Crypto Project Polkadot’s three-year involvement with the SEC leaves it in regulatory limbo

Amid enforcement actions against crypto projects, Securities and Exchange Commission (SEC) Chairman Gary Gensler likes to plead with well-intentioned projects to come in and talk to the regulator about ways to become compliant with US 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 run by the Web3 Foundation with a market capitalization of $8.1 billion, took the SEC’s invitation at face value and began a three-year odyssey with its Strategic Hub for Innovation and Financial Technology (FinHub). Led by Valerie Szczepanik, FinHub participated in more than 50 meetings with the project, ostensibly to provide guidance on ways Polkadot’s original 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 November 4, a media representative for the foundation sent out an email timed for the third anniversary of its engagement with the regulator saying, perhaps inadvertently, that “The Web3 Foundation announces [that] Polkadot blockchain’s native token (DOT) has changed from a security to a software in the eyes of the US Securities and Exchange Commission.

This was not entirely true. It also seemed unlikely given that the SEC’s Gensler has largely followed the path blazed by his predecessor Jay Clayton in expressing a belief that almost every crypto token in existence today, with the exception of bitcoin, is a security.

“We used the third anniversary of our first engagement to go with this,” said Daniel Schoenberger, Web3’s legal director, referring to the announcement. “Obviously communicating the issuance of a no-action letter would have been the stronger message. However, after the 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 develop its token in a responsible way and avoid enforcement actions that have hit Telegram and the social network Kik, but because it has not yet received regulatory relief, it does not really know what the SEC, especially its enforcement. division, is ultimately thinker.

The other problem is that all this confusion belies what appears to be 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 conducted on the SEC’s side by Szczepanik and 2-3 employees, covered all aspects of Polkadot’s operations and ways it could fall under US securities laws. There are several methods used to determine whether a token is a security, but the most common is the Howey test, which asks a series of questions stemming from a 1946 US Supreme Court decision specifying whether a particular engagement constitutes an investment contract. It asks four simple questions. Was there a:

• Investment of money
• In a joint enterprise
• With the expectation of profit
• Largely based on the efforts of others

If the answer to any of them is “yes”, then the asset in question is a security.

The Howey test forms 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 these talks began, there was no question that the DOT was a certainty. It was issued in 2017 under SEC Regulations D and S, which exempt issuers from complying with securities laws by limiting to whom assets can be marketed, when the Web3 Foundation raised $145 million. Additionally, when the tokens were actually released to buyers in 2019, they were still considered to be securities by the team.

The discussions focused on two main themes. According to Schoenberger, the SEC first wanted to make sure the technology was fully developed, meaning the blockchain network was launched according to the specifications outlined in the project’s white paper. This step is crucial to prove that DOT, used to access the network, has real utility and is not seen as just an asset to be sold at a higher price in the future. Second, the SEC focused on ways the Web3 Foundation divested itself of day-to-day control of the network.

“In working with the SEC, we found that while we were impressive with our technology, it was in some ways even more difficult to orchestrate our ability to decentralize our business processes and set up communication and disclosure processes to demonstrate that we no longer had material that non-public information.”

For example, 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 into three such agreements with a focus on network development, marketing and business development. This is an important point, as many decentralized projects use a similar construction where there is both a non-profit foundation and a for-profit entity, which can employ the project’s founder, who actively works on the network. Sometimes these projects can even exercise supermajority voting power on networks, making decentralized governance little 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, suggesting that the two parties themselves could not propose and adopt governance proposals unilaterally. Schoenberger claims that no supermajority voting rights exist.

Other topics addressed by the SEC focused on indicators of buyer intent, meaning whether the DOT was purchased for consumption or investment purposes. In the eyes of the SEC, the buyer’s intent can be as important under securities law as the manner in 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 purchased DOT with the intention of using the DOT on the network?
• What kind of due diligence was done on buyers?
• Do you have any listing agreements with exchanges?

One area of ​​operation of less concern to the SEC according to Schoenberger was the stake model. More than half of the DOT in existence, 56%, is staked on the network, meaning it is sent to the network as collateral to help secure it, an activity that currently yields an annualized return of 5.92%. This question is relevant for two reasons. First, because in an interview following the Ethereum merger 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 his concern about effort concentration. Polkadot, on the other hand, has 297 validators and a spokesperson says Forbes that it is on its way to reaching 1000. Validators on a proof-of-stake system are rewarded with new tokens for verifying transactions on the blockchain; they must stake existing tokens to participate.

When it came to the question of returns, which may sound like the returns offered by centralized lenders like Celsius, BlockFi and Voyager, all of which have either gone bankrupt or been investigated by regulators for issuing unregistered securities, Schoenberger says that staking. returns should be interpreted differently. “With DOT’s inflation model, if you don’t bet, you lose over time.”

The SEC also did not appear to consider questions about Kusama, Polkadot’s testnet, where the token KSM was issued for free to DOT buyers and currently has a market cap of $326 million. Schoenberger calls Kusama a “canary in the coal mine” and notes that since Kusama is technically ahead of Polkadot on the development roadmap, it’s even less likely to be a certainty. 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 issued for free.

In addition, Schoenberger noted that the SEC does not appear to hold the foundation accountable for the security status of dozens of tokens operating 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 accountable for the status of decentralized application tokens on top of that network.

So what does all this mean? The foundation says it will continue to engage in dialogue with the SEC, but with no promise of injunctions in the form of a no-action letter. To be clear, Schoenberger says 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 seems the project may remain in a state of limbo. This certainly doesn’t help at a time when crypto markets are suffering through a months-long bear market. Bitcoin is down 56% year-to-date as it crosses the $20,000 line, while DOT is down 73%.

Of course, with crypto being a hot-button issue in Washington and other capitals around the world, the project is also keeping abreast of other legislative and regulatory activities that could affect Polkadot’s future, such as the Lummis-Gillibrand Financial Innovation Act which will apparently favor Commodity and Futures Trading Commission (CFTC) over the SEC as the main US crypto regulator

Schoenberger does not believe the CFTC should regulate the DOT. When asked who he thinks should be its overseer, he first suggested that the product shouldn’t have one because it’s software. But in a follow-up call, a spokesperson explained, “We’ve done the hard work to go through the current process with the SEC, and we believe the current securities laws have worked for us so far. We’re similarly ready to comply with any new applicable laws and cooperate with any new regulators that require jurisdiction below Our goal has always been to be legally and regulatory compliant, as we strongly believe in the importance of achieving Web 3.0, and to do so, legal and, to do so, regulatory compliance remains our goal.” Web 3.0 refers to a decentralized version of the internet.

So it looks like Polkadot will remain stuck, like many other projects with similar levels of development until something shakes out. While getting a sign-off from the SEC would be great, that wasn’t the only reason Polkadot went through the process.

“We hope that going through this whole process can inform others,” says Shoenberger.

The SEC declined to comment for this article.