A Proposed Framework for U.S. Cryptocurrency Regulation
New York, NY — William Hinman, Director of the Division of Corporate Finance of the U.S. Securities and Exchange Commission (SEC), recently made comments foreshadowing the SEC’s inevitable treatment of cryptocurrencies, indicating that a certain degree of decentralization among a coin or token’s management and promoters could cause it to fall outside of the definition of a security. This perspective was received across the crypto industry as welcome news, as freedom from any form of authority remains an undeniable undercurrent of the general crypto movement.
However, Mr. Hinman’s comments also suggest that the vast majority of coins and tokens willbe considered securities and will therefore be subject to SEC regulation. But does this need to be bad news for the crypto world? Not necessarily, if Congress and the SEC are open to new ideas.
After discussing the various interests of the stakeholders involved,this article proposes elements that could be included within a U.S.-based cryptocurrency regulatory framework that balances these interests.
Some in the crypto community would be in favor of all coins and tokens being completely unregulated, embracing a true renegade spirit above all else. Although the Howeytest, the SEC and others may have a different opinion on the matter, this aspect of the crypto movement should be acknowledged when crafting an appropriate regulatory response.
Regulation makes sense only when its real-world impact makes sense, and while great strides have been made during this decade in the form of new fundraising options that help democratize offerings and leverage modern technology such as Regulation Crowdfunding and Regulation A+, any exemption from the securities laws must be responsive to user demand in order to be effective, and many question whether the current securities laws provide a suitable solution for crypto-based offerings.
**Disclaimer: Please do not misinterpret any of the following information and commentary as legal advice or investment advice; it is simply a personal expression of the author’s interest in cryptocurrency and the law. Please consult a lawyer and/or financial representative prior to investing.**
The catalyst for the development of the federal securities laws was the stock market crash of 1929 and the Great Depression that followed, remedying a situation that was clearly in need of reform. When contemplating cryptocurrency regulation, it is important to remember that Bitcoin was famously borne out of the 2008 financial crisis as a potential alternative to the massive global banking network – also seeking to remedy a situation that demanded reform.
Current State of the Cryptocurrency Industry
Many crypto projects openly seek to disrupt current industry, displace entrenched middlemen and shift power from the few to the many. Although most individuals do not want to see governments topple and fiat currencies fall to zero, there is a general sentiment ingrained in the crypto movement that tells the status quo, “We can do this better, and we do not need you,” where “you” refers to a wide variety of long-standing entities, groups and institutions.
The SEC’s mission statement is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Even the strongest advocates for laissez-faire crypto regulation would agree that rampant fraud and manipulation have plagued the industry since nearly day one. And this hurts everyone. In the absence of regulation, the prevalence of scams and illicit activity would surely continue. Perhaps more notably, according to some, it is the lack of regulatory clarity that is causing many would-be investors to remain on the sidelines, without the requisite confidence or mandate to make crypto investments.
While there are those who may view regulation as an unnecessary and detrimental burden, Howeywill likely continue to rule the day for the foreseeable future, rendering most if not all “centralized” cryptocurrencies to be classified as securities. However, regulation could be welcomed and embraced by all, as long as it is aligned with boththe SEC’s mission statementand the mission statement of the crypto community – not that crypto officially has one, but it would read something like this: “We aspire to bring positive change to the parts of the world that are due for change, no matter how big or small, and to do so in the most creative, innovative and impactful ways technologically and humanly possible.”
U.S. Global Leadership
So, taking the SEC’s mission statement at its word, if a crypto regulatory framework consisted of investor protections, efficient markets and capital facilitation on one hand, and had the real-world impact of actually attracting projects and investors on the other, the United States could become the true global leader of this extraordinarily promising industry.
When walking around at the major crypto conferences, I cannot help but think that the next Bill Gates, Steve Jobs or Jeff Bezos could very likely be somewhere in the building. Cryptocurrencies made major inroads into mainstream culture in 2017, and while 2018 has not yet seen the same growth in values and market caps, the incredible innovation continuing to occur in the space is nearly mindboggling. Certain commentators have hypothesized that the vast majority of coins and tokens will not even exist in just a few years.
While they may be correct, the important corollary point is that at least somecoins or tokens willcontinue to exist, and these survivors are likely to achieve profound results. But right now, much of this innovation and investment opportunity is being driven away to crypto-friendly foreign jurisdictions. In many cases, it is clear that projects are completely avoiding the U.S., and that we may be chasing away unfathomable opportunity.
If the status quo remains and the square pegs of cryptocurrencies need to fit into the round holes of the current regulatory regime, the practical effect will be more of the same. In the event that cryptocurrency is even a fraction of what its advocates believe it can be, the U.S. will not want to be last in line, nor somewhere in the middle, but rather at the forefront as nurturing pioneers.
Future State of Crypto
The crypto community often talks about how it feels like we are back at the beginning of the .com days, collectively building something of great magnitude and importance that we may not even yet be able to fully understand nor articulate. The most successful crypto projects will bring tremendous job growth to the areas and jurisdictions in which they operate, in addition to potentially providing astute investors with exponential returns. Silicon Valley was not always Silicon Valley, and just imagine if our country had missed out on hosting core technology giants such as Google, Facebook and Microsoft. Congress and the SEC are fundamentally mandated to act in the best interests of the public, and the open question is how much protection and regulation is truly in our best interests when the opportunity cost may be early involvement with the greatest technological projects, companies and innovations that the world has ever seen.
With the help of Congress, our securities laws ought to continually adapt over time to both new technology and public demand in order to satisfy the “facilitate capital formation” prong of the SEC’s mission statement, and ever since the recent proliferation of initial coin offerings (ICOs), there has been growing pressure for guidance and clarity regarding whether and how cryptocurrencies will be regulated. Under the federal securities laws, offers and sales of securities must either be registered with the SEC or fall within an exemption from the registration requirements. The variables that make up a given exemption consist primarily of (i) the aggregate amount raised, (ii) the number of investors permitted, (iii) the types of investors permitted and (iv) whether general advertising and solicitation is allowed.
With cryptocurrency proving to be categorically different in many respects than anything to come before it, perhaps Congress and the SEC would best serve the general public by adopting a new approach for this new industry in the form of a new exemption. So, what might a crypto-specific exemption look like? If Congress and the SEC were to consider the creation of a “Regulation Crypto” in order to truly harness the energy of the movement and facilitate its growth, its elements could include the following:
Central Platform and “Light” Registration
While crypto renegades may have a hardened stance against any regulation, most in the industry would agree that we can greatly benefit from protection against fraud and, somewhat ironically, a certain degree of centralization and oversight. Currently, information in the crypto world is highly asymmetrical, difficult to organize and, especially if one reads social media content, unverified at best and blatantly false at worst. For these reasons, and to counteract the proposed substantial freedoms for issuers that follow, the proposed framework would be premised on the initial requirement that a coin or token issuer must “register” their offering with the SEC in advance of any solicitation and sales.
Similar to a funding portal under Regulation Crowdfunding, the SEC could create and maintain a central website platform upon which all ICOs are listed and conducted, providing the SEC with direct oversight capabilities and transparency for all transactions and parties involved.
The registration process for an issuer would be simpler, less burdensome and at a lower cost, focusing on the information normally provided in white papers and details about the offering. This “light” registration would constitute an exemption from the requirements of the typical arduous registration process while still retaining the benefits derived from mandatory issuer disclosures, representations and warranties, as well as from SEC involvement at the outset.
Potential investors would be subject to standard know-your-customer and anti-money laundering requirements after which they could log in and be presented with all available offerings, with the result being that investor access to crypto investment opportunities would be fully democratized.
Offering nuances common in the industry such as discounts, bounties and airdrops could be supported, all on a blockchain and under the watchful eye of the SEC. In concert with the SEC’s mission statement, a central, trusted hub would provide sound investor protection and go a long way in facilitating capital formation. As the crypto industry is often referred to as the “Wild West,” this would bring us to the doorsteps of our industrial revolution.
Aggregate Amount Raised
Unlimited. We should ideally want every dollar invested in crypto to have a touchpoint in the United States. We are very much in the midst of a worldwide competition to attract crypto-based activity, and our regulatory approach ought to acknowledge the reality that even a relatively high dollar limitation on fundraising is a non-starter for many projects.
A large war chest of working capital for an ambitious project should not be viewed negatively, as there is nothing inherently evil about raising a large sum of money and then using it to build a big idea as outlined to investors. In fact, for crypto projects, sizable initial offerings may not just be warranted, but necessary. It is important to remember that the crypto funding model is different than that of a traditional startup company.
Crypto projects generally do not contemplate multiple financing rounds and instead prefer to have a finite initial raise, which is distinctly different from startups that typically employ a piecemeal approach over time at often increasing valuations. While the crypto model could be criticized for excessive funding and overblown valuations in certain cases, it generally enables investors to come in at an equal valuation to one another and acts as a safeguard against future dilution. Further, with every aspect of business and society being re-examined for inefficiencies that can be solved with blockchain technology, disruptive projects using unique business models are challenging entire established industries and brilliant minds are uncovering new use cases for blockchain-based assets that may wind up being among the great innovations of our time.
As such, even valuations that appear high initially may be dramatically undervalued in the long run, and projects may justifiably need significantly more fundraising flexibility than available through existing exemptions. In the aggregate, ICOs raised over $3 billion in 2017, and through the first half of 2018, despite the high degree of regulatory uncertainty, the industry is on pace to raise over $20 billion this year.
With money continuing to pour into promising projects and target funding amounts often exceeding the limitations provided by available exemptions, it is clear that we need a more fitting solution to facilitate crypto investment from the masses. While a correlation admittedly exists between higher dollar volumes and the temptation for corruption, the market is already wising up to over-funded projects and greedy founder teams, and natural market forces will dictate optimal and appropriate funding levels for crypto projects over time.
However, while a target funding amount would be “unlimited,” this freedom would be tempered by certain requirements. Every offering would need to have a clearly defined hard cap to provide context for investor expectations, and individual investors would still be subject to certain limitations regarding their personal investment amounts. Offerings would also be naturally limited by the ability of issuers to justify the target funding amount, and restrictive mechanisms powered by smart contracts could be employed to ensure the corresponding use of funds once they are raised.
Time- or milestone-based fund disbursements from escrow accounts could also be self-imposed or mandated to guard against outright theft and to incentivize proper behavior. The SEC’s continual oversight would act to discourage bad actors, as all fundraising activity would be seen, monitored and scrutinized. With the proper mechanics in place as determined by Congress and the SEC, the money legitimately needed for the big ideas of tomorrow could be attracted and protected.
Types of Investors
Anyone – including both accredited and non-accredited investors. Anyone with hard-earned cash and the desire to deploy it. Under certain existing exemptions, securities may be sold only to “accredited investors,” meaning investors that clear certain high income or asset thresholds. Current rules require an individual to either (i) have a net worth of at least $1 million, excluding the value of one’s primary residence, or (ii) make over $200,000 in each of the last two years; the idea being that such people are “sophisticated” enough to make wise decisions and have money they can afford to lose. However, while its origins may have been innocent and its motives noble, the accredited investor definition is fraught with inconsistency and illogic, and the concept on the whole is now arguably more detrimental than beneficial to the common good. The roots of the modern accredited investor classification date back to the early 1980s, when information was more prone to being reserved for the privileged and people did not have access to the collective knowledge of the world on smartphones in their pockets.
While income and wealth may have been better indicators of intelligence, experience and judgment in the past, the Internet has undeniably democratized access to knowledge and information to a degree that warrants corresponding change. It is also not very difficult to poke holes in the logic of the accredited investor definition.
We can all think of examples of people who might have a million dollars in the bank but probably think that a “prospectus” refers to a promising relief pitcher in Triple A, as well as the inverse, such as a college business professor who could write a book about capital markets but in many cases is prohibited from investing even a dollar into a private company.
The college student who diligently studies crypto projects after his or her homework and saves up enough cash on the side to potentially benefit from that knowledge should not be prevented, nor discouraged, from doing so. And what about the accredited investor making over $200,000 who decides to leave for a new job below the threshold – if they are now making $190,000, does their “sophistication” suddenly float away like a soul leaving the body? If you are wondering about the current percentage of households that do not qualify as accredited investors, the answer may surprise you: approximately 90%. Yes, 90%.
Although it may be true that “it takes money to make money,” we should stop and ask ourselves whether this really should be effectively codified. And demographically, accredited investors are a relatively homogenous group consisting primarily of older, affluent white men, who through their investment decisions ultimately determine the products and services we have in our society.
I would ask Congress and the SEC, shouldn’t “investor protection” include protecting the decisions and dreams of all those would-be investors who are essentially banned from investing? While government should undoubtedly play the role of referee, no one likes it when the referee determines the outcome of a game.
In addition, although the crypto funding timeline is often criticized for fundraising first and building second, this temporal change in the fundraising process is uniquely tailored to achieving the full democratization of an investment opportunity.
Instead of cronies, insiders and repeat players being permitted to dominate the crypto investment scene with the exclusive inroads and earliest access they have historically enjoyed, the crypto approach provides the possibility of a level playing field among investors – and in order to truly realize this possibility, allinvestors ought to be included.
At minimum, amending the definition 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. Ideally, however, the existence of the accredited investor distinction in modern times would be reconsidered on grounds of patronization and unfairness.
General Advertising and Solicitation
General advertising and solicitation permitted, with a few caveats. First, before any advertising or solicitation can occur, the offering must be registered and approved for inclusion on the SEC platform, and second, all advertisements and solicitations must include the issuer’s web page URL from the platform, after being populated by issuers as part of the light registration process. While white papers come in all shapes and sizes, a new, standardized format to present details about a project and its offering would be mandated, providing clear and complete disclosure information.
The uniformity of this data would enable investors to be sufficiently informed and to optimally navigate the decision-making process; its availability would help to ensure that all investors are on equal footing without informational asymmetries; and its centralization would enhance the SEC’s ability to hold issuers accountable if necessary. Further, by requiring the presence of a direct link to the platform web page in all advertisements and solicitations, all the strings of an issuer’s communications web would lead back to this centralized informational safety net.
It is also worth noting that, while private solicitation is, of course, private, “general” solicitation often ends up having an exclusionary effect as well because only certain investors are presented with and/or are aware of any given opportunity. This framework would provide for realgeneral solicitation – a central home where investors ranging from the casual to the institutional would know to come in order to evaluate all available crypto offerings – which would not only benefit issuers by providing access to a broader investor pool but would also give investors true equality of opportunity.
Number of Investors
Here is where things get really interesting. Certain existing exemptions allow for an unlimited number of investors to participate, and under the proposed new framework, the number of investors would also be unlimited; however, the additional requirement would be that there must be a minimumnumber of investors participating in an offering, calculated pursuant to a set dollars-to-investors ratio.
In addition, no individual holder (including founders, management and promoters) would be permitted to hold more than a low set percentage of a coin or token’s total supply. The permissible ratio and the single-investor percentage limit could be established by the SEC, with the conceptual target being sufficient “decentralization” of the holder base, while the registration and reporting requirements otherwise triggered by the shareholder limits of Section 12(g) of the Exchange Act would be relaxed. And finally, if investor interest in a specific project caused its target hard cap to be reached and the offering to be theoretically oversubscribed, instead of allowing for fundraising in excess of the cap or shutting certain investors out, every investor’s permissible subscription amount would be proportionally decreased, such that the cap would be maintained and the investor base would be even further decentralized.
Using Mr. Hinman’s same and sound logic that the sufficient decentralization of a project’s management and promotional efforts can aid in alleviating concerns regarding fraud and abuse, sometimes to the point that a coin or token would not be a considered a security altogether, that concept would be applied here to the project’s overall coin or token supply. Although there may be an entity structure or at least a high degree of organization at the top of a crypto project, coin and token holders tend to become bona fide evangelists of their favorite project(s) in far higher proportion than stockholders of traditional companies, often fulfilling informal functions and serving in volunteer roles for a project’s benefit.
Aided by the never-ending chatter on Telegram, Discord and other digital crypto meeting grounds, a distinctly different culture exists in the crypto industry, where even an average holder is likely a super-fan of the coin or token and thriving digital communities develop around projects. This culture ought to be both taken into account and leveraged for good. In addition, the long-term success of a crypto project is especially dependent on achieving mass adoption of the newly-created network, so a required minimum number of initial investor-evangelists provides a strength-in-numbers benefit and, to some degree, an incremental investor protection.
It has also been well documented that tapping into the “wisdom of crowds” often produces statistical outcomes superior to decisions made by the few, so mandating that there be a sufficient “crowd” before any money exchanges hands could serve to increase the odds of a successful investment. While there may still be organization and direction from the top down, founders and core actors would be prevented from excessive initial ownership, and the aggregate promotion and “efforts” expended in relation to a crypto project with a quantifiably broad investor-evangelist base would be sufficiently decentralized – perhaps not enough to warrant full “utility” status, but enough to be a meaningful requirement within a crypto exemption framework.
In addition to supporting and facilitating ICOs, the centralized platform could potentially also serve as an exchange for coin and token sales in the secondary market. Existing cryptocurrency exchanges are often outside the scope of U.S. jurisdiction, charge exorbitant listing fees and are infamously prone to major hacking events. A national crypto exchange could employ world-class security measures and would be subject to direct federal oversight, thereby enhancing investor safety and confidence.
Arguments in favor of allowing immediate aftermarket liquidity would be strengthened and, aided further by the cap on initial investor holdings, a mandatory lock-up requirement could be avoided under the exemption. Restricting all holders from selling their coins or tokens for a certain period of time would significantly suppress investor interest, and with the incredible speed at which the crypto industry moves, a blanket ban would go against both crypto culture and practical necessity.
Instead, a more balanced approach could be implemented where only the “centralized” holders of a project are subject to a relatively short lock-up, with such holders identified using the same test, criteria and/or standards that the SEC eventually employs in determining “centralization” as part of the initial security vs. utility classification of a coin or token.
This way, those entrepreneurs, managers and promoters (and anyone else) that, in the SEC’s determination, contribute to a coin or token being “centralized” (and therefore, a security) would be restricted for a material amount of time within the accelerated crypto environment, while the fundamental liquid nature of cryptocurrency would be maintained to some degree. Additionally, while a government-run exchange would not engage in the same profit-maximizing behavior of existing exchanges, it could potentially be a significant source of federal revenue.
While it may also work to allow multiple private exchanges to satisfy secondary-market demand similar to registered funding portals under Regulation Crowdfunding, a national exchange would firmly entrench the United States as the global leader of the cryptocurrency world and would align well with the SEC’s stated mission to “maintain fair, orderly, and efficient markets.”
Overall, the outlined approach seeks to take the best of both the freedom and aspirational characteristics of the cryptocurrency movement and the SEC’s protective and organizational capabilities. An industry built almost entirely on the premise that things should be different deserves a regulatory approach that is a significant departure from what has been mostly the same for nearly a century.
This offering framework would provide investors with information, equal access and confidence; it would provide projects with the freedom to raise unlimited capital within a highly structured procedure; and it would provide the SEC with full oversight over the entire process.
Although this framework could be viewed as unworkable for a variety of reasons and certain details would still need to be determined, even if it serves as more of a wish list than future law, Congress and the SEC would be serving their constituencies well by incorporating its principles into their eventual treatment of cryptocurrencies.
These truly are special times, and if cryptocurrency ever does achieve mass adoption on a global scale and becomes a major part of our collective future, being forced to rely on the existing securities laws may cause the U.S. more aggregate harm than good. The mandate to facilitate capital formation is a mandate to support new technologies and accommodate the wishes of the citizenry, with just the necessary amount of protection.
And while this proposed framework may question some of long-standing fundamental pillars of U.S. securities laws and render other exemptions less attractive, with every aspect of business and society being re-examined for inefficiencies and the crypto movement bringing positive change to the parts of the world that are due for change, perhaps the existing securities laws and these other exemptions could be worth re-examining in light of the aforementioned principles.
The cryptocurrency revolution is still in its early stages and may or may not ever fully deliver on its promise, but if it does, the ultimate question will be whether the United States is strategically positioned at its epicenter or is on the outside looking in.