It seems like every day we hear more from the SEC about the perils of Crypto-investing, and yet get more proof of how futile some of their efforts will be. Yesterday, we learned about the launch of KodakCoin, which promptly sent the stock of Kodak up 44% and it continued to go higher. The question, therefore, is whether equity rules would provide protection to ICO investors, when the simple announcement of an upcoming ICO can add over $300 million in market cap to a stock in the highly regulated, national market system. Of course, it doesn’t even take an ICO, as evidenced by the shares of Long Island Ice Tea, which more than doubled by changing its name to Long Blockchain… To be clear, we at CoinRoutes believe that there would be significant benefits to some regulation and the establishment of standards for the ICO market, and welcome some of what the SEC is reportedly considering.
For example, we believe that Bitcoin magazine’s report on the SEC crackdown against Initial Coin Offerings and cryptocurrencies could be good news for those of us in the crypto business that have launched or are planning a legitimate ICO. The SEC should crack down on fraud and should require full disclosures of risks and governance structures to investors. The SEC, however, should not force ICOs into decades old equity regulations that do not apply. Unfortunately, however, the current rules, without exemptions, would create barriers to legitimate business opportunities that utilize blockchain technology and modern network concepts.
Case in point is the Gordian knot that Matt Levine described in today’s money watch column. He points out that, in order to issue a potentially useful token, Kodak utilized an exemption under Regulation D, which only supports selling tokens to accredited investors. The tokens, however, are designed to be used by anyone with photographic content, so they would need to be freely transferable for use. That, unfortunately, means that the post-ICO market for those tokens would need to be open to all, which would, in all likelihood, be deemed as violating securities laws.
While we can disagree on whether this coin might be useful, there are certainly coins that will provide value to their owners. Unfortunately, if the SEC insists that all tokens whose value is at least partially dependent on the “managerial or entrepreneurial efforts” of their founders, are securities, then those emerging business concepts will be seriously impeded. This would essentially force the businesses developing these tokens to either potentially violate securities rules or ignore the US market altogether. That would be a very bad outcome for our economy, so we should work towards a better solution.
The best way forward would be to issue guidelines for ICO disclosures and documentation that include all the important components of registered equity offerings. This means, at a minimum, that ICOs should be forced to disclose risk characteristics, distinguish between developed/working software and future plans, identify what, if any, revenue accrues to the token, specify the potential for future issuance of the tokens as part of a scarcity analysis, and describe the governance structures which influence the value of the token. That said, there are issues with the current equity rules, many of which date back over 70 years, and the first one is that many ICOs are quite different than equities.
Some ICOs, such as the network token that CoinRoutes plans to offer, are clearly not equity securities. These ICOs can be used as a medium of exchange for services or as collateral for participating in a network. In our case, the operators of routing software will need to pledge a substantial amount of tokens to have access to the shared market data of the network. While the amount of tokens required to be pledged will be fixed, the value of those tokens in the market will be related to the perceived value of the data on the network. The main issue with current regulations is that they only work in a world where the value of the security is influenced solely by the actions of the corporation issuing it. In our case, and in the case of many network tokens, however, the corporation issuing the token could cease operations entirely, but the network could still grow in value if competitors to the original corporation flourish.
Unfortunately, there is no current legal structure for a “security” that is not directly tied to the fortunes of a corporation, which means that many of today’s rules do not apply. Disclosure forms that focus on company financials, officers and operations have either zero or marginal value and there are many other roadblocks that have no real benefit. In addition, we should consider the entire justification for limiting investment in these products to “accredited” investors. The public demand for early stage investments, after a decade of being excluded from such investments by private equity, is very large. This is the real story of the ICO boom and the silly examples of listed securities jumping based on the intention of companies.
The current regulatory situation is confused. There have been over $4 billion in ICO funds raised, and there continues to be high demand. There are also many projects in the pipeline, of varying levels of professionalism and success probabilities. That said, there are major disagreements in the industry. Some people believe that companies can proceed with the current ICO processes, if they provide proper disclosures and risks to investors, and others believe that most ICOs will need to register as securities. Still others believe that all of 2017’s ICOs are potentially at risk from the regulators, and that it would be very risky to proceed with SAFT or utility token ICOs in most circumstances.
It is clearly a bad thing for promoting entrepreneurship and economic growth for one of the most important new technologies to suffer from such confusion at the hands of the regulators, so it really does need to be remedied quickly. My suggestion, for what its worth, would be for the regulators to change Regulation A+ to specifically codify rules for ICOs and leave them as a separate asset class from equities. At the same time, however, the regulators should establish a framework for the markets that currently trade crypto-assets. It would be extremely disruptive to require that all the current exchanges become broker dealers and Alternative Trading Systems overnight, yet the market would benefit from guidance considering the growing pains that these markets are going through.