Size Does Matter — Part 2

A Philosophy of Securities Laws for Tokenized Networks

Tokenized Network Equity Implicates the Securities Laws

I’m going to be blunt: in its early stages the tokens on pretty much every tokenized network meet one or more tests for being securities and, more to the point, implicate just about every policy concern underlying the securities laws.

Phew. Glad we got that out of the way. = )

I feel like I probably don’t have to belabor or justify this point too much, since there are already so many SEC reports, SEC settlements, court opinions and mountains of legal scholarship and cryptolegal scholarship and cryptotwitter commentary on the issue — you can just go read that shit.

What I want to do here is go like maybe one to three layers deeper on this than usual.

Pretty much all of the securities law commentary on tokens out there refers primarily or exclusively to issues under the Securities Act of 1933. This is the U.S. law that enshrines the fundamental tenet of securities regulation: that all securities offers/sales must be either registered with the SEC or formally exempt from SEC registration. This law is what mainly defines when a set of founders or a company can sell you some new tokens/securities. But….

…did you know…

….there are actually….

…more securities laws? Yes, :

Here are the ones I most want to talk about:

• the Securities Exchange Act of 1934, which regulates secondary securities markets generally (the “Exchange Act”)
• Section 12 of the Exchange Act, which determines when issuers must become public reporters and what they must report (“Exchange-Act-reporting companies”)
• The Williams Act, which amends the Exchange Act to add Section 13, which requires large holders (or groups of holders) of the equity securities of a reporting issuer to publicly identify themselves and confess their takeover plans, and regulates the manner by which they can acquire controlling positions in an issuer from the open market
• Section 14 of the Exchange Act, which regulates the solicitation of votes (sometimes called “proxies”) on matters pertaining to the governance of a securities issuer
• Section 16 of the Exchange Act, which regulates purchases and sales of equity securities by large (10%+) holders and directors/executive officers of an issuer

Once you view open network tokens as being shares of network equity, I think it becomes pretty obvious that they implicate many if not all of the same policy concerns as are addressed for conventional “equity securities” under the Exchange Act. This is the first point I want to make to you here, and I will elaborate upon it in the rest of this article.

The second, potentially even more controversial point I want to make is that, up to a certain juncture (the juncture of “sufficient decentralization”), applying those regulations (albeit perhaps in slightly modified form so that they work with crypto) is a good thing that everyone should want to get behind.

Indeed, I believe that by adapting some of the tests and criteria that are to be found in the Exchange Act, one can cut through the morass of lameness I listed off in bullet points in Part 1 of this article AND help the SEC and legislators much more precisely define the much maligned/sought after point of “sufficient decentralization” where a share of network equity ceases to be (or should cease to be) regulated as a security. I’ll elaborate on that as well.

But I am getting ahead of myself. Let me slow down & explain a bit more.

Everything You Always Wanted to Know About the Exchange Act But Were Afraid to Ask

I am taking the inspiration for the title of this section from a long-running panel which occurs every year at the end of the Securities Regulation Institute event in Coronado, California entitled: “Everything You Always Wanted to Know About Securities Laws But Were Afraid to Ask.” Yes, that one has a broader title, but it is done by a panel of excellent lawyers who probably were a lot smarter than me even before they gained like 20+ years of securities law experience a piece, many from within the SEC.

Me? I’m just going to cover the Exchange Act, and I’m not even going to cover all of that, and even the parts that I cover will probably be covered pretty lazily.

Okay, with caveats out of the way, let’s begin:

1. The Exchange Act Embodies a Principle of “Size Matters”

The most crypto-relevant thing to know about the Exchange Act is that most of its provisions apply on a basic “size matters” principle. Section 12 requires issuers to become “reporting companies” if either their securities trade on a “national securities exchange” (like NASDAQ or NYSE) OR they have more than $10M in assets as well as more than 1,999 equityholders of record or more than 499 equityholders of record who are not accredited investors.

A “reporting company” is what you probably think of as a “public company”: it is subject to extensive regulations and publishes comprehensive quarterly, annual and periodic public reports with the SEC. The costs of complying with the public reporting and related auditing, accounting and governance requirements imposed on a “reporting company” typically tally in the millions of dollars per year. Thus, it only makes sense to impose such regulations on issuers of sufficient operational and/or market scale.

Because “size matters,” it absolutely is possible to become a “reporting company” by accident. That is why even most “tech unicorns” with valuations in the billions of dollars usually tightly control secondary trading in their stock; otherwise, the stock could be acquired by too many people and the issuer could be forced to prematurely incur the burdens of a “reporting company” while still in private scaling mode.

Notably, most ICO issuers who have struck settlements with the SEC have been ordered to register as “reporting companies” under Section 12(g) the Exchange Act — this is because their tokens are presumed to be held by more than 499 unaccredited investors and they are presumed to have $10M+ in assets, thus triggering reporting company requirements. Implicitly, this also means that the SEC views such tokens not just as securities but as equity securities. You will get the gist from this article that I think their view in that regard is not without merit.

2. The Exchange Act Is Primarily About Imposing Good Disclosure Practices on Critical Market Players Who May Have Structural Conflicts of Interest

I know, I know — everyone in crypto hates proscriptive rules. We are rebels. The “accredited investor rule”, when considered in isolation, is deservedly maligned — it feels like it’s just about who can buy securities at low prices, and who has to buy them at more expensive prices. It feels like an outgrowth of the nanny state.

That’s the ’33 Act. You may not like it. That’s fine. I could justify (and have justified) it as potentially being more about protecting markets than individuals, despite that it’s often framed as “protecting investors.” But we all know it’s overly complex, focuses on the wrong things, and could stand to be both greatly simplified and liberalized. Let’s save that debate for another day. Because right now we’re not talking about the ’33 Act. We’re talking about the Exchange Act, baby. And that’s a whole different world.

The Exchange Act is all about securities markets. It applies mainly public companies and freely trading securities, and leaves all that permissioning hogwash to the ’33 Act. Cryptoeconomics people should love the Exchange Act — they might view it as old-fashioned and insufficiently voluntarist, but they at least should find it interesting in a “game recognize game” kind of way.

From the standpoint of securities issuers and securities holders, really this law is all about letting people do pretty much whatever they want as long as they make the right public disclosures, and the disclosures are designed to tease out potential bad behavior by people who have structural conflicts of interest and could potentially abuse them for their personal gain.

Issuers who get so big that they become integral to the capital markets have to publish regular reports about their financial status, plans, critical personnel and potential liabilities — they do this not just “voluntarily” but by law, under the close supervision of the SEC, because everyone knows you can’t trust people to confess the sins or structural weaknesses or potential conflicts of interest they’re most ashamed of, but which may be most relevant and impactful to the marketplace. You need not just voluntary disclosure, but legally required, supervised disclosure, to ensure that information asymmetries are eliminated and markets can truly be “free.”

Does this sound familiar? Yes, it’s basically “don’t trust, verify” on the legal/social layer. IOW, the Exchange Act is cypherpunk af.

It’s worth noting in passing the other side of the Exchange Act — which we’re not going to talk a ton about here — is about regulating securities intermediaries. In the normie finance world these are your stock exchanges, securities brokers, securities dealers, proxy solicitors, etc. In the crypto world these would be your Coinbases and Binances, your market makers and OTC traders, your crypto banks and all-too-human crypto trading whales. While these players are very needed for cryptocurrencies, they are also the single biggest trust hole and source of abuse in the industry. I take it as a given that true cypherpunks really don’t mind if they are regulated. I think they should be heavily regulated and that regulators have mostly been asleep at the switch with them. What most people are worried about is that the regulations will adversely affect the tech itself — that is what we’re going to keep our focus on.

3. The Exchange Act Makes Issuers Be Transparent

A securities issuer that meets the “size matters” test has to file the following reports with the SEC pursuant to the Exchange Act:

• annual / quarterly reports (Form 10-Ks and 10-Qs)
• annual shareholders’ reports (Schedule 14As)
• current reports (Form 8-Ks)

Taken together, these reports keep shareholders thoroughly informed about the issuer, by the issuer, under conditions designed to ensure that the disclosures will be accurate and not misleading.

Information is power, and so having this information, when combined with their ability to freely sell their shares (and, oftentimes, the right to elect directors — more on that later), enables shareholders to keep the issuers — and their current management teams — accountable for the results of their decisions. This happens on a market-wide basis, and insiders are prohibited from taking advantage of information asymmetries. The basic motto is: there should be an even playing field for everyone, and sunlight is the best disinfectant.

Among the disclosures that are included in these reports are:

• comprehensive overviews of the issuer’s business and financial condition, including disclosures about past and expected future performance, future plans, liabilities and risks
• GAAP-compliant, independently audited financial statements
• the names and roles of the issuer’s most important decision-makers, how much stock of the issuer each such person holds and on what terms each such person holds it (e.g., subject to time-based vesting, performance-based vesting, etc.)
• the compensation practices of the issuer, especially as applied to directors and officers
• related party transactions between the issuer and its directors, officers or large stockholders — for example, the issuer hiring the CEO’s other company to perform an important job
• reports about material current events regarding the issuer, which must be published within 4 business days of the event, including e.g.: mergers, acquisitions and dispositions of material assets/entities/businesses, departures or firings of executive management, material lawsuits, material commercial agreements with third parties, bankruptcy of the issuer, expected delisting of securities of the issuer from a major exchange, unregistered sales (private placements) of the issuer’s securities, material modifications to the rights of the issuer’s current securities holders, new bonuses or other compensation to directors or executive officers, material changes to the issuer’s governance structure, etc.

These rules are highly desirable. Investors in a company or project need to know about their revenues, expenses, assets, liabilities and plans in order evaluate the prospects of the investment. There are also major conflicts of interest that arise when managers have great influence over a large project with extensive assets — the insiders can wield their influence to get paid too much, or get paid in ways that cause their incentives to diverge from those of the securities holders — and thus investors have a right to know about compensation arrangements and “related party transactions” with executive officers and/or their affiliates. If a company’s securities are about to get delisted from a major exchange or the company is about to go bankrupt or get acquired, the securities holders have a right to know about that as soon as possible — and they should know about it all at once, before any insiders or other major market participants can trade on the information ahead of them.

4. The Exchange Act Requires Insiders to Disclose Their Trades and Return Ill-Gotten Gains to Shareholders

Probably the best thing here is just to quoth the SEC’s website:

Section 16 of the Exchange Act applies to an SEC reporting company’s directors and officers, as well as shareholders who own more than 10% of a class of the company’s equity securities registered under the Exchange Act. The rules under Section 16 require these “insiders” to report most of their transactions involving the company’s equity securities to the SEC within two business days on Forms 3, 4 or 5.

Section 16 also establishes mechanisms for a company to recover “short swing” profits, or profits an insider realizes from a purchase and sale of the company’s security that occur within a six-month period.

In addition, Section 16 prohibits short selling by insiders of any class of the company’s securities, whether or not that class is registered under the Exchange Act.

I’m not sure I need to belabor too much why these rules are desirable; they seem pretty self-explanatory. If you are an investor in a project or a company, you don’t want the people running that project/company, or its biggest whale investors (who likely have extra information), to be able make all kinds of profitable trades from their insider information while you, a hapless pleb with a smaller stake, no control, and less information, just HODL. Also, even when insiders are selling in the ordinary course (rather than flipping for short-swing profits), you want to know about that too, as it may imply an increase or loss of confidence in the investment prospects of the projects by the people best positioned to judge it.

5. The Exchange Act (Via the Williams Act) Prevents 51% Attacks by Creeps

The Williams Act does a bunch of things, but was mostly passed to counter the practice of “greenmail” by “corporate raiders” like Carl Icahn back when M&A was still kind of a punk rock thing. It amends the Exchange Act to create Section 13 and impose reporting obligations on major investors who might be in a position to manipulate the market for an issuer’s securities in a manner intended to facilitate a “creeping acquisition” of a majority of the issuer’s securities at artificially low prices.

In other words, the Exchange Act (via the Williams Act) imposes disclosure obligations that limit the ability of well-endowed creeps to manipulate an issuer and/or its securities through secondary market trading. It is sort of a supplement to Section 16. Whereas Section 16 is primarily intended to regulate the activity of potentially conflicted and powerful “insiders”, Section 13/the Williams Act is primarily intended to regulate outsiders who are “un-conflicted” in a bad way — because they’re all about themselves.

The core disclosure obligation under Section 13 is, again, best summarized by the SEC:

If your company has registered a class of its equity securities under the Exchange Act, shareholders who acquire more than 5% of the outstanding shares of that class must file beneficial owner reports on Schedule 13D or 13G until their holdings drop below 5%. These filings contain background information about the shareholders who file them as well as their investment intentions, providing investors and the company with information about accumulations of securities that may potentially change or influence company management and policies.

While perhaps the reasons why these rules are good may be less obvious, they are good and the reasons why bear some reflecting on. For our purposes, you can think of Section 13 as the first anti-51%-attacker rule in the realm of traditional corporate finance. Consider:

• the governance of most public companies on the most critical issues (like authorizing more stock, participating as a constituent company in a merger, dissolving, etc.) comes down to a vote of the majority of issued and outstanding shares of common stock of that company — i.e., public companies are majority-governed
• because these companies are majority-governed, having 51% of the shares is not just 1% more valuable than having 50% of the shares — it’s many many multiples more valuable — that multiple is what is referred to in traditional corporate finance as a “control premium”, and actually you could argue this is more of a sliding scale as well, since large but sub-controlling stakes confer control-like advantages that should also command a premium
• so if someone were to try to buy 51% of a company in a transparent, arms-length process, they should expect to pay a control premium
• thus, it is much better for them if they can secretly buy 51% of a company at the base market rate — i.e., without the control premium — before anyone ever knows it
• thus, there should be regulations that prevent, or at least very strongly discourage, these unfair events from happening

So yeah, these rules are good and just make sense. Before they were passed, “corporate raiders” like T. Boone Pickens were fleecing public shareholders left and right by acquiring huge amounts of shares secretly and then seeking to leverage their controlling (or very large and, for all practical purposes, controlling) stakes to extract value from both the shareholders and the issuer to line their own pockets. After they were passed, all those guys had to change jobs and become “shareholder activists,” which is a slightly less blatant form of ripping off shareholders, and (as much as the former BigLaw lawyer in me hates to admit) may even overall be a net socially positive thing for most shareholders of most companies, most of the time.

actual corporate raider, caught in the wild

I suppose you can see where I’m going with this. Turns out, corporations with publicly trading equity securities are not too different from public tokenized networks after all. Both can be 51% attacked. The potential analogy is particularly strong when one thinks about PoS networks; stronger still when one thinks about DPoS networks with a voting component, like Tezos. And just like with blockchains, corporations typically should not and do not rely solely upon the law to protect themselves — they also can rely on, essentially, cryptoeconomic algorithms like a “poison pill” plan — an interesting topic for a future article!

In the meantime, all of this surely has to make us wonder; Is it possible that securities regulations, and not just cryptoeconomics alone, may have some reasonable role to play in guarding against 51% attacks and similar attacks against blockchain networks? We shall see…

6. The Exchange Act Regulates Issuers’ Governance and the Process of Soliciting Votes As Part of the Governance Process

Section 14 of the Exchange Act requires that issuers or other persons soliciting a vote from shareholders provide a “proxy statement” giving shareholders all the relevant information so that the vote is informed. A lot of that information pertains to who manages the company, which voting securities in the company they hold, what their conflicts of interest may be, and similar things.

This is very useful. For example, before a shareholder votes in favor of electing a new director of a corporation, the shareholder would probably like to know if the director holds a lot of stock of the corporation, or of a competing corporation, or of another corporation that is hoping to land a lucrative commercial deal with this one. The shareholder would like to understand what the director’s expertise, competence and history are in managing a corporation. The shareholder would like to and deserves to know whether the director’s incentives are aligned with the shareholder’s.

There are all sorts of situations in the blockchain world where a requirement like this may be warranted. For example, if leadership from the MakerDAO Foundation is soliciting approval by MKR holders of a new type of token to serve as CDP collateral — shouldn’t MKR holders get a regulated disclosure about which MakerDAO leaders may hold material amounts of that token and stand to gain economically if it is approved?

One interesting facet of the proxy rules that would be interesting to think through in this context is the “unbundling rule”. The policy goal behind the rule is to ensure maximal shareholder freedom by enabling them to vote a la carte on proposals, rather than potentially having to approve some they dislike in order to approve the other proposals that they do like. An example would be a proposed merger-of-equals between a Japanese and U.S. company that creates a new parent company in the Netherlands and thus changes stockholders’ voting rights because Dutch corporate law now applies: the SEC may require that the changes to the voting rights be voted on separately from the merger itself.

One can see how some kind of unbundling rule rule could apply to solicitations of token-voters in a system like Tezos’s to require that each material proposal be separately voted on, rather than requiring voting on a “package deal”. For example, if the protocol upgrade both introduces anonymity features and changes the inflation schedule — why should token holders need to approve the inflation schedule if they just want the anonymity features?

If the policy goal underlying the rule were broadened further (which likely would require changes in law), one could imagine this being applied to the node update process in hardforks even for non-coin-voting networks — instead of devs releasing a “package deal” hardfork update to the major clients, they could be required or incentivized to break them up into single proposals so that a given node operator has a choice of which changes to signal support for.

Of course, on the negative side, such an approach could also have significant drawbacks in terms of logistics and coordination, as well as predictability of the upgrade path.

In any event, the point is this: there are reasons why such disclosure-based protections would be useful in crypto, and they are almost totally absent from the blockchain world today. Yet getting rid of such protections in the traditional corporate world would be close to unthinkable. It’s not that blockchain dev geniuses have figured some brilliant DAO-based method of coding conflicts of interest out of the world; it’s just that no one is holding them accountable the way traditional companies are held accountable in the normie corporate finance world. But someone should be holding them accountable, and the natural group to do so is the tokenholders, miners and other major network participants, who will need to receive good thorough disclosures in order to do so.

So, now you know all about the Exchange Act and why it’s actually cool. In Part 3 of the Article, we’re going to talk about what it looks like to apply the Exchange Act to network equity tokens.

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