BX3 Capital participated in a Congressional roundtable called “Legislating Certainty for Cryptocurrencies.” Helmed by Ohio Rep. Warren Davidson, the bipartisan group heard testimony from some 50 companies and organizations with interests in the cryptocurrency sector, including Blockchain and ConsenSys. A commonality emerged from the four hours of hearings: The industry needs some guidance. In response, BX3 Capital has provided concrete ideas for regulations, below.
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September 28, 2018
Dear Mr. Davidson:
Please accept my sincere thanks, on behalf of BX3 Capital, our clients, and the many stakeholders in the blockchain and cryptocurrency spheres, for your leadership in this burgeoning industry. The roundtable on Tuesday was an important step towards developing a regulatory framework that will encourage the visionaries in this space to build and invest in US-based projects. It was our honor and pleasure to participate in the roundtable, and we look forward to continuing to assist in the legislative process.
BX3 Capital is a business advisory firm, the vast majority of whose clients are innovating and operating blockchain based businesses, and most of whom have issued or seek to issue their own native token. Our mission is to assist with all matters of “business building,” and to get these projects ready to meet and welcome investors. In that vein, we see all of the issues discussed Tuesday: SEC regulations, corporate structuring, taxation, and accounting. We are on the front lines of the regulatory debate and as such, find ourselves with plenty of practical insights and ideas that we would like to share with you in response to your request yesterday for “papers” that will help guide the legislative thought process.
Summary of Issues
If there is one thing that we established with certainty this week, it is that we have no certainty. Without exception, each participant could point to instances of legislative and regulatory ambiguity that were causing immediate—and possibly irreparable—harm. Consistent with our own experiences in the marketplace, we heard participants discuss how this lack of clarity, coupled with a general concern about regulation by enforcement, was creating what should be unthinkable outcomes such as the migration of projects, along with their corresponding technology, intellectual property, and capital, to jurisdictions perceived as crypto-friendly. The longer the door is open, the harder it will be to close. That capital and those innovations will never come back. One of the participants highlighted the risk to national security that will come from a continuing outflow of technology and capital. I share his concern. As a practitioner in this space, I can say with certainty that we are behind.
Clarity, if not certainty, will go a long way. Many projects that originate in the US want to stay and build here. A legislative framework should, most importantly, encourage that behavior. We spoke extensively about protecting investors and protecting consumers. We should not lose sight of that goal, however we must also balance what is perhaps a significantly greater risk to the economy as a whole. That risk is the loss of technology and capital. In summary:
The legislative goal should be to encourage innovation and investment, in a manner that is considerate of investor and consumer protection, and that does not result in excessive regulation or taxation.
1. Central Registry for US Token Issuance
Token Taxonomy occupied much of the roundtable discussion, with no clear resolution, because we are looking at something entirely new. It is like and unlike many things that are familiar to us. Tokens can be digital representations of equity rights, debt instruments, voting rights, interests in goods, services, or interests in other digital things. Trying to cram the taxonomy into a “security”, “commodity”, or a “utility” box is likely too narrow a view. For this reason, we suggest not trying to do so. Instead, we suggest that before a token can be issued in the US, it must be registered in a Central Registry. This could take the best characteristics and information required of the Maltese framework, including the following, and would be in lieu of any other traditional SEC “security” filings (Reg D, A+, etc.).
- Identifying information for project;
- Whitepaper with prescribed minimum disclosures, such as:
- Project description;
- Desired amount to be raised;
- Expected use of funds;
- Function and use of token;
- Expected secondary market for token, if any;
- Name and background information for issuers and, as applicable, promoters; and
- Name and contact information for a designated compliance agent for the project.
For the short term, the US Central Registry could be developed and managed by the SEC because it is this regulatory body that to date seems to have had the most involvement in the cryptocurrency space. As the market progresses, it may make sense to migrate the ownership of the Registry to a different existing, or new, regulatory body.
This framework is intended to be a “light touch” approach, and the registration is meant to eliminate any further need for “Token Taxonomy.” Because these will not all be “securities” in the traditional sense, there will no longer be a concern about errors in classification that result in issuer penalties. Instead, there will simply be the new asset class “Digital Tokens,” and ALL tokens will need to comply with light registration.
2. Issuer Requirements to Reduce Risk for Token Purchasers
While there should be no limit on the amount that can be raised via a token offering, issuers should be required to set a hardcap on the amount of each individual token raise. This requirement is necessary to ensure that token purchasers can set reasonable expectations with respect to the percentage of what they are purchasing. As discussed further below, token purchasers should be allowed to purchase as much of the token offering as they like towards the hardcap, but subject to the restrictions in subsection “b,” below.
b. Token Purchasers/Recipients
To protect consumers from fraud and market manipulation, the following rules should apply with respect to token purchases and ownership.
i. Limitation on Issuer and Promoter Ownership
Issuers and promoters should only be allowed to hold a certain percentage of the tokens after an initial raise. That percentage should be low enough (e.g., 10% or less) to help prevent the possibility of market manipulation by the issuer or the promoter. Once the initial token raise is complete, the issuer should be able to increase its percentage ownership by buying the tokens back in a secondary market. Nevertheless, this buyback should only be allowed to occur after a certain period of time (e.g., one year).
ii. Elimination of “Accredited Investor” Requirements
Discussion of “Accredited Investor” requirements also permeated the roundtable discussion, and the prevailing sentiment seemed to be that these rules were outdated at best but also ineffective, and inappropriately restrictive in a token-based economy, in which the token can represent any number of things, rather than a “security” in the traditional sense. For these reasons, and in conjunction with the new asset class “Digital Tokens,” there would no longer be a requirement that token purchasers be subject to the historic accreditation rules.
Short of this, the mere amendment of the definition of “Accredited Investor” in order to allow anyone to invest at least a limited percentage of their income or net worth would be a major step in the right direction.
iii. Minimum Numbers of Purchasers
To ensure decentralization, and to mitigate individual purchaser risk, each initial token issuance would be required to have a minimum number of purchasers, and no individual purchaser would be allowed to hold more than a set percentage of the initially offered tokens.
Should a token issuance be oversubscribed (i.e., the dollars committed by potential purchasers exceeds the hardcap), no one should be turned away. Instead, the proportion of tokens that each purchaser can acquire should be reduced. True decentralization is best able to occur when there is mass adoption of a platform. The best way to ensure a mass adoption is to get the tokens in the hands of as many people as possible. Further, by ensuring a minimum number of purchasers, each offering has the opportunity to be vetted by a broader spectrum of participants. This crowdsourced approach to issuer diligence has the potential to be very effective in producing a semi-self-regulating marketplace for token purchases.
iv. Know Your Customer (KYC) and Anti-Money Laundering (AML)
To ensure “light touch,” KYC and AML should both be required, but only for Token Purchasers who are buying in excess of a set USD equivalent amount (e.g., $10,000), or a certain percentage of the available tokens in the initial token offering.
c. Central Registry Disclosures
The Central Registry itself should contain certain minimum disclosures to assist potential investors, including:
i. Issuer and Promoter Background Checks
For each token that is registered on the Central Registry the issuer and promoters should be required to disclose certain aspects of their background, including convictions, bankruptcies, etc., so investors are making informed decisions about the project team from whom they are purchasing tokens. FINRA’s Form U4 could be a good proxy for the information requirements.
ii. Annual Financial Statement Audit
Part of the requirement of listing a token on the Central Registry is the commitment from the issuer that it will have an annual financial statement audit conducted by an independent CPA, with the results of that audit posted on the Central Registry not later than 90 days after the close of the issuing entity’s fiscal year.
Favorable tax policy has the potential to be the single largest influence on the flow of capital into a US cryptocurrency-based economy. Following the theme of “light touch,” the items below could provide the necessary changes in our existing tax framework to open the floodgates to US cryptocurrency adoption.
While the general understanding is that tokens that function as equities should be treated as equities for tax purposes, the Internal Revenue Code is less clear. The optimal solution would be to add consistency in the definition of a “token” for Central Registry and taxation purposes. Additional clarity should also be added to ensure that taxes are appropriately assessed on the sale of tokens that could function as the advanced purchase of goods or services, but tokens with the characteristics of an equity raise, or a debt issuance, should NOT be subject to tax on the initial funds raised, consistent with a traditional equity or debt raise.
Modification of the like-kind exchange rules under Internal Revenue Code Section 1031, to allow taxpayers to defer tax on the gain that is realized when tokens are exchanged for other tokens, would be a massive driver of capital toward cryptocurrency investments in the US.
This deferral should only last to the point when a token is exchanged for fiat, for goods, for services, or for any non-token property. While a permanent modification of Section 1031 would be optimal, a five-year sunset would also be effective, giving ample opportunity to stimulate investment in the space, and also evaluate the marketplace to determine whether continued deferral is appropriate.
One of the final takeaways from the roundtable was that many members of Congress lack a fundamental understanding about blockchain technology, and that this unawareness could be a hindrance to the legislative process. Without an understanding of its fundamental power to transform so many aspects of the way the global economy transacts business, the significance of what we are doing risks being lost. For all of the reasons described in the opening paragraphs of this letter, that would be a tragedy.
We are passionate about what we are doing. We believe in the transformative nature of the technology and are committed to its success. To that end, we will happily make ourselves available to assist in the educational process. From developing materials, to leading classes, to hosting webinars, we are willing to help. Please do not hesitate to call upon us.
As specifically relates to the suggestions in this letter, we again ask that you reach out if we can provide any additional information or clarifications that might assist you.
Finally, I would like to reiterate our sincere thanks for including us in this process.
Michael J. Minihan