Ethereum co-founders knew ETH was a security from the get-go, insider says

An Ethereum insider says the network’s co-founders knew all too well that their 2014 token crowdsale involved unregistered securities and relied on friends in government to keep them out of trouble.

Last November, Steven Nerayoff released an audio recording of several phone conversations he had with Ethereum co-founder Vitalik Buterin in April 2015, several months before the Ethereum blockchain officially mined its genesis block. Nerayoff, a former legal advisor to the Ethereum Foundation, says he’d been tasked with assessing the network’s problems and proposing a ‘restructure plan’ to ensure its long-term survival.

Nerayoff had teased the release of the recordings for weeks in advance, claiming that Ethereum insiders like Buterin and Joseph Lubin are involved in “the biggest fraud of our lives.” Unfortunately, the recording (full transcript viewable here) proved a bit of a letdown on that front, although Nerayoff claimed shortly before its release that evidence of said fraud will be detailed in a lawsuit he intends to file at some future date.

What the recording did show was just how out of his depth Buterin was at the time. Having just turned 21, Buterin was clearly overwhelmed by Ethereum’s haphazard organizational structure and its dwindling financial resources.

The controversial crowdsale of ETH tokens the previous summer had brought in over 30,000 BTC tokens worth over $18 million at the time. But the failure of Ethereum’s leadership to deliver on many of the pre-sale promises they’d made to the roughly 9,000 participants had left many of the latter feeling betrayed by Buterin, Lubin, and the other co-founders.

As Nerayoff explained to Buterin, a lot of these crowdsale participants were “not wealthy people … they’re young people that have sold their Bitcoin and put their savings into this thinking this is the next best thing. These people are not going to be happy if this thing goes below par, so to speak. So one issue is, you must not only keep the organization going, you must keep Ether above par.” 

Nerayoff added that he was “fairly convinced that securities laws and these other laws have been tripped. And so the question … is anybody going to come after you? And the likelihood of that diminishes greatly if the price of Ether stays above par and people don’t lose money.”

Buterin never pushes back against these observations, likely because he understood the reality of Nerayoff’s argument. But Nerayoff’s suggestion that Buterin had the power to boost the price of ETH—and Buterin’s apparent acknowledgment of this reality—ticks another box on the Howey test for determining whether assets are securities.

"At this point, if you're investing in Ethereum, I would say you're investing in the team and community."
–@VitalikButerin pic.twitter.com/DGBF8VMgRp

— Pledditor (@Pledditor) November 16, 2023

For those who might argue that inference isn’t evidence, consider that in March 2014, Buterin gave a presentation on Ethereum at the Texas Bitcoin Conference in Austin. In a sideline interview, he ticked more Howey boxes by telling would-be crowdsale participants that not only was ETH considered an ‘investment,’ but “if you’re investing in Ethereum, I would say you’re investing in the team and the community.”

Papering the cracks

Nerayoff wasn’t the only Ethereum insider who believed ETH met the criteria for an unregistered security. Nerayoff posted screenshots of emails from July 2014 detailing a conversation between Lubin and Jeffrey Alberts, a partner at the law firm Pryor Cashman (CC’d were Buterin, Nerayoff, and another Pryor Cashman partner, Bertrand Fry).

Lubin speaks of the need to acquire “a strong opinion letter” that would leave Ethereum insiders “well insulated from criminal liability regarding securities laws” should they permit U.S. residents to participate in the crowdsale that was then only a week away. (Lubin later publicly celebrated this “piece of paper in our pocket” as having legally immunized the crowdsale in advance.)

Alberts replies that while the opinion letter “probably does give you a defense under certain circumstances,” there was no legal defense against fraud. Based on Alberts’ advice, the Ethereum Foundation reserved $1 million from the crowdsale proceeds to cover potential legal bills.

In mid-December, Nerayoff sat for an interview with attorney John E. Deaton and offered additional evidence of ETH’s security status. Nerayoff displayed an ‘opinion party certificate’ from Pryor Cashman that lists what Nerayoff called “certain requirements that Ethereum is attesting to (to the law firm) in order for the opinion to be valid. Vitalik signed that. One of those [requirements] was not held up to be valid.”

Per Pryor Cashman’s instructions, the Ethereum Foundation agreed to issue 60 million ETH (the same amount sold via the crowdsale) to blockchain reward miners over a 40-month period so that the distribution of tokens would be balanced.

The exact wording of this stipulation read: “An amount of Ether equal to 30% of the Pre-Sale Amount will be issued annually to blockchain miners, with the result that blockchain miners are expected to have received, by roughly three years and four months after the launch of the genesis block, an amount of Ether equal to the Pre-Sale Amount.”

According to Nerayoff, “effectively, what they were saying was, ‘we’re not decentralized, and in order to become decentralized, we need to balance it out with the miners.’ The problem with that analysis is that, if you go out three years and four months, they issued less than half of that, which means the opinion letter’s no good and [ETH is] probably a security.”

Pumping Joe’s bags

Ethereum’s crowdsale is widely regarded as a fundamentally flawed procedure in which a relative handful of whales—less than 100—snapped up as much as 40% of the available tokens. Lubin himself informed these whales in advance that they wouldn’t be subjected to any real scrutiny should they wish to purchase more than the stated 12.5% maximum available to any one buyer. (There’s also evidence that Ethereum issued 168,000 additional ETH via its ICO than the amount Buterin claimed on Github at the time.)

A couple of years ago, former Ethereum developer Lane Rettig claimed that maybe 60% of all ETH in existence was still the product of the premine and that Lubin was “probably the largest holder” of ETH following the crowdsale. Rettig said the premine was “the biggest reason I left Ethereum,” adding that this belated realization that his work was ultimately responsible for “pumping Joe Lubin’s bags” was “just not what I want to do.”

At the Consensus 2022 event, Lubin was asked to clarify the size of his bags. Lubin refused to offer specifics but claimed that his ETH holdings have “never been even close to even half a percent” of the total supply. But as Nerayoff noted to Deaton, Lubin didn’t say it was “never more than half a percent,” and Lubin’s phrasing doesn’t rule out the possibility that he holds 40% of the total supply, which is objectively not close to half a percent.

Nerayoff told Deaton that it was “two parties, maybe it was three parties, that bought the vast majority of all the ETH” in the crowdsale. Nerayoff further claimed that these same few parties were also “mining the vast majority of the ETH” right up until Ethereum’s ‘Merge,’
aka the 2022 shift from a proof-of-work consensus mechanism to one based on proof-of-stake.

In Nerayoff’s view, the fact that the miners receiving ETH via block rewards were also the biggest ETH crowdsale participants meant the network had become more centralized over time, making a mockery of its public proclamations of seeking greater decentralization. (That ship has now permanently sailed, given the post-Merge whale-favoring design of staking-based transaction validation.)

Enter the Hinman

Government agencies are notoriously slow off the mark, but other Ethereum insiders expressed similar concerns that the crowdsale would eventually provoke the Securities and Exchange Commission (SEC) to act. Vinay Gupta, who worked as project manager on strategy and communications for Ethereum’s 2015 launch, was sufficiently worried to discuss the matter with his own attorneys.

The attorneys told Gupta that ETH was indeed an unregistered security and “you can’t massively profit from this at the same time that you’re selling it to people.” Gupta was advised to either divest himself of his ETH holdings or move to a jurisdiction without an extradition treaty with the United States.

Gupta chose the former and now says his decision to divest cost him an estimated $56 million. Still, how was he to know Ethereum had men on the inside ensuring the SEC would take no action against it?

In June 2018, William Hinman, then-director of the SEC’s corporation finance division, gave a now-infamous speech at the Yahoo Finance All Markets Summit on the topic of “whether a digital asset offered as a security can, over time, become something other than a security.”

In this speech, Hinman declared that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” As such, Hinman believed that “applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.”

This speech has come under renewed scrutiny in recent years, in part due to the SEC’s suit against Ripple Labs over whether its XRP token is an unregistered security. Internal SEC documents disclosed in that suit reveal internal debate amongst SEC execs regarding Hinman’s Ethereum comments prior to his speech, including whether they reflected broader SEC policy or simply Hinman’s personal views.

The fact that Hinman himself referred to the speech as the ‘Ether speech’ in SEC emails—despite his also referencing the BTC token in the same speech—raises additional questions as to his motivations in crafting it. As does his June 4, 2018 email stating that he was planning “a call with Buterin later this week to confirm our understanding of how the Ethereum Foundation operates.” (Hinman would later deny under oath that he communicated with anyone other than SEC staff regarding the substance of the speech.)

Conflicted much?

Before joining the SEC in May 2017, Hinman was a partner at the Simpson Thacher & Barlettt law firm. That same year, the firm became a member of the Ethereum Enterprise Alliance (EEA), a group formed to “build, promote, and broadly support Ethereum-based technology.”

Hinman left the SEC in December 2020 and quickly rejoined Simpson Thacher as a senior advisor. It was later revealed that Hinman was paid millions of dollars from Simpson Thacher during his SEC tenure, money that a source close to Hinman described as part of Hinman’s pension from the firm. However, the majority of it appears to have come via partnership income, aka profit sharing.

Simpson Thacher quietly left the EEA in the spring of 2022, later declaring that its “minimal involvement” with the group was “purely educational, to gain a better understanding of blockchain technology.”

But the exit dovetailed with the whistleblowers group Empower Oversight finally receiving SEC emails they’d sought via freedom of information access requests. The emails showed the SEC ethics office warning Hinman early on about his ‘retirement benefits’ being based on Simpson Thacher’s future profits, which could give him “a financial interest in the firm’s profitability while you are in government.”

The SEC ethics office warned Hinman that this “future interest is enough to give you a full financial interest in the firm,” and thus, he should recuse himself from any matters in which Simpson Thacher stood to benefit. Despite this warning, Hinman met with another Simpson Thacher partner at least three times during his time on the SEC payroll.

The SEC ethics officials continued to press Hinman in January 2018, saying “[i]t occurs to us that you have a full financial conflict with your old firm, not just an impartiality one.” The SEC warned Hinman not to have “any meetings with your old firm, even group meetings.”

And yet, Hinman met with Simpson Thacher partner Chris Lin in August 2019 so that Lin could “report what is going on in China.” At the time, Lin represented Canaan, a China-based block reward mining firm that Simpson Thacher helped take public in November 2019.

How did Hinman get away with this flagrant ignoring of ethics guardrails? It didn’t help that in 2021, Carl Hoecker, the SEC official tasked with investigations of wrongdoing by agency staff, was found guilty of “serious misconduct” following an Integrity Committee probe that began in November 2017. Predictably, Hoecker’s punishment was limited to a brief suspension without pay, after which he went back to doing his heckuva job keeping watch over other SEC execs until May 2022.

Say it ain’t so, Joe

In 2020, Lubin told a podcast that Ethereum “arrived on the scene before regulators were watching,” and the co-founders had been “fortunate enough to be able to frame our token as a utility token” by the time regulators began watching.

The year before, Lubin told a conference audience that “we are big friends and fans of [the SEC]. I think they’re really understanding the space well.” Lubin described how the SEC had “introduced a new construct–decentralization–into their thinking,” and thus, no Ethereum transactions “are considered to be transactions of securities.”

There’s no doubt that Hinman had been lobbied hard on this ‘decentralization’ angle ahead of his June 2018′ Ether speech.’ Emails show Lubin pushing to meet with SEC execs—including Hinman—with the first meeting taking place in December 2017.

This full-court press quickly gained pace, as the court-ordered release of Hinman’s calendar of appointments shows. Between March 29 and April 23, 2018, Hinman met twice with Lubin and individuals associated with ConsenSys, Lubin’s Ethereum-based blockchain software outfit. Two other Hinman meetings show the subject of discussion was ‘ETH’ or ‘Ether.’

That March, the Andreessen Horowitz venture capital group—a major investor in Ethereum-based projects—submitted a white paper to the SEC proposing a ‘safe harbor’ for ‘decentralized’ tokens. The paper singled out ETH as “a good example of this type of protocol token that has become so decentralized it should not be deemed a Security.”

In September 2019, Cooley LLP attorney Nancy Woitas appeared on a crypto regulation panel and referenced Hinman’s speech, saying, “most of what he says in there came out of the safe harbor, as well as the meetings that we had with him.”

Lowell Ness, a partner at Perkins Coie, told a BlockCon audience that he wrote the material presented to the SEC in the safe harbor paper. Ness added that the firms who attended an April 2018 meeting with SEC officials were taken aback by the “interesting dichotomy” between the SEC’s public tough talk re ‘crypto’ enforcement versus “this interesting sort of welcome that we got privately.”

For the record, both Cooley and Perkins Coie belonged to the Enterprise Ethereum Alliance.

Also, for the record, on June 2021, Andreessen Horowitz announced that it had added Hinman as an advisory partner to its $2 billion ‘a16z crypto’ fund.

Sham Master Jay

Hinman’s boss at the SEC was then-chairman Jay Clayton. Clayton’s tenure was marked by a significant number of civil actions against projects involving initial coin offerings (ICOs), nearly all of which occurred on Ethereum. And yet, Ethereum somehow escaped censure for enabling this illegality.

In February 2018, Clayton told the Senate banking committee that “every ICO I’ve seen is a security… Those who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement provision.” And yet, Ethereum’s own deeply flawed ICO and its subsequent failure to decentralize got the thumbs-up from Hinman just four months after Clayton made that statement.

Clayton was a partner at the Sullivan & Cromwell (S&C) law firm (of FTX fame) before his SEC stint and rejoined the firm after leaving government. It’s unclear when the relationship began, but at some point, Lubin hired S&C to advise ConsenSys on regulatory matters, including its various funding rounds.

In his July 2021 deposition in the Ripple suit, Hinman was specifically asked whether he’d had any communications with Clayton regarding Hinman’s pre-speech meetings with Lubin and other ConsenSys officials. Hinman admitted having communicated with Clayton regarding the ConsenSys meetings “once or twice.”

Like Hinman, Clayton’s devotion to The Cause went neither unnoticed nor unrewarded. In March 2021, the One River Digital Asset Management firm—which in December 2020 bought around $600 million worth of ETH and BTC and announced plans to boost that sum to $1 billion by early 2021—added Clayton to its advisory council.

An interesting footnote regarding the dynamic duo of Clayton and Hinman. The pair both worked on the 2014 initial public offering of Chinese tech giant Alibaba (NASDAQ: BABAF) as the point people for their respective law firms. A mere three years later, Alibaba would be responsible for 10% of global blockchain-related patent applications.

ETHgate

While his stint as SEC chair was due to run through June 2021, Clayton opted to resign on December 23, 2020 (less than three weeks after Hinman made his own premature exit).
That same day, the SEC sued Ripple Labs for offering unregistered securities.

In 2021, documents filed by the SEC in its suit v. Ripple indicated that “on approximately April 13, 2018, staff in the SEC’s newly-formed Cyber Unit began investigating whether Ripple’s and others’ conduct violated the federal securities laws.” On April 12, 2018, Hinman emailed Lubin to say he’d “greatly enjoyed” meeting Lubin and his team and wondering if “we could have a brief call in order to discuss the possibility of another meeting?”

The alleged favoritism the SEC showed Ethereum while aggressively targeting rival protocols such as Ripple has become known as ‘ETHgate’ among Ripple supporters. To be sure, CoinGeek can hardly be described as Ripple fans, seeing little difference between XRP, ETH, and any of the other bazillion ‘alt-coins’ that emerged in the 15 years since Satoshi Nakamoto released his Bitcoin white paper. 

But as the saying goes, just because you’re paranoid doesn’t mean they aren’t after you.

The empire strikes back

Nerayoff’s public re-emergence onto the digital asset stage followed a failed attempt by the U.S. Department of Justice (DoJ) to put the former Ethereum insider inside a prison cell for a long, long time.

In 2017, Nerayoff worked as an advisor for some of the countless Ethereum-based projects that launched ICOs that year. In September 2019, Nerayoff and his alleged co-conspirator, Michael Hlady (aka Michael Peters), were arrested and charged with attempting to extort millions of dollars from a Seattle-based token project. (The project goes unidentified in court docs but was long ago outed as StormX.)

Nerayoff, who’d signed a deal to assist StormX in launching its ICO, was accused of shaking down StormX’s founders for millions more in cash and tokens than their original agreement called for, with Hlady allegedly issuing veiled threats of violence to compel the founders to agree. An FBI director called it “an age-old extortion scheme … with a modern day twist.”

While Hlady pleaded guilty in April 2021, Nerayoff maintained his innocence from the start. Nerayoff claimed he’d been set up by Hlady, who Nerayoff alleged was an established conman who’d stolen hundreds of thousands of dollars from him. Nerayoff further claimed that Hlady was a government informant who’d exchanged 100 text messages and 45 phone calls with a Federal Bureau of Investigation (FBI) agent during the period in which the alleged extortion was said to have occurred.

Nerayoff was ultimately vindicated in May 2023 after the DoJ abruptly filed a motion to dismiss the indictment with prejudice, citing “material exculpatory evidence obtained by the government well after return of the Indictment” and “subsequent investigation based on that evidence.” The Department of Justice (DOJ) concluded that it was “unable to prove the charges in the Indictment beyond a reasonable doubt.”

Among this exculpatory evidence were Skype video recordings of meetings between Nerayoff and StormX founders that, in Nerayoff’s lawyers’ view, “clearly establish that not only were the agreements entered into freely, the parties’ dealings were entirely cordial.” Nerayoff’s lawyers noted that some of the exculpatory evidence had “been in the government’s possession since sometime in February 2019,” seven months before the complaint was filed.

The dismissal brought a halt to a motion filed by Nerayoff’s team one month prior that sought to compel the government to produce certain evidence related to his case. Nerayoff claimed that the government had tried to strongarm him into helping them bring criminal cases against some prominent figures within the blockchain sector. Nerayoff said he refused to cooperate despite the government’s suggestion that doing so could shave years off the sentence he’d receive on the extortion charge.

Selective outrage

Despite Nerayoff declining to throw anyone under the bus to save his own skin, at least one of Ethereum’s co-founders doesn’t appear all that grateful. Last September, Buterin was asked by journalist Laura Shin about some of Nerayoff’s recent claims. Buterin said that in 2015, he was still too young and naïve to “detect the problems in someone like Steven Nerayoff.”

Buterin went on to say that the Ethereum Foundation had since “successfully distanced ourselves” from “bad characters that caused us a lot of damage.” Buterin claimed Nerayoff was involved in “huge amounts of, like, fraud and behaving in … ways that made women around him very uncomfortable at the very least … That’s a shady character, man.”

It’s unclear what Buterin is referencing here re ‘uncomfortable women.’ Granted, Nerayoff has spoken favorably of Andrew Tate, the U.K. kickboxer turned misogynist-for-profit and multilevel marketing scammer. Nerayoff has clarified that his empathy for Tate has more to do with Tate allegedly being subjected to the kind of ‘bogus’ charges that Nerayoff says he endured via the “unchecked power of governments.”

Regardless, Buterin compared Nerayoff unfavorably to Virgil Griffith, the former Ethereum developer currently doing time in a U.S. federal prison after ignoring warnings not to travel to North Korea to educate regime officials on how ‘crypto’ could help them evade U.S. economic sanctions. Buterin said he couldn’t say bad things about Griffith “just because he was, uh, you know, more geopolitically open-minded than a lot of other people.”

Buterin’s blinkered devotion to Griffith ignores the grotesque human rights violations that North Korea’s regime inflicts on its own people. Just last week, two teenagers were
sentenced to 12 years of hard labor simply for watching South Korean television dramas. It seems that in Buterin’s world, Kim Jong-un is less of a ‘shady character’ than Nerayoff. High praise, indeed.

Only the beginning

Nerayoff appears nowhere near done shaking Ethereum’s tree, telling Deaton that he has “a lot of recordings” from the period of his involvement with the Ethereum Foundation.

Nerayoff closed his Deaton interview with the bombshell that the 2016 hack of The DAO—in which nearly 15% of all ETH in circulation was stolen from a decentralized autonomous organization and resulted in the controversial fork of the blockchain—was “an inside job by members of the Ethereum Foundation.”

While Nerayoff had made this claim prior to the interview, he explained to Deaton that “whoever was controlling the Bitcoin wallet [from the crowdsale] is directly implicated, but it had to involve quite a number of people, so there was no DAO hack. That was a complete inside job. They benefited from it in a whole host of different ways.”

Nerayoff said he wasn’t going to offer up any “individual accusations” during the interview but did say that “one of the wallets connected to a certain individual communicated with the hacker’s wallet 10 days before” the hack. “Another one of the individuals at the Ethereum Foundation set up the contract for the hack and set up the wallets … There’s a lot more. I’m just giving you some anecdotal stuff.”

Nerayoff added that the so-called ‘DAO Report’ issued by the SEC in 2017 detailing the fallout from the hack—and which declined to “pursue an enforcement action in this matter”—was allegedly written by none other than Bill Hinman.

Elsewhere, other blockchain analysts believe they’ve connected the 2016 hack of the Gatecoin exchange to wallets linked to the Ethereum Foundation. But that’s a subject for the next installment in our ongoing series delving into the shady dealings that seem to surround Ethereum, the insiders who’ve profited from it, and the network’s deep ties to China. Stay tuned.

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