It’s understandable that early stage investors have shown they’re willing to take risks with companies like Uber or Airbnb that are up against fragmented regulatory authorities and whose risk is contained to operations. These, for the most part, have been manageable legal risks as companies scale.
However investors are normally very averse to novel structuring or securities risk, and for good reason. Securities risk is one of the few risks that can’t always be contained behind the corporate veil and tends to hit investors hard at any size.
Initial coin offerings (ICOs) seem to have skipped over all that. However the current discussion of ICO enforcement overly obsesses on the question of which tokens are securities, and because most ICO investors don’t have regular interactions with the SEC they forget the regulator’s true mandate.
In the mad rush to participate in jaw-dropping financing rounds, investors may have exposed themselves to unexpected — and profound — financial risk. When the SEC asserts its full authority it could entirely reshape the ICO market and have serious legal consequences for large investors.
More Than Defining What A Security Is
Right now the conversation surrounding ICOs is mostly about what qualifies as a security. As the Munchee case demonstrates, the SEC isn’t going to give a free pass to ‘utility tokens’, or tokens that are used by the business operationally. If you’ve marketed an ICO on the basis of the potential for profit, you have an unregistered security and a lot of lawyers in your future.
The early stage venture capitalists, high net worth individuals, and entrepreneurs participating in ICOs are mostly left alone by the SEC in private transactions. Most haven’t ever had to get their Series 7 / 63, which are basic securities law certifications. This creates a culture of compliance that looks very different to someone who works on a trading floor, and there are blind spots in the larger discussion of ICO compliance.
There really hasn’t been much change in investor outlook based on the SEC beginning to tweak its view of what tokens qualify as securities. Many investors look at the risk of ICOs basically in these terms:
“Yes, the token might be found to be a security. Sure, there might be fines — for the company — and maybe the company might go out of business. But the upside is huge, and we can take some losses.”
However the reality could be much, much worse.
Why The SEC Exists
The SEC didn’t come into existence because people didn’t understand what securities were, or needed enhanced legal structure for securities. The SEC exists to control trading on insider information, and to prevent the attendant fraud and financial manipulation of everyday investors.
So what every major ICO participant should be asking is what other rules might have been broken once the SEC, inevitably, determines that the tokens you invested in are securities.
As the SEC is investigating the marketing claims of ICOs to determine whether they’re securities, how long do you think it will take them to notice that marketing claims and material information for some investors are markedly different from others? How many ICOs try to curry favor with big names by giving insider tips? How likely do you think most ICOs are to be led by people familiar with regulations relating to disclosure of inside information?
This is where the risk of ICO investment could leak back from company management to investors. Per the Dirks Test established by the Supreme Court in 1984, the recipient of inside information violates securities law if he or she should know the tipper is breaching fiduciary duty.
That can be a broad standard. In the case of Raymond Dirks of Dirks Test fame, he didn’t even profit from the information — he simply passed on information to investors who sold. How much of that do you think has happened with ICOs?
Importantly, the Dirks case also arose from an existing investigation into a company violating securities law. And SEC investigations often happen as follow-ons to civil suits from investors, or from priority areas of policy enforcement.
Cases like Munchee are making it clear that many tokens can be viewed by the SEC as securities, and large investors are attractive targets for litigation. How long before the SEC acts, or private investors file civil suits of their own? Tezos has already proven that it doesn’t take SEC action to get the ball rolling.
Historical Analogue
A salient historical analogue in enforcement history is the junk bond market, which grew from $10B in volume in 1979, to $189B in volume in 1989. This represented a 34% compounded annual growth rate over this period, and caused the SEC to examine how stringently major players were complying with existing regulations.
The market cap of the top 100 ICOs is over $61B and an overripe target for SEC enforcement. ICOs are just hitting the $5B volume mark in capital raised, are entirely unregulated, and surpass early stage VC funds raised. Even more troubling, the top ten investment fund ICOs have raised $371.1M, and at least four have tokens trading at roughly half of what they raised on literally months ago — those kinds of losses are the sort that draw lawsuits and attract the attention of the SEC.
The question really isn’t if, but when we’ll see the Michael Milken of ICOs. Milken was indicted for a series of violations that might look familiar — failure to disclose commission schemes, tax evasion, and insider trading. He was sentenced to ten years in jail despite working regularly, by many accounts, with compliance staff at Drexel Burnham Lambert. Many believe he was a victim of the SEC wanting to make a point to an overheated market.
ICO Compliance In The Future
Eventually it seems possible the market may be constrained to an era where ICOs are traded on registered exchanges exclusive to accredited investors. CoinList-like exchanges for Know Your Customer (KYC) compliance are well-placed for this.
For those hoping that consumers will someday directly access these equity returns, the SEC’s core mandate of controlling information to the benefit of retail investors will likely make that project impossible. Startups would have to become markedly more sophisticated about releasing information, board members would have their hands tied in communication, and cost for compliance would be prohibitive without substantial modification of SEC regulations.
Once the market calms down and the SEC begins approving them, ETFs will likely be able to act as an ICO vehicle for the public (as they currently do with venture). Overall this doesn’t really strike me as revolutionary so much as incremental.
The most interesting change is the potential reduction of barriers for long-term private investment to gain liquidity after shorter holding periods, or potentially to become underwriting capital altogether.
ICOs could allow angel investors to get liquidity within reasonable timelines (rather than 10–12 years), enabling larger bets and for a wider range of entities to access early stage equity returns directly without complex, lengthy, expensive transactions. A more robust market could help address the challenges of capital-intensive startups, as we’ve seen with some ICO megaraises, allowing for more innovative companies.
Certain venture firms might even become more similar to investment banks, performing underwriting functions for much earlier stage companies entering the token markets.
What seems likely, at least, is that ICO proponents are going to have to limit themselves to innovating within the pool of accredited investors. Once the SEC files its first insider trading suit against a venture firm, the willingness of large investors to finance securities risk will dry up.
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