A Smarter 2020
A bit on what came to pass during 2019, some 2020 predictions and an in-depth analysis of the SEC’s proposed amendment to the definition of an accredited investor.
When I look back at each year that goes by, I find that it usually follows a theme. In the blockchain regulation context, following these themes over the last few years was specifically interesting. 2017’s theme was the wild, wild west, meaning little to no regulatory awareness and oversight. 2018’s theme was the antidote to the gold rush, or the massive regulatory panic. 2019’s theme was about attempts at giving better regulatory clarity. I believe 2020’s theme will be getting smarter. Getting smarter means knowing where to put the focus, knowing what to discard and paving a clear path forward.
Giving Clarity Doesn’t Cut It
Events during 2019 showed us that giving regulatory clarity when it comes to interpreting existing financial and securities laws in the blockchain context isn’t that simple. Several regulators, including the SEC, tried to do this yet not much clarity was achieved. In other cases, even though clarity was achieved to some extent, it didn’t solve the problem for the entrepreneur or venture since the existing legal framework just wasn’t compatible. We saw some of the most dominant players in the blockchain market venturing into countries that decided to pass blockchain-specific legislation such as Liechtenstein, Estonia and Malta.
It was fascinating to see the wild variation in terms of the regulatory approach among the fresh blockchain acts. As an advocate of the economic approach, I can’t face away from the fact that the strictness of a regulatory approach is usually in direct correlation with the financial incentive the country has to draw innovative businesses into it.
Smaller economies like Wyoming as well as Estonia, Malta, Liechtenstein and Gibraltar will have a stronger incentive to be quick to regulate nascent industries in order to draw these businesses in and grow their economies. Further, their regulatory teams are less overloaded and work more closely together with the government, enabling them higher flexibility in drafting the act and passing it. Bigger economies like Switzerland, UK and Germany would be more reluctant as they are already global financial hubs and their incentive to attract the fresh meat is lower. These countries will usually prefer to turn to existing regulatory frameworks and give regulatory clarity by interpreting them in light of the innovative industry at hand (which is, as we’ve mentioned, often not so effective at giving clarity).
Private Placements are the Mainstream
Local licenses are great as a quality and due diligence stamp for the startup, but none of them is a cross-border license. this may be less troublesome in a big market like New York, but in smaller countries like the others mentioned this means that having a license doesn't necessarily mean the company can work with outside markets. For sale of securities which is fully regulated all over the world and requires a prospectus in each country, this can be a real dealbreaker.
This is why the private placement regime is the most popular among security token issuers. Whether it be the American Reg D, the European limited offer exemption or other securities laws’ qualified investors exemptions offered in other countries, when you focus on qualified/ institutional investors and carry out due diligence according to the the accreditation criteria of each country, you are good to go almost globally.
Most blockchain startups don’t have the budget to go through the regulatory process of approving a prospectus and what follows it (underwriting, listing, audits, etc.).
Beyond that, many blockchain entrepreneurs feel that the value of being able to easily issue and sell peer to peer securities on the blockchain must be met with low regulatory difficulty or else be lost.
Not Wealthy, but Smart
Moving into 2020, one the most interesting regulatory moves for me is the SEC’s proposed amendment to the definition of an accredited investor. I am very excited about this as during the last 2 years I called many times for a review and broadening of the private placement regime in order to allow easier more extensive funding for blockchain ventures. Many people I know are knowledgeable to make an educated investment decision in their knowledge areas, but don’t necessarily have the required capital to qualify as an accredited investor.
Let’s take a closer look at the proposal. According to the paper, the SEC’s objective is to find “possible ways to simplify, harmonize, and improve the exempt offering framework under the Securities Act of 1933 to promote capital formation and expand investment opportunities while maintaining appropriate investor protection.” the exempt offering framework, a.k.a Reg D, allows companies to raise capital from accredited investors without approving a prospectus or going through any regulatory approval process.
The proposed changes both change the existing definitions as well as add new definitions. A comparative look at the current definitions versus the proposed changes is called for. I left out the obvious ones- banks, broker dealers, insurance companies and investment companies.
The most interesting change and the one that indicates of a paradigm shift is the addition of a sophisticated investor option. For the first time in over 80 years, the SEC is conceding to rely on something other than wealth (which may be even more important)- knowledge. Indeed, a smarter 2020.
The not-so-bright side is that a license or certification directly related to investment advisory would be the initial qualifying knowledge. This means that the gate wouldn't be opened as widely- but this is an encouraging first step.
The SEC mention they “acknowledge that there may be individuals that hold other professional or academic credentials that can demonstrate similar comprehension and sophistication; however, we believe that it is appropriate at this time to tailor this category of credentials and designations to certain ones that directly relate to securities and investing. For example, while commenters have suggested criteria such as college degrees and advanced degrees generally for the accredited investor definition, we are concerned that such a broad approach might not provide a consistent measure of financial sophistication for a variety of reasons, including the range of degrees, the different types of institutions that grant degrees, and the various career paths that degree holders can take.”
Please excuse my poor graphic skills…
The proposed additions, if approved, can add significant liquidity to the Reg D market. More important than the changes themselves is the shift in the approach and while the SEC is taking baby steps for now, I believe with time the knowledge categories will be further (yet cautiously) broadened.
The European Angle
In the European Union, the sophisticated investor option has been in existence for years. This is the general rule:
“Subject to mutual recognition, a Member State may choose to authorise natural persons who are resident in the Member State and who expressly ask to be considered as qualified investors if these persons meet at least two of the criteria set out in paragraph 2:
a) the investor has carried out transactions of a significant size on securities markets at an average frequency of, at least, 10 per quarter over the previous four quarters;
b) the size of the investor’s securities portfolio exceeds EUR 0,5 million
c) the investor works or has worked for at least one year in the financial sector in a professional position which requires knowledge of securities investment… [Prospectus directive, article 2 (1)(e)]”
The European requirement here is a bit more open for interpretation than what I expect the new SEC’s definition is going to be. Through rather obscure terms like “transactions of a significant size” and “professional position which requires knowledge of securities investment” one might stretch out the definition and be able to meet it.
We will be following you, 2020. Stay tuned.
