to which you can add transactions but cannot alter them once they are validated. Any activity that depends on the validity of a ledger -- of a secure history of transactions - can be instantiated on a blockchain. Since the DRGN is how one access the Dragonchain blockchain platform -- "micro-licenses" is what Roets calls them -- owning DRGNS is the prerequisite to using any application that runs on the Dragonchain blockchain, which itself runs on Ethereum. The key to Dragonchain's business is to build applications that make the blockchain easily accessible, that permit transactions to be appended to it flexibly. Those two attributes will determine how many different kinds of activities will be able to use the platform.

The SEC described Dragonchain's business more briefly: to create a "turnkey" blockchain platform that other businesses could use to "introduce blockchain technology into their daily activities." That is basically correct, and really all one needs to know. It is not beyond the ken of mere mortals, no matter what Roets thinks.

One mere mortal who surely gets it is SEC Chair Gary Gensler. At the same time that Roets was out selling DRGNs, Gensler was himself learning "the complexity of blockchain technology," the only way one really learns anything - by trying to teach it to someone else. In 2018, Gensler was a professor at MIT, and taught a course there called Blockchain and Money. That course -- video lectures, class discussions, reading lists and all -- are available online, so anyone can take it without having to get into MIT, do any homework or write any papers. At that price, it was worth auditing, so I did.

It's a very good course, and Prof. Genlser was both a funny and engaging teacher, but you can tell this course was his way of learning the blockchain world. He had a tough audience too - chock full of MIT graduate students from both the business school and the engineering school. They kept him on his toes, and to see him spar with them was a highlight of the course.

But the takeaway is that Chairman Gensler understands cryptosecurities very, very well -- a lot better than Joe Roets understands securities law.

In the end, Roets only had one relevant argument: that the DRGN was a utility token and not a security. Not only is DRGN how one accesses the platform, but DRGN buyers agreed that they were not financial instruments, not securities, and that they were not buying any equity in Dragonchain. And, Roets argued, he and Dragonchain had nothing to do with developing any markets for DRGNs. That was all the work of third parties. In essence, paraphrasing the old song, once the DRGN goes up, who cares where it comes down.

You can guess what happened next. The SEC complaint meticulously alleges how Dragonchain and Roets actually did sell DRGNs, not as utility tokens to ultimate users of the Dragonchain platform, but broadly through its "website, social media, conference appearances, and Telegram." DRGN was "pre-sold" to members of a crypto investment club, and its ICO was pitched to crypto investors -- and sold to 5,000 of them! -- with promises of increasing value as the "ecosystem matured," a cap on the number of DRGNs that could be minted and instant liquidity on numerous coin exchanges. The SEC showed how DRGN's buyers were investors with no interest in actually using the platform, but only looking to earn profits from the success of Dragonchain's business, no matter what they said in subscription agreements they probably never read.

True utility tokens would have no value at all outside their use as access keys. See the discussion of Turnkey Jets in But DRGNs, which sold for about $0.06 each in the ICO, shot up to $5.50 in January 2018. Then their price fell below a dollar by March, below a quarter by July, below a dime by December. DRGNs are now worth about two pennies, but there's chatter about how their price may hit a dollar again in a year. And that's how DRGNs fly; the same way all securities do. They aren't magic.


Aegis J. Frumento

380 Lexington Avenue
New York, NY 10168

Aegis Frumento co-heads the Financial Markets Practice of Stern Tannenbaum & Bell, New York City.  He represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations).  He has decades of experience representing SEC, CFTC and FINRA regulated firms and persons in regulatory enforcement investigations, hearings and lawsuits.  Drawing on his five years managing the Executive Financial Services Department of Morgan Stanley Smith Barney, Aegis has rare depth of experience in the securities and corporate governance laws affecting senior executives of public corporations.  When not litigating, Aegis enjoys working with new and existing broker-dealers, registered investment advisers, and private equity funds, covering all legal aspects from formation to capital raising. Those clients now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises, including the use of cryptosecurities to represent equity and debt interests. 

Aegis's long and distinguished career includes having been 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.  Aegis is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.  He is the current Chairman of the New York City Bar Association's standing Committee on Professional Responsibility.

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

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