Masternodes in Legal Limbo as Regulators Fail to Act

Grant Gulovsen is an Illinois-licensed attorney in private practice. The views expressed are his and are not intended to be legal advice.

Last November, Commodity Futures Trading Commission Chairman Heath Tarbert stated that both his agency and the Securities and Exchange Commission were “thinking carefully” about Ethereum 2.0’s new proof-of-stake (PoS) transaction validation model. Nine months later, the SEC has yet to provide any indication about its conclusion on the subject. And, to the extent that so much of the current crypto industry is built on Ethereum, including most of DeFi, this is a problem.

Masternodes – servers on a decentralized network that perform specific services that regular nodes are unable to perform – have always inhabited a gray legal and regulatory area (at least in the context of U.S. securities law). Given the similarities between the staking mechanisms proposed for Ethereum 2.0 and those found in most masternode-based networks, I was hopeful that some guidance from the SEC on Ethereum 2.0 might help clear this up. But the agency’s silence has left many blockchain networks that use or are considering using masternodes in a state of legal limbo.

What are masternodes?

Masternodes are very similar to full nodes on the Bitcoin network (both of which maintain a full copy of the blockchain and perform tasks related to block validation). But masternodes provide other services, such as allowing for anonymous and instant transactions on the primary network.

Dash, which is perhaps the best-known masternode-based network, utilizes both “Proof-of-Work” and “Proof-of-Service” algorithms to pay out block rewards. In the latter algorithmic model, masternode operators are required to deposit a fixed number of tokens in a wallet that is viewable to the network. In exchange for allocating these tokens and providing additional services to the blockchain network, masternode operators are given a percentage of the block rewards in a revolving queue. 

As long as the masternode is performing at a minimum acceptable level and the balance in the wallet is maintained, the masternode will remain “in service” and stay in the reward queue. But if it starts failing to perform as required or the balance in the wallet falls below a minimum threshold, the masternode is taken offline and sent to the back of the reward queue.

Projects that utilize or are considering utilizing masternodes are left in a position all too familiar to the crypto industry as a whole.

What does the SEC have to do with this?

The starting point for determining whether something qualifies as a “security” under U.S. law is by looking at the statutory definition of “security,” which can be found in 15 U.S.C. §§77b(a)(1) & §78c(a)(10).

In both statutes, the term “investment contract” is included in the definition of a “security.” As stated by the SEC in its 2017 “DAO Report” and subsequently by several U.S. federal district courts (most recently in the Opinion & Order in the SEC v. Telegram case), in arrangements involving digital assets (which include masternodes) we should consider whether they are “investment contracts.”

So do masternodes involve investment contracts?

In deciding what is an “investment contract,” the SEC applies the Howey Test, named after the defendant in a 1946 Supreme Court case.  

Three tests

The SEC’s application of the Howey Test requires the following three elements to be present for a “contract, transaction or scheme” involving digital assets to be considered an “investment contract,” or security:

Let’s consider these in turn as they relate to masternodes.

Is there an investment of money?

To the extent that masternodes require operators to stake a certain number of tokens to be considered “in service,” the answer to whether there is an investment of money involved is clearly “yes.” The fact that the consideration paid is not in the form of cash is irrelevant for purposes of this part of the Howey Test. 

Is there a reasonable expectation of profits?

Where masternodes offer block rewards or other financial returns in exchange for staking tokens, the answer to whether there is a reasonable expectation of profits is also “yes.” As stated by the U.S. Supreme Court in SEC v. Edwards (2004), “[T]he commonsense understanding of ‘profits’ in the Howey [T]est [is] simply ‘financial returns on … investments.’”

Are profits derived from the efforts of others?

One could argue that to receive block rewards, operators must (at least theoretically) actively monitor their masternodes to ensure their wallets stay full and the masternode software is updated regularly to avoid being penalized. Thus, the argument goes, any “expectation of profits” would be derived from the efforts of the masternode operators themselves and not any third-party, such as the team behind the network.

But “in light of the remedial nature of the [U.S. securities] legislation,” the federal courts have “adopt[ed] a more realistic test, whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” It is therefore the efforts that affect the failure or success of the network as a whole (and not just individual masternodes) which is the correct focus of the “efforts of others” element.

Is the network ‘sufficiently decentralized?’

Ultimately I believe the question of whether profits from masternodes are “derived from the efforts of others” turns on the issue of whether the underlying network as a whole is “sufficiently decentralized.” That was the phrase used by SEC Director William Hinman in his June 14, 2018, speech declaring Ethereum (the non-2.0 version) did not trouble U.S. securities laws. 

As Director Hinman stated:

Thus, the fundamental question is whether the profits derived from staking tokens are ultimately dependent upon the efforts of a central management team (e.g., to generate revenue, drive adoption or further develop the network). 

If there is a central management team or entity upon which masternode ROI is dependent, then. absent any additional guidance from the SEC on the subject, there is a high probability operating masternodes on such networks would be considered (by the SEC at least) to involve investment contracts, i.e., securities.

Given this, until the SEC offers the industry some guidance on how it views Ethereum 2.0, projects that utilize or are considering utilizing masternodes are left in a position all too familiar to the crypto industry as a whole: being forced to read tea leaves instead of relying on clear regulatory guidance. As the growing list of SEC Cyber Enforcement Actions shows, attorneys make lousy fortune tellers.