Bye- Bye Basis
(My thoughts on SAFTs and why it matters here)
Basis Protocol, which raised $133 million from a number of credible investors, announced this week that it was shutting down. In its official statement, Basis cited “U.S. securities regulation” as a reason for its shutdown.
From the onset, I should clarify that this post is not a critique of the Basis business model or mathematical theories. Rather, I want to use Basis as an example to explain some relevant legal issues that I think are important and just starting to unfold.
Before I launch into the legal issue breakdown though, what even is Basis?! In short, Basis is a Stablecoin. There’s been extensive analysis done on Stablecoins which you can read here (an explanation with a pro/con of stablecoins by Metastable’s Haseeb Qureshi) and here (an overview of stablecoins by Myles Snider). Examples of other types of Stablecoins can be found on the Stablecoin Index here, which is a website that tracks and compare various stablecoin projects (created by Mike and Myles).
The TLDR of it: a stablecoin means that the tokens of that stablecoin project are “pegged” to to an asset— in this case, 1 Basis can be pegged to always trade for 1 USD. In order to do this, Basis compares itself to a central bank, because its protocol can algorithmically adjusting the supply of Basis tokens in response to changes in, for example, the Basis-USD exchange rate. For the sake of this post, I am accepting those descriptions on its face, and leave the criticisms for my more knowledgeable friends in the cryptosphere.
Now let's get to the fun stuff and break down the potential legal issues.**
Unregistered Securities + SAFT Considerations
Here is the first bullet point in Basis’s official statement for shutting down:
As regulatory guidance started to trickle out over time, our lawyers came to a consensus that there would be no way to avoid securities status for bond and share tokens (though Basis would likely be free of this characterization).
The immediate question that pops up: why would these two tokens (the bond and share) be considered securities?
Well— ACTUALLY— the Basis protocol issued three classes of tokens: there’s the basis token, the bond token, and share token.
Screenshot of the token descriptions from the Basis white paper below:
In short, Basis is a three token model with two securities and one stablecoin. Thanks to Preston, a lot of this research is already done for me.
“Both holders of Base Shares and Base Bonds are incentivised to participate on the basis that the price of Basecoin (note: Basis used to be called Basecoin) is going to rise. Every bet being placed by every user of the system goes one way.”
In other words, when price rises, base shares benefit because they will dividend out stablecoins to those shareholders (increase supply). And when price decreases, basis issues bonds with increasing rates to buy back the stable coin (decrease supply).
The official statement that Basis puts out adds an interesting “Basis would likely be free of this characterization”, which makes no sense for these "bond and share tokens”. I don’t really know if there is any analysis I need to do here, except to say that shares and bonds are securities, plain and simple.
For the legal nerds; there is a 1985 Supreme Court Case (i.e. highest order of law of the land,) Landreth Timber Co. v. Landreth, which ruled that:
(b) When an instrument is labeled "stock" and possesses all of the traditional characteristics of stock, a court is not required to look to the economic substance of the transaction to determine whether the stock is a "security" within the meaning of the Acts.
Meaning, if you are going to name something a “stock”, any court can pretty much judge based on that label that your instrument is in fact a security. (PSA: this analysis has nothing to do with the Howey Test, so pls do not bring that up to me).
Which like, @ Basis WHY would you name your tokens “share tokens”?! That just destroys **any** argument you would’ve had up your sleeve.
To be clear, Basis is not shutting down because they illegally offered securities in the initial fundraise. In fact, the Reg D fundraise is very much OK. (I don’t want to bore you with the specifics of securities law, but if you are so inclined, feel free to check out the primer that I have written about here).
As some background: Basis, through Intangible Labs (the company behind the Basis) raised $125 + million via a SAFT from a bunch of private (VC) investors. Essentially, a SAFT starts off as just a regular fundraise under Regulation D, which is an exemption that an issuer can rely on to legally not have to register its security. This means that the investors must all be accredited, which seems to be the case here. So the "unregistered securities” cry is not really the issue here.
The way that the SAFT was structured, however, is likely the major thing that fucked Basis over. If the underlying asset in the contract (in this case, the Basis bond/share tokens) is a security, those tokens will still remain a security at launch.
In other words, it is the subsequent token sale/re-sale that is precisely the issue here.
As a refresher, the SAFT is a framework that was proposed a “legally compliant” way to raise money via a token sale. The argument goes like this: I am selling you a right to this token in the future, and even though what you are buying right now is a security (since it is pretty much a piece of paper that gives you the right to own those tokens later), what you get later will not be a security. I (along with a bunch of other lawyers) always had my reservations around it, since I didn’t buy that argument fully. The Cardozo Blockchain Project (disclaimer: my alma mater) does a better job at poking holes in the SAFT structure though, which you should read here.
Basically, if what underlies your SAFT is a security, there is quite literally nothing that can change that form later on, no matter how you structure it for now. There also is quite literally zero legal precedent in which a security can turn into a non-security.
By the way, pls do not @ me with the “but ether isn’t a security’ thing— I know what Hinman said, that is not the official SEC position— hell, that’s not even law. And Ether / Basis and the way they are structured aren’t even remotely similar to each other.
My main gripe is somewhat related to this tweet storm: (I know self-quoting is a weird flex, but ok let me have it!)
I don’t think it’s fair to expect crypto- entrepreneurs to necessarily know any of these legal principles / laws that I am laying out. I do, however, expect **lawyers** and Basis’s legal counsel to know this.
Even that aside though, here’s the thing:
The SAFT was a creative framework that relied mostly on the “kicking the can down the road” tactic. That is a dangerous tactic. You can not take a ‘maybe this will be legal maybe this won’t but I’m sure by the time my token is live the regulatory stuff will be figured out” when it touches U.S. federal securities laws. To be honest, that’s frankly irresponsible and leads to, well, what happened with Basis. The SAFT also sold a fantastic (and very tempting) vision to early stage startups with real runway limitations, which was that— hey, here is a “legally compliant” way for you to raise millions in capital and to build your product. Of course this makes for easy buy-in for entrepreneurs of early stage startups who are simply focused on building and shipping product. Unfortunately, what was not made clear was this: if your underlying tokens are securities, the SAFT will not save you.
Where there is room for startups to fail, the failure of a reasonable law or ruling can negatively impact society at large for decades to come. That being said, where there are gaps and gray area in the law, there will be those who will navigate around it. In the case of crypto assets, some of that navigation happened fast and loose. But some of that was also done in earnest good intentions. Enforcement actions may instill fear in those in the former category, but proves frustrating and hugely unhelpful to those in the latter category.
Before I conclude, I want to point out one thing: Basis is able and willing to refund most of its capital. This is because that capital raised was held in fiat currency, which was insulated from the ups and downs of the crypto volatility. Others have also pointed this out, so I am not the only one to claim this observation here.
The main takeaway?
Cryptoassets are new, but the concept and characteristics of securities are not. One of the most hair-pulling things I saw last year was all these ICOs being conducted at massive scale, all claiming to be ‘SEC-compliant’ without really understanding what that means. And I totally get why. It is easy to look at these large ICOs raised under the SAFT structure and think that because it’s been done already by other ICOs, it means that it is the fail-proof way to conduct a token sale.
Basis is the first project of this scale to have shut down so publicly, and I don’t think it is the last. There may have even been projects on a smaller scale or shut down privately that I have not heard about yet. Basis was an ambitious project, and I respect the team and their vision in creating the project. But when it comes to U.S. federal securities laws, you just can’t win if you play fast and loose.
** I am not a barred attorney. I just like the law and am studying for the bar exam right now and writing this stuff is way more interesting. Take everything with a grain of salt, and take this post with two.
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