Rapid technological innovation over the past five years has created unprecedented opportunities for entrepreneurs – often outside the world of traditional finance and capital markets. Cryptoassets, for example, may prove to be socially beneficial tools for enabling entrepreneurs to more efficiently raise capital, and making sure those and other welfare-maximizing financial innovations succeed has become paramount for researchers and policymakers. In a recent paper, The Leviathan of Securities Regulation in Cryptoasset Markets, I aim to assist U.S. capital market regulators in determining how best to achieve this goal.
Unlike many foreign countries, the U.S. does not have regulations tailored specifically to crypto-markets, relying instead on existing securities and commodity regulations. The Securities and Exchange Commission (“SEC” or “Commission”) in particular has emerged as the leader in enforcing those regulations.[1] A fundamental problem, though, is that neither complying with such regulations, nor the amount of penalties paid for noncompliance, should be the measure of regulatory success in the cryptoasset market. A more appropriate yardstick would be whether the regulations and enforcement have benefited market participants and channeled their behavior towards productive results. My article shows that, unfortunately, compliance with pre-crypto securities law may neither generate economic benefits to market participants nor channel their actions toward creating a more efficient and transparent cryptoasset market.
In researching my article, I identified the current state of enforcement with respect to cryptoassets. Figure 1 summarizes several categories of actions. [2]
Figure 1: Summary of Violations
Figure 1 illustrates that a significant number of cases involved fraud. Another major category, however, concerned primarily violations of the securities registration provisions, i.e., Section 5 of the Securities Act of 1933. In these cases, of which Telegram[3] and Kik[4] are good examples, non-fraudulent issuers sought capital to finance their cryptoasset projects.
I next ascertained the changes in issuer behavior. Following a barrage of enforcement actions, crypto-issuers focused on compliance. Figure 2 summarizes the results of my review of SEC Forms D, 1-A, and S-1 filed between July 2017 and June 2020 by issuers offering cryptoassets such as tokens and coins.
Figure 2: Total Filings
Figure 2 shows a clear preference for private placements under various exemptions from the registration provisions of securities law. Crypto-issuers mainly avoided public offerings. This finding was expected given that selling securities to the public entails expenses for drafting, marketing, obtaining SEC approval of offering documents, lost time and opportunity, and litigation. Several examples of the costs most relevant to crypto are as follows.
First, technological development is fast-moving, and technologies may become obsolete, making it imperative to raise capital quickly. A public offering, however, is often delayed by factors such as SEC comments to offering documents. Second, after an offering, an issuer, its directors and officers, and perhaps others can be sued for material misstatements and omissions in the registration statement and prospectus. Similar cost concerns may also apply to offerings conducted under Regulation A.
Third, issuers are not the sole or even best source of reliable information in crypto-offerings. The technology already ensures information transparency and immutability; the code is often open source, released through depositories such as Github, and publicly reviewable; smart contracts are designed to be self-executable; and applications and organizations built on blockchain are decentralized and autonomous. These realities suggest that the information supplied by an issuer may be redundant with the point of view of market participants who have direct access to data. The community can review the main assets of crypto-issuers, i.e., their code, often before making investment decisions. The bricks-and-mortar corporations for which securities regulation was designed never provided analogous advantages to prospective investors.
Fourth, ongoing reporting obligations – some dating from the 1970s-1980s, when digital assets were close to science fiction – are also costly. Finally, as argued in previous work,[5] digital-asset securities sold by the issuer to the initial investors can expire, and the ultimate cryptoassets are traded and exchanged as non-securities under the Howey test.[6] However, the issuer may still be required to comply with reporting and disclosure rules.
I next examined whether crypto-investors benefit from the registration and disclosure provisions of securities law. Empirical research suggests that cryptoasset markets either react negatively to regulation or are not fully sensitive to it. Cryptoasset investors may place greater importance on variables that are not fully captured in regulations. Depending on the specifics of a project, the value of cryptoassets may depend on the network effect, adoption by users, developer activity, network and product functionality, decentralization, scalability, and other factors, most of which are public information that may be outside the issuer’s control. Securities regulation and accounting tools have not been designed with these factors in mind. The market would thus not fully benefit from issuer compliance with the registration and mandatory reporting rules and, consequently, from their enforcement.
Not surprisingly, issuers prefer private placements. Private placements present a clearer cost-benefit picture. Regulation D, for instance, reduces issuer costs of compliance and disclosure. It also resolves the timing issues discussed above and opportunity cost problems. Yet, what is beneficial to issuers may be costly to investors. One reason is that the nature of cryptoassets may undermine issuer incentives for adequate voluntary disclosure in private placements.
An investment contract to develop and deliver cryptoassets is akin to bonds.[7] It is not the bond-purchasers but the shareholders of an issuer-developer who bear the costs of disclosure, which means that their incentives to disclose may be insufficient. In addition, crypto-issuers could find it best to not disclose information if doing so would erode competitive advantages and increase the risk of hacking.
Finally, for a voluntary disclosure approach to work, investors need to draw appropriate inferences from issuer silence. To do so, investors must, at a minimum, know what information the issuing firm has and wishes to conceal. They also need to understand the nature of projects and what questions to ask. Herein lies a problem. Although the majority of investors in Regulation D offerings are accredited, Regulation D links this status to wealth, income, investments, and assets, which are inaccurate proxies for investor sophistication and capacity to make appropriate inquiries in complex crypto-projects. When investors do not know which information firms have and prefer to conceal, issuers’ incentives to disclose are lower. Consequently, the currently popular private placement option does not ensure that investors would receive valuable information from issuers.
To conclude, forcing issuers into compliance with pre-crypto securities laws would not make the crypto-market more transparent or efficient, and investors either would not receive an optimal level of disclosure from issuers or would rely on publicly available information and discount issuer disclosure. In the end, active enforcement of current securities laws may lead to inefficient outcomes.
ENDNOTES
[1] Douglas Eakeley & Yuliya Guseva (with Leo Choi & Katarina Gonzalez) , Crypto-Enforcement Around the World, South. Cal. L Rev. Postscript (forthcoming 2021), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3713198.
[2] Yuliya Guseva, The SEC, Cryptoasset Markets, and Game Theory, The J. of Corp. L. (forthcoming 2021).
[3] SEC v. Telegram Grp. Inc., No. 19-cv-9439 (PKC), 2020 U.S. Dist. LEXIS 53846 (S.D.N.Y. 2020).
[4] U.S. Securities and Exchange Commission v. Kik Interactive, 2020 WL 5819770 (S.D.N.Y. 2020).
[5] Yuliya Guseva, A Conceptual Framework for Digital-Asset Securities: Tokens and Coins as Debt and Equity, Maryland Law Rev. (forthcoming 2020), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3619643.
[6] S.E.C. v. W. J. Howey Co., 328 U.S. 293 (1946).
[7] Guseva, supra note 6.
This post coms to us from Professor Yuliya Guseva at Rutgers Law School. It is based on her recent article, “The Leviathan of Securities Regulation in Cryptoasset Markets,” available here.