SEC Halts “Smart Contract” Exchange Built on Silicon Valley Start-Ups
Two entrepreneurs wanted to create a business that centered on valuing private start-up companies. They experimented with models that began with a variation of “fantasy sports,” changed to a contest and became a game. It ended with one which involved securities based swaps sold in violation of Dodd-Frank and a Commission enforcement action. In the Matter of Sand Hill Exchange, Adm. Proc. File No. 3-16598 (June 17, 2015).
Sand Hill Exchange was created by Gerrit Hall and Elaine Ou, both named as Respondents along with their business. Mr. Hall holds an MBA from MIT. Ms. Ou, with a masters degree from Harvard and a PhD in electrical engineering from Stanford, created models for counter-party risk in credit default swap pricing. The two founded and ran Sand Hill.
To create a business that would involve valuing start-up enterprises, Mr. Hall and Ms. Ou began in December 2014, creating a variation of a fantasy sports league. Users could by or sell stock of private companies whose shares were listed by Sand Hill. They paid with credits issued by the Exchange. Prices were determined by an algorithm – they were essentially “fantasy,” not actual prices.
After moving to a Silicon Valley accelerator run by venture capitalists, Mr. Hill and Ms. Ou changed the model, turning “fantasy” investing into a valuation contest. Users supplied data from which Sand Hill created consensus valuations for each firm. This version of the business morphed into a game in early 2015. Using the consensus valuations as a starting price, users were asked to bet if the price would rise or fall. The game was shut down for lack of interest, but efforts at the business continued.
In the new version, users deposited cash or bitcoins and then bought or sold what were called “smart contracts” – arrangements tied to actual companies on which users could make a profit. Profits and losses came from liquidity events. If the referenced firm experienced a liquidity event such as an IPO, merger or dissolution, the contract buyer received one dollar for every $1 billion that the company was valued at. The payments were funded by the two founders. The reference companies included Uber, Pinterest, Snapchat and Coinbase, all private firms with securities outstanding. The firms were listed on the website of the exchange.
In an effort to attract users the two founders made exaggerated claims. Those include descriptions of how the market worked, the actual volume and the safety of the client accounts. In addition, the prices listed on the web site did not accurately reflect purchase and sales by users. Rather, they were set by an algorithm.
Respondents were in fact selling derivatives linked to the value of private companies which were bought and sold by about 83 users. Those derivatives were securities based swaps. Those include any agreement which is a swap and is based either on an index that is a narrow-based security index, a single security or loan, or the occurrence or nonoccurrence of an event relating to a single issuer of a security or of a security provided the event directly affects the financial statements, condition or obligations of the issuer. Dodd-Frank created a regime for the sale of such instruments that involve persons who are not eligible contract participants, making it illegal to sell to them absent an effective registration statement and off a national securities exchange. Here Sand Hill violated these provisions. When the SEC staff contacted Respondents they terminated the business. They also agreed to refund user money.
To resolve the proceeding, each Respondent consented to the entry of a cease and desist order based on Securities Act Section 5(e) and Exchange Act Section 6(1). In addition, Sand Hill agreed to pay a penalty of $20,000.