The SEC’s Crypto Crackdown — They Can’t Get Here From There, Part 1
When I first came to work at a Wall Street investment bank, some of my new colleagues joked that I should keep on the QT the identity of my prior employer, the SEC’s Division of Enforcement in Washington. Alas, I am no stranger either to how the SEC works, or to how changing regulation can shape industries. This post looks at some of the institutional dynamics at play with the SEC’s approach to utility crypto, and the next will take a closer look at the legal arguments framing this approach.
Although my path to Wall Street from the SEC was somewhat unorthodox, there is in fact a different, revolving door between the SEC and securities law and financial firms, which contributes structure to the overall community of the securities bar. I worked with some notable attorneys at the SEC’s Division of Enforcement — many now work for major law firms and financial institutions. Not everyone passes through that door, however, and I know others still fighting the good fight at the SEC.
Over the past 6 months, I’ve discussed with many crypto execs how they structure their transactions, attended roughly a dozen events focusing on how the regulators are treating crypto, and read numerous legal articles on the topic. Over time, it was clear that legal issues were quite relevant to how crypto projects were designing their technologies and token sales.
The SEC likes to leverage its resources, and the magnitude of ICOs presents an opportunity to do so. The SEC may argue that tokens are sold to raise capital and thus are securities. This is a simple argument that is facially plausible. Courts may not care that the implications of this argument could be to shut down the underlying technology, at least in the U.S., and perhaps even globally. We think the SEC and the courts should care.
A key innovation of the ICO is giving to utility liquidity at scale. We’ve previously discussed the link between crypto and utility (see here), so let’s focus now on “liquidity at scale.” Tokens are transferable by design upon release, and exchanges have sprouted to facilitate their transfer outside of their native networks. Moreover, trading of tokens is typically open to a wide range of buyers and sellers across the globe.
Utility tokens have a dual function that can make U.S. securities law a poor fit. As stated by law professors, the challenge of applying the U.S. securities laws to utility crypto “primarily arises from the dual nature of many utility tokens: they are consumptive insofar as they entitle their holders to access a technological service, but they also can be used by some purchasers as an investment opportunity.” See here. Consider two examples. First, many tokens ideally should have some form of interoperability across blockchains, and exchanges are one way to facilitate this. However, exchanges can also be indicia that tokens are securities. Second, the SEC is reportedly subpoenaing documents relating to, among other things, pre-sale practices in token sales, potentially to probe adequacy of disclosure. Pre-sales are typically to accredited investors, in larger transactions, and frequently at lower prices than will prevail at the later, public sales. Some large purchasers may sell their tokens soon after the public ICO, while others may hodl them (by choice or agreement). However, another view of pre-sales is as sales to wholesalers or sales with discounts based on volume and/or timing of purchase. The wholesaler, just like an investor, is looking to sell at a higher price than it purchased. That does not make the wholesaler an investor, however.
As we’ll explore further in Part 2, poor fit does not prevent regulators and plaintiff securities lawyers from tailoring arguments to bring crypto to heel, which may be particularly harmful for a high-tech sector like crypto. The SEC’s preference to regulate by enforcement (for a vintage explanation, see here) aggravates the fit problem, because it magnifies uncertainty in a nascent, fast-changing area of technology, where there is particular need for legal guidance on how to allocate financial resources. Most Enforcement actions — even those that are litigated — are settled, and provide no binding precedent. Time-consuming production of non-binding results is not a particularly efficient way to guide development and integration of crypto’s multiple complex disciplines, such as software engineering, cryptography and game theory.
An alternative approach, to regulate through guidance such as no-action letters, tends to be late-arriving. Transactions involving instruments with a mix of features, both utility and investment potential, are not new. The SEC’s Division of Corporation Finance has issued no-action letters — a form of legal guidance specific to the parties applying for the letter — when faced with mixed transactions where the role of consumption outweighs the motivation for profit. See, for example, here (trading platform for event tickets). Whether a token sale is an unregistered securities offering is a fact-based determination, but there are commonalities in many ICO fact patterns, suggesting the value of no-action letters as guidance.
Sorry, Indy, your 2017 ICO isn’t “safe.” The SEC routinely investigates facts that are over a year old, and the ICO boom did not begin in earnest until the spring of last year. In fact, 2017 ICOs present fuller sets of facts, including what the progress of the project has been, who holds the tokens now, and who might be injured parties. Enforcement actions on fuller sets of facts can send different, more complete messages than actions on interrupted sales, like the SEC’s Munchee cease & desist order in December.
SEC subpoenas or no, the law hasn’t changed, so completed ICOs should expect their counsel to stand by them. This not a situation where the SEC has stopped giving no-action letters or other forms of safe harbor for the sales of utility tokens without securities law registration. The SEC wasn’t doing so before, and isn’t doing so now. Many of the same law firms now advising sales of utility tokens outside the U.S., or restructuring to finance with security tokens (e.g., with some type of hybrid structure), were likely advising several months ago that utility tokens could be sold in the U.S. without securities law registration/exemption, and in many cases giving their clients memos to that effect. Some of these memos were likely researched as well as any analysis motivating the SEC’s investigations.
Having said that, community counts — ICOs should understand how their counsel fit into the securities law community, as well as into the power structures of their own firms. The securities bar is like the crypto community, a community, many of whose senior members have few to no crypto clients, and are rather concerned with shepherding deals and IPOs past the Division of Corporation Finance. Some crypto practitioners are more closely plugged in to the traditional securities practices of their law firms, and their power centers, than others. These dynamics may affect approaches to legal challenges ahead.
Even now, if sale of utility crypto supports an important protocol or dapp, there is a temptation to keep selling, even in the U.S. Utility crypto with attractive use cases is fighting the good fight. If necessary, let the SEC make its case in court. We pay taxes not only for the SEC to balance capital formation and investor protection, but also for the judiciary to provide precedent in fact-heavy areas of the law where statutes and regulations leave important questions unanswered. The expense of the process is a barrier, no doubt.
Do I have to add that the above is not legal advice? As a law school professor of mine would say, “to ask the question is to answer it,” but repeating for those needing, the answer is that none of the above is legal advice. There are a number of good attorneys who can give you some, however.
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