Corrected July 1 | Would-be financial technology innovators are shying away from digital assets because of the cost to comply with, or risk of drawing the ire of, U.S. regulators, according to securities law practitioners tracking financial technology.
The Securities and Exchange Commission is still vigorously enforcing rules for digital offerings, even years after their launch, in ways that leave the industry in the dark on how to comply, they say.
“I would say the SEC’s lack of formal binding guidance has definitely slowed down token offerings in the United States and created some uncertainty for issuers,” Andrew Hinkes, a Miami-based securities litigator, told CQ Roll Call.
At issue are initial coin offerings, or ICOs, which were all the rage in 2017. The idea was to raise money by selling digital tokens that could be used for future credit with the company issuing them, and to use the capital as seed money to develop software that investors would have access to.
Then the SEC cracked down, deciding that most of them were securities transactions that should have been registered.
The agency announced the settlement of an enforcement action as recently as Friday, when Dubai-based Telegram Group Inc., a messaging app company, agreed to return more than $1.2 billion to investors and to pay an $18.5 million civil penalty over an unregistered offering of digital tokens called Grams in 2018.
No reliable guidance
Hinkes, of counsel at law firm Carlton Fields PA, argues that the agency created confusion and uncertainty through informal, nonbinding guidance in speeches, public statements and consent orders. There isn’t any reliable guidance that potential innovators can count on, he said. Hinkes is also an adjunct professor at New York University’s business and law schools, where he teaches courses on securities law and cryptocurrency.
“The structure of the securities laws and the often-used exemptions from the registration that’s normally required is problematic here because the crypto world has embraced so many new and innovative products and offering strategies,” Hinkes said. “A lot of these issuers only found out that they failed when a regulator gave them a call or filed an enforcement action against them.”
ICOs are meant to operate on a decentralized public ledger like blockchain, a network of computers with no central authority.
Decades before the concept was invented, the Supreme Court in SEC v. Howey in 1946 laid out the test to determine whether something is a security. That analysis turns on a case-by-case assessment of whether a potential investor expects to turn a profit from the efforts of a third-party promoter. It’s that case-by-case approach that lawyers say stifles fintech.
Without more clarity, they say, companies aren’t keen on testing the waters.
“The law is broad enough and fact-based enough that it is very difficult to have comfort that you’re not going to fall into the bucket of a security,” Kayvan Sadeghi, a New York-based securities lawyer at Schiff Hardin, said in an interview. “It seems clear that the SEC starts with the presumption that if it’s an ICO it’s likely to be a securities offering, so projects are staying out of the United States because there is no easy way to get comfort that a token won’t be treated as a security.”
The numbers bear that out. Cryptocurrency-focused news site Cointelegraph reported earlier this year that year-over-year fundraising via ICOs dropped 95 percent last year.
“I think people back in the 2017 to 2018 time frame were trying to come up with creative solutions and were willing to take chances,” Sadeghi said.
SEC Chairman Jay Clayton said in 2017 that there are cryptocurrencies that do not appear to be securities. And other agency officials have indicated, in nonbinding guidance including public statements, that the SEC supports cryptocurrency. But confusion persists, experts say.
“Compliance with securities law is costly, in part, because in crypto, it is fraught with uncertainty,” Yuliya Guseva, a Rutgers University law professor and expert on cryptocurrency, said in an email. On one hand, the SEC’s approach gives it flexibility on enforcement, but on the other, it leaves market participants without clear direction, she said.
Companies tried to distinguish their ICOs from securities by planning to relinquish control of the coins after the capital was raised, Guseva said.
That was the case with Telegram, the company that settled Friday. The U.S. District Court for the Southern District of New York rejected its concept of separate phases, holding that the substance of the entire coin offering was part of a single scheme that constituted an investment contract subject to registration and disclosure rules.
Kik, a Canadian company that offers a messenger application, launched a token called Kin that generated over $100 million. It, too, planned to eventually relinquish control, but the SEC wasn’t persuaded. The case is pending in federal court.
“The SEC has brought enforcement actions and generally has routed all defendants in litigation,” Hinkes said.
Other recent settlements include one by BitClave PTE Ltd., a San Jose, California-based blockchain services company accused of violating securities laws with a $25 million coin offering that drew more than 9,500 investors in 2017.
Even issuing digital assets to overseas investors could run afoul of U.S. securities laws. U.S. District Judge Kevin Castel of the Southern District of New York in an April 1 order denied Telegram’s request to limit the court’s injunction to only the territorial United States.
Some companies have successfully navigated a digital coin offering by using Regulation A-plus, a streamlined option sometimes called the mini-IPO that allows issuers to raise as much as $50 million per year using less onerous disclosures.
Two startups, Blockstack and YouNow, each received SEC approval last year using this pathway. But it’s not an option for all digital assets, the lawyers say.
SEC Commissioner Hester Peirce, a champion of fintech, released a proposal this year that could allow issuers a limited period in which to launch a coin offering and advance it to a decentralized automation transaction without having to register the offering with the agency.
Sadeghi, Hinkes and Guseva praised Peirce’s safe harbor proposal as at least a step in the right direction, but each indicated a greater preference for regulators to forge a clearly defined, low-burden path.
The SEC didn’t immediately respond to a request for comment.
Correction: This report was revised to reflect the status of the SEC’s case against Kik.