The SEC’s reliance on a nebulous US Supreme Court decision raises important questions for the future of decentralized finance.
Reves v. Ernst & Young,[1] a 30-year-old US Supreme Court decision on farmers’ co-ops, is garnering attention in the Web3[2] world, specifically in the context of protocol-driven decentralized finance (DeFi).[3] The case popped up in recent speeches by senior Securities and Exchange Commission (SEC) officials, including congressional testimony of SEC Chair Gary Gensler,[4] and featured in one of the SEC’s latest moves in crypto enforcement — an August 2021 action against a company called DeFi Money Market (DMM).[5] These developments raise several important questions. What is the relevance and application of the Reves four-factor test? How does it apply (or not apply) to Web3 generally and DeFi specifically? Most importantly, does it give the SEC broad authority to regulate DeFi?
This piece offers an initial analysis of these issues as they may arise in certain contexts. Several points stand out. First, the Reves decision principally focuses on whether a particular instrument is both bought and sold as an investment. Second, while each protocol must be analyzed on its own facts, that focus on investment, and the attendant investor-investee relationship, may not fit DeFi protocols (and their associated tokens), given their decentralized nature. In particular, how the test would apply to liquidity provider tokens (LP Tokens), which are commonly issued as deposit receipts by decentralized protocols, is unclear. Finally, applying Reves to protocol-driven DeFi platforms — particularly without additional public guidance from the SEC — raises questions of fair notice and poses risks to the continued development of DeFi in the US.
Reves v. Ernst & Young: A Primer
In Reves, the Court considered an important question: what kind of instrument qualifies as a “note,” such that it can be regulated as a “security,” under the Securities Exchange Act of 1934?[6] That law defines a security to include (among many other things) “any note … [except for a note] which has a maturity at the time of issuance of not exceeding nine months.”[7] To determine what kinds of notes qualify, the Court adopted the “family resemblance test,” which features a grab-bag of legal concepts, including a rebuttable presumption, seven potential analogies, and a multifactor balancing test.[8]
In particular, under the Reves test, the threshold issue is whether the instrument in question is a note exceeding nine months’ maturity. If so, the note is presumed to be a security; if not, then no presumption applies.[9] The presumption that a note is a security can be rebutted in one of two ways. First, one can show that the note bears a strong family resemblance to one of seven kinds of instruments that are not securities:
- A note delivered in consumer financing
- A note secured by a mortgage on a home
- A short-term note…
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