Howey Schmowey – The Real Answer Is To Update Securities Regulations (#GotBitcoin?)
This month there have been two SEC enforcement actions that made headlines in the crypto community. One was the case against messaging platform Kik and their Kin token sale; the other was the action against holding company Longfin. In the first case, while investors lost money, it is unclear that Kik misled them about the potential for the Kin token to be used or about its fundamental value proposition. In the second case, however, the allegations are that Longfin committed clear fraud by misrepresenting their crypto business. Howey Schmowey – The Real Answer Is To Update Securities Regulations (#GotBitcoin?)
There is no doubt the Longfin case was dealing with a security, since the company went public via the arduous and little-used provision of Reg A+. The problem is that the management allegedly made fraudulent claims about their crypto-oriented business. The SEC charged that investors lost money because they were misinformed about Longfin’s business prospects. The fact that they were a security provided almost no protection whatsoever. (Protection will be limited to potential restitution from enforcement or shareholder lawsuits, which will be small and take place well after the fact.)
In the Kik case, they issued a token that, based on the letter of the law, might well be a security, but they did not follow securities laws when selling the token. Purchasers of the Kin token also lost a lot of money, but most of that loss is related to the collapse of the token market at large, rather than issues with the token itself.
Juxtaposing These Two Cases Makes One Thing Very Clear:
Whether or not an asset is deemed a security or not has little to no relationship to the ability of regulators to protect investors against fraud.
The reality is that raising money based on either outright fabrication or by materially misrepresenting the business can be attacked both by criminal prosecution and civil litigation. Securities laws provide help in that regard in cases where the representations made by the issuer deviate from what is required, and those representations are material to the investment decision. When required disclosures are not relevant to the investment decision, those rules provide little help. This leads directly to the second point:
If Tokens Issued By Corporate Entities Are To Be Deemed Securities, Required Disclosures Should Be Updated.
Current required financial disclosures are wholly inadequate to provide investors context for the value of tokens being used by emerging companies for financing. In this case, for example, it is unclear that Kik’s disclosures of the prospects of their token were problematic, but it is very clear that the required disclosures for securities, had they been followed, would have shed little to no light on the investment prospects for the token. Securities disclosures pertain exclusively to the issuer and their finances rather than clarifying the likelihood that the token being issued would gain acceptance. Unfortunately, Kik’s company finances would have provided limited information to the central question that Kin token holders needed to know: whether or not Kin would become highly used, either in their own network or on others.
Lastly, it should be pointed out that there is an inherent double standard in the US securities laws: If a company is already a security (whether OTC or listed), then non-accredited investors can be duped by inadequate disclosures and use of the same techniques that unscrupulous ICO promoters used. On the other hand, law-abiding founders of new companies are restricted from raising capital via tokens from those same investors.
To illustrate, consider the cases of Long Island Iced Tea (which became Long Island Blockchain) and Riot Blockchain (formerly Bioptix). In both cases, moribund public companies changed their name and announced business “pivots” to blockchain technology. In neither case was the future business direction spelled out in detail, nor were there anything resembling the type of disclosures regulators want to see from new companies. In both cases, the hype (in the short term) attracted large numbers of the investing public, propelling the stocks higher. In both cases, there was nothing resembling the sort of disclosures made by principled founders of blockchain products, yet the losses to investors were very real. The sole difference between these examples and the average ICO from 2017 is that both of those companies were already publicly traded.
Sadly, I don’t expect securities laws to undergo an overhaul in the U.S. anytime soon, so we are likely to see America fall behind the rest of the world in terms of capital markets innovation. If, however, U.S. regulators were to take action, a good start might be to create a subclass of securities for utility tokens issued to fund “for profit” enterprises. If such a designation (informally or formally) were established, the SEC could work with the industry to create appropriate disclosures and rules for those assets. I am sure that groups such as the Wall Street Blockchain Alliance or ADAM would be happy to help, as would firms such as Messari, which is building a private marketplace of project disclosures.
This approach would have another benefit, which would be to help ease the SEC into regulation of the exchanges and dealers that trade these tokens. Principles such as “Best Execution” which are sorely lacking in these markets could then be promoted, with the likely result of increased trust (and therefore volumes) in the crypto markets overall.
Coinbase, Kraken To Jointly Define Which Cryptos Are Securities
Major United States’ crypto firms such as Coinbase and Kraken teamed up to launch a rating system to jointly define which digital assets are securities.
Crypto Ratings Council To Launch On Sept. 30
In a move to provide more clarity for what tokens can be traded without the supervision of regulators, major U.S.-based exchanges formed the so-called Crypto Ratings Council, the Wall Street Journal (WSJ) reports on Sept. 30.
According to the report, other members of the Crypto Ratings Council include Circle Internet Financial, Bittrex, Genesis Global Trading, Grayscale Investments, Anchor Labs and DRW Holdings’ Cumberland unit. The group continues to recruit participants, the report notes.
Security Status: Scale From 1 To 5
Expected to officially launch on Sept. 30, the new crypto council will be publishing online ratings for digital assets on a scale of 1 to 5, where the highest value means that a certain token is considered as a security that cannot be issued, sold or traded by unregulated firms.
As such, Bitcoin (BTC) is rated at 1, as regulators publicly said that Bitcoin is not a security, participants reportedly stated.
Brian Brooks, chief legal officer of Coinbase, who reportedly conceived the rating system, emphasized that the question whether a certain token is a security or not is “one of the biggest uncertainties around crypto and the reason why more asset managers are not comfortable with it.”
Mary Beth Buchanan, Kraken’s general counsel, expressed hope that the U.S. Securities and Exchange Commission (SEC) will view the initiative as a positive step, claiming that the council aims to show the regulator the exchanges’ efforts to come to a decision on the matter.
Blockchain Association’s Efforts
According to the WSJ, a number of companies participating in the council are members of the Blockchain Association, a lobbying group that backs a House bill that would exempt many cryptocurrencies from SEC rules. The firms reportedly briefed senior lawmakers on the matter.
On Sept. 26, SEC Commissioner Hester Peirce, who is also known as Crypto Mom in the community, expressed some frustration with the pace of the SEC’s regulation, calling the regulators excessively paternalistic. Peirce said:
“If you want a government that’s more forward-thinking on innovation, that means that if something goes wrong, you can’t go running back to the government and say ‘Hey, you didn’t protect me from myself!’ […]I think we need to be a little less paternalistic.”
Coinbase’s Chief Legal Counsel Tackles Crypto Ratings Concerns
Brian Brooks, chief legal counsel at major United States digital wallet and exchange Coinbase, has responded to concerns that conflicts of interest could compromise the company’s newly created Crypto Ratings Council.
In an interview with crypto media outlet The Block on Oct. 3, he addressed critics who claim the council’s compliance guidance might be affected by the private stakes of those involved.
“Not legal advice”
Coinbase has previously clarified that the evaluations produced by the council are designed to serve as a “scalable, points-based rating system,” drawing upon yes-no questions formulated on the basis of the U.S. Securities and Exchange Commission (SEC) guidance for classification.
In The Interview, Brooks Said That The Council’s Ratings Are Emphatically Not Legal Advice, Adding:
“This is essentially an automated compliance tool, of which there are many in the financial services world. Think Hummingbird for AML compliance, or Fair Lending Wiz for fair lending compliance. No one thinks those tools represent the practice of law. And this certainly doesn’t constitute investment advice – we’re not rating the quality or value of assets, only their status as a security or not.”
Potentially Compromised Assessment
Concerns have nonetheless been raised by industry participants such as Tyler Gellasch, executive director at Healthy Markets and former counsel to SEC Commissioner Kara M. Stein. He has said council members may themselves have a stake in the assets they are evaluating, potentially compromising their assessment, warning:
“A group of private companies jointly declaring how they think things that directly impact their bottom lines should be regulated isn’t likely to be all that persuasive to regulators or investors.”
“The Point Is To Get Clarity”
Given the council’s status as an independent body not endorsed by the SEC, Commodity Futures Trading Commission or other agencies, Gellasch pointed to what he deems the “very limited utility” of the provision.
He also argued that thorny situations could develop should investors take their cue from the ratings and then find that the SEC has diverged from the council’s opinion.
Brooks robustly denied allegations that private parties’ interest could compromise the ratings, noting that many assets have already been rated 5 — meaning they are highly likely to be classed as a security. He said:
“The point is to get clarity, not justify listing assets that wind up being deemed unregistered securities.”
At the time of the council’s launch, Kraken’s general counsel Mary Beth Buchanan expressed hope that the SEC would view the initiative as a positive step for the industry.
As Cointelegraph reported previously, Coinbase — alongside fellow major exchange Kraken — established the Crypto Ratings Council in late September aiming to provide investors with an ostensibly independent evaluation as to whether certain crypto assets are likely to be deemed security tokens or not.
Members of the council were reported to include Circle Internet Financial, Bittrex, Genesis Global Trading, Grayscale Investments, Anchor Labs and DRW Holdings’ Cumberland unit.
SEC Proposes Giving More Investors Access To Private Markets
Americans who meet certain standards would be able to invest in startups before they become public.
More Americans would be able to reap the rewards of investing early in the next Uber Technologies Inc. or Facebook Inc. under a proposal advanced Wednesday by the Securities and Exchange Commission. They could also get more chances to lose their shirts.
The proposal would expand the number of people allowed to invest in private securities offerings, hedge funds and private-equity funds—vehicles that are more opaque and riskier than securities traded on closely regulated public exchanges.
Currently, people who may invest in those markets, known as accredited investors, must have the financial resources to withstand big losses: either $1 million in net assets, not counting their home, or at least $200,000 in annual income.
The SEC proposal, which was approved by a vote of 3-2, would allow investors with certain qualifications, such as an entry-level stockbroker’s license, to sidestep the income and wealth thresholds.
Proponents, including SEC Chairman Jay Clayton, say that many people who don’t meet the financial qualifications for accredited-investor status are nevertheless knowledgeable enough to participate in private markets, where startups like Uber have grown into multibillion-dollar companies before offering to sell their shares to the public.
“Our current definition includes investors that spend their days cruising around in a Ferrari that Daddy paid for,” SEC Commissioner Hester Peirce said. “Yet it excludes investors who spend their days earning money and their weekends and nights figuring out how to invest it.”
The proposal goes to the heart of the SEC’s Depression-era mandate to protect Main Street investors from the vagaries of financial markets. While Republican-appointed commissioners like Ms. Peirce and Mr. Clayton want to expand individual choice, those picked by Democrats object that the proposal would expose many Americans, including retirees, to undue risks.
“The issue is balancing investor protection with the more ideological notion that people should be able to put their capital where they want to,” said Elisabeth de Fontenay, a law professor at Duke University.
Under the proposal advanced on Wednesday, current income and wealth requirements would remain unadjusted for inflation, making it likely that more households would qualify as accredited investors over time. The number of households who meet the current definition rose to 16 million in 2019 from 1.31 million in 1983.
“The failure to update these thresholds may be less about providing American investors access to lucrative private markets, and more about providing private markets access to potentially vulnerable American investors,” said Allison Lee, a Democratic-appointed commissioner. “Once they cross the threshold, there are no limits on the amount that can be gambled and lost.”
The commission is also seeking comment on whether the financial thresholds should be reduced in areas with lower costs of living, and whether investors who are advised by professional brokers should also be considered accredited. By law, private issuers may only solicit accredited investors. The proposal is subject to a comment period before a final rule is proposed.
Supporters say the SEC plan would help level the playing field between the affluent and the knowledgeable, while creating deeper pools of capital for young companies and private-equity firms to tap. They add that the advent of the internet has given people more information to assess risk.
The move to expand access to private securities comes after decades of rapid growth in such markets, which once amounted to a tiny fraction of the funding raised on public debt and equity offerings. The SEC estimates that $2.9 trillion was raised through private channels in 2018, versus $1.4 trillion in registered offerings.
“Today’s proposals are an important step in our ongoing efforts to assess the private offering framework as a whole, including ways to increase opportunity for more of our Main Street investors to participate in the private capital markets,” Mr. Clayton said.
The SEC declined to estimate how many individual or institutional investors would become accredited under the new standards, though it said the proposal “may result in a significant increase in the number of individuals that qualify.”
Privately held companies aren’t required to provide audited financial statements, making their securities more difficult to value. And investments in private equity or venture capital take much longer to redeem than mutual funds, so investors must bear the risk of losses over longer periods.
Pension funds and other institutional investors often enjoy strong returns on private markets. That is partly because they employ lawyers and accountants who negotiate fair prices for prospective investments, as well as disclosure of earnings and other information that affects share prices. Many experts say individual investors would be hard-pressed to secure such concessions from private issuers.
Even the most experienced and deep-pocketed investors often fail to estimate accurately how much private companies are worth, critics say. They point to SoftBank Group Corp.’s recent fiasco with WeWork, whose valuation plummeted from $47 billion in a January funding round to $8 billion in October.
The proposal continues a decadeslong process of creating exemptions to securities laws, which critics say undermines more transparent public markets. This is one reason the number of publicly listed companies has fallen since the 1990s, experts say.
“The federal securities laws were established to ensure investors have the information they need about companies to accurately assess the companies’ values and allocate their capital wisely,” said Tyler Gellasch, executive director of Healthy Markets, an advocacy group. “The SEC is simply continuing to erode that basic regulatory framework, leaving in its place an opaque, two-tiered market that has greater risks and costs for investors.”
Kik’s Drama With The SEC May Soon Be At An End
The SEC has proposed a summary judgment that it hopes will conclude the regulator’s lengthy battle with Kik over the firm’s 2017 ICO.
A new round of documents have been filed in the lengthy dispute between the United States Securities and Exchange Commission, or SEC, and Kik Interactive Inc. over the messaging company’s 2017 initial coin offering, or ICO.
Both parties are seeking summary judgment, with the SEC submitting a proposed order that it hopes the court will sign.
However, Kik is confident that the judge will rule in its favor, asserting that the SEC’s argument rests heavily on construing the Telegram case as precedent.
SEC Proposes Summary Judgment Order
The SEC filed a proposed order on May 8 outlining its request for summary judgment that it hopes the court will choose to sign.
If signed, the order would find Kik guilty of violating U.S. securities laws through failing to register its public and private offerings with the SEC, invoking the three-pronged Howey test to argue that Kik’s tokens comprised securities.
On the same day, Kik filed a memorandum in support of its motion for summary judgment, rejecting the arguments posed by the SEC.
Kik Rejects SEC’s Motion
Firstly, Kik advances that “the SEC cannot establish two of the three requirements of the Howey test: a common enterprise and expectation of profits from the essential managerial efforts of others.”
The firm asserts that its ICO comprised two separate offerings — an exempt offering of securities to accredited investors, and a public ‘token distribution event’ that sold utility tokens — emphasizing that the token sales “involved different rights, different contractual agreements, different purchasers, and different consideration.”
The filing also argues that the SEC places extensive and misplaced reliance on the recent preliminary injunction ordered in the regulator’s suit against Telegram and precedent for the denial of Kik’s motion for summary judgment.
“Telegram involved an entirely different set of facts and circumstances, and so even the tentative conclusions reached at the preliminary injunction stage are irrelevant to this case,” the motion states.
Judge Expected To Rule Next Month
Speaking to Cointelegraph, a Kik representative described the documents as “the standard last step in the process.”
“The judge likely won’t rule for another 4-6 weeks,” the representative added.
Kik’s General Counsel, Eileen Lyon, told Cointelegraph that the SEC’s argument “relies heavily on the recent Telegram case which we think was poorly reasoned and wrongly decided.
“As you know, the Telegram case is not binding precedent, so it will be interesting to see what impact it might have, in light of the many other authorities we have cited and the significant factual differences in the two token offerings,” she added.
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