Part 2 Beyond the Wall — Is the SEC losing legitimacy?
If so, how does it get it back. Click HERE for Part 1
The SEC appears to be rapidly losing legitimacy. The players that tried an approach of engagement, like Coinbase, are getting hammered. A growing list of billionaires from Elon Musk and Mark Cuban and common folk alike are criticizing the approach of investor protection from profits in an increasing brazen manner. Meanwhile it is clear that a new wave of flanking maneuvers are underway with decentralized finance. Tokens, token models, NFTs, art, social tokens, DAO’s, coops, continuous offerings, crowdfunding, utility tokens, all are arguably pushing up against the age-old definitions of “securities” under Reeves and Howey and even Chairman Gensler analogizes it to the “wild west”.
Even law professors are getting in on the action of forcing reaction, or perhaps in age old guerilla warfare tactics an “overreaction”. Check out this non-fungible token titled “SEC No-Action Letter Request” as a NFT. Points deducted for not referencing letter in the metadata, but clever nonetheless. It is clear that we will see increasingly insurgent and brazen attempts of attacking the four corners of the regulatory framework to force results that appear “absurd”.
To Chairman Gensler any tradable token doodad on a blockchain is a security. The wild west was the wild west, specifically for the reason that the writ of power and law from a centralized authority was lacking. To analogize back to the “Free Folk”, will decentralized finance (which includes many outside of the US) bend the knee to allow a centralized authority to regulate? What if they aren’t US citizens, or if it is a “sufficiently decentralized” network that the rules and regs were clearly not designed to address? These questions are never answered. The only path appears to be just fight it out in court.
How can the SEC get its legitimacy back and why is it losing it?
As the enforcement cases take years to come to fruition, the cases themselves begin to actually hurt the retail investors that the law is meant to protect. Ask your average XRP holder what they think about the regulatory regime and the fact that the enforcement actions are years in arrears. The belated approach of enforcement allows many more to get hurt than if there was just a simple but clear model for registration and a path to “sufficient decentralization”.
Clearly there are multiple ways for the SEC to claw back legitimacy. Many sophisticated experienced and borderline “adult” investors are locked out of an increasingly large swathe of the investment world. Which path to choose for the SEC to regain legitimacy is a very interesting question. Will it try through reforming its rules and enforcement parameters, or perhaps through increasing violence (“zealous prosecution”)? The direction and tact appears under the new Biden administration appears to be more rule through “fear”. It is clear that the new SEC policy appears to be one of putting on brass knuckles and slugging it out. The tact of constructive engagement delineated in the proposed defi “safe harbor” proposal from Hester Peirce is completely ignored.
The current paradigm has plenty of zits of its own
There has already been much written defending “crypto”, permissionless systems, distributed ledgers, and the industry as a whole. It is difficult to constantly defend against allegations of fraud, wild west illegal activity, and salacious stories of money laundering and illicit activity when there is no comparative frame of reference. Everything is relative. What this series will do is offer a critique of the current “paradigm”, why the system is breeding contempt, and a grass roots desire to reform and remake the current regulatory regime.
It is clear that many feel the current system is sick, bloated, expensive, rife with its own fraud, and arbitrarily and capriciously enforced. The current system gates many lucrative investment opportunities behind “paywalls”, toll trolls, and makes rules that ensure that only the bourgeois can access. This article will look at the existing paradigm through the analogy to Westeros and critique it. There is value in self reflection and reformation and maybe it would explain the growing resentment of the current paradigm and why this does not look stable to hold together under popular revolt.
Why you throwing shade at these paragons of regulatory excellence? Because it is inefficient, anti-innovation, and doesn’t even perform its stated policy goals well or at all.
The Current regulatory paradigm is prohibitively expensive in both cost of compliance and opportunity cost of time. How much does it cost to go public? In other words, it is interesting to try and calculate what percentage of capital it costs to raise capital. How much has to go to the plethora of hard costs, underwriters, accountants, legal, and the ongoing reporting regime as well.
I am flabbergasted to know why nobody talks about the sheer capital inefficiency to raise capital in the public markets. So I got to Googling. Most of the following is from the PWC report for those considering an IPO. I selected from a smaller IPO range of 25M to 99M, which is telling that it takes a 25M raise to even make the list.
- Underwriter fee — 7%
- Legal 1.6M to 1.9M
- Accounting 375K to 550K (obviously this is also ongoing to keep Edgar and SEC happy)
- Printing 89K to 550K
- Exchange Listing Fee 20K to 150K
- Misc 272K to 675K
- Finra 20K -30K
- SEC 13K to 23K
So with some basic assumptions, if we take the middle range of a 50M raise and the middle of the fee structure. Guess how much is left over? Reminding the reader that this actually comes out of the shareholders pie as these are true expenses and the capital will not be available for company needs and investment into growth. A staggering 13.1% of the capital is gobbled by gatekeepers, accountants, lawyers, etc before it even gets to the company. That is 13% that is not invested in hiring employees, capital investments, and company infrastructure. With a little cowboy math, as long as the cost of fraud is less than 13% then both the company and the retail investors are better off without this public policy “framework”.
That does not even quantify the future costs of compliance (audits and Sarbanes Oxley), the increased risk of shareholder litigation, and other expenses (such as D&O Insurance and the opportunity cost of time).
Assuredly there is some good that comes from companies investing in and the company being forced to put in place accounting systems and proper auditing controls, and governance etc. That said, there is no doubt why more and more companies are choosing to go public later and later to avoid this money pit or defer to SPAC’s to bypass this regulatory regime entirely using regulatory shells as a service to skip the line and hassle.
To contrast how capital raises can be done, albeit without the same regulatory framework, one only has to look at a recent batch auction of 2007 Kia Sedonas. Yes you heard that right. With a few lines of code a project from Ethereum called Miso, was able to start a batch auction for 9,800 $DONA tokens redeemable for 2007 Kia Sedonas from the tongue and cheek bargain auto dealer Jay Pegs Automart. Regardless if this is a real auction of 9,800 used minivans or not, it becomes readily apparent that capital formation is heading toward a future where the intermediaries and regulators are going to be under pressure to justify their worth.
How many grifters can a system sustain?
With technology “friction costs” of intermediaries and trading should inexorably trend down. The future will be one or two possible outcomes 1) Where almost everyone is an “accredited investor” that can invest in earlier stage investments without opting in to the default regulatory frameworks or 2) Where capital formation just flows to offshore markets that embrace a permissionless reformation. The “invisible hand” will work its magic the same as it always has.
The SEC to its credit has made the bar to raising crowdfunding easier with Regulation CF. Regulation CF has definitely made it easier for earlier startups to raise capital, and increased access to non-accredited investors, but it is still plagued with HUGE fees and costs. Regulation CF still requires running the rubric of capital raising behind intermediaries, paper filings and gatekeepers and still costs well over 10% of the capital to raise.
Is there a traditional finance and crypto marriage to be struck that can efficiently raise capital and programmatically manage the securities regulations? I do find mechanisms such as the rolling “SAFE” continuous offerings to “accredited investors” to be interesting, as I am sure there is some excitement around digital shares such as “tZero” and LTSE’s focus on longer term value creation. But that really doesn’t touch the regulatory leviathan and the expense of raising capital in public. There are large swathes of the citizenry that are locked out of investing in the best risk rated investments. These technologically savvy investors are actually more sophisticated investors and internet research savvy than the gatekeepers give them credit for. So, the question has to be asked is the regulatory wall to protect investors, or to keep them out and from competing on the juiciest yielding investments in order to protect incumbents.
There is a moment in Game of Thrones where the kingdom is forced to sit down with the Iron Bank and negotiate a loan to fund its side of the civil war. the Iron Bank really just wants a return on its investment and to pick the winning side, or else, if it backs the wrong side it won’t get paid back. This is the conundrum in which regulators around the world find themselves. How to encourage new technological innovation that may be good for retail, and yet, due to disintermediation threatens the financial incumbents that the whole stack of cards is premised on.
It may be anathema in current circles to trust folks to safeguard their own assets without a centralized authority in control. Yet we have always allowed that for a wide range of other assets, such as jewelry, gold, real estate, and even cash sitting cool as a cucumber in the fridge. Which is probably why the bottom 90% has their wealth so heavy into real estate and vehicles. Neither asset class which really generates positive cash flow. It seems the notional difference is that this also threatens the incumbents. This dichotomy of the regulated legacy financial institutions crying to their regulators is captured much more poetically by Hester Peirce here.
Because of the prohibitive expense, uncertainty and opportunity cost innovation is hobbled
For those uneducated in such things, hobbling is basically tying a horse’s back legs together so that it can’t kick and be tended to, to clip its hooves, or provide veterinary care. Similarly, innovators and entrepreneurs have their hind (and in some cases front) limbs bound together to try to attempt to navigate the gauntlet that is preparing for an initial public offering.
In “Grow fast or die slow: Why unicorns are staying private”, Mckinsey demonstrated that in 2016 there were over 146 companies worth more than 1B and 14 over 10B that have opted to stay private. I would presume that some of this has to do with the regulatory burden and some has to do with advancements of private equity financing. But it is obvious that companies are waiting much longer to access public markets to raise capital, which is odd as technology has theoretically made it easier to aggregate data, disclosures and to track digital shares, etc. For those considering it, here is a 152 page checklist from Latham & Watkins.
What about capital formation for small companies, or just how many small businesses just choose to not raise money outside of their tight family networks, due to the expense, and overhead of implicating the securities public policy frameworks? Put differently, how many good innovative ideas just wither and die on the vine as they don’t have access to the capital formation to productize?
This is hard to know, it is in the Rumsfield “known, unknowns.” How many of these ideas would benefit from a vibrant and more obtainable crowdsource and investment framework? It is difficult to measure this, but I feel from my own experience with Farmapper it is just better to not raise money from others to avoid the quagmire and expenses. This is the case, especially at an early stage of growth. Other anecdotal evidence might be that half of the “unicorn” billion dollar startups are founded by immigrant founders. Which of course shows the vibrancy of the immigrants entrepreneurial muster, but might also be emblematic of a mindset and skill set to circumvent red tape, elite nimbleness, and willingness to go for broke that it takes to reach “unicorn” status.
In Part 3 we will dive into the disclosure regime itself and try to determine whether it is obfuscation by overproduction? What is the point of disclosure if nobody reads it?
Special thanks to Nick Rishwain for providing feedback.
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