Hi Crypto Insiders, For those unfamiliar with me, I’d like to introduce myself. I’m Liam. I’ve been writing Inside Business for the past 18 months and am the former Managing Editor at Inside.com. I’ve long had an interest in blockchain and have been an advisor, consultant, and investor in the industry since 2016. I also hold a Law Degree and Master of Laws and currently work at Zargar Lawyers in Vancouver, advising tech startups and small businesses including blockchain companies. Over the next five weeks, I will be publishing one newsletter every Saturday for our Inside Cryptocurrency audience, analyzing the laws and regulations around different applications of Blockchain technology. At the end of these five weeks, I will join the "Inside Cryptocurrency: Law and the Blockchain" event, where I will discuss these issues directly with you. We will start with one of the most interesting applications of Blockchain technology: its potential to revolutionize capital markets. To provide a thorough analysis of the regulatory environment we will look at the following: - The Current Situation: How do capital markets currently operate and what are the issues?
- The Blockchain Future: How could capital markets function if blockchain technology becomes widespread in the space?
- Overview of Legal Considerations: What are the general areas of law that must be considered when analyzing the application of blockchain technology to capital markets?
- Past Cases: A quick glance at three foundational cases involving major companies raising ICOs.
- The DAO Case: An in-depth look at how the U.S. has dealt with DAO and the concept of decentralized funding/investing.
- Trends to Watch: What are some emerging trends that investors and market participants should be aware of?
This series is not intended to provide legal advice, its purpose is to share knowledge and information gained through the study and practice of law and participation in the sector. This is a quickly evolving industry so please ensure that you stay up to date with any changes and consult a lawyer who is familiar with your personal situation before participating in the industry in any capacity. |
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The Current Situation Today, capital markets fall into two categories: public and private. Public Markets include companies that are listed on stock exchanges while Private Markets are defined by investment opportunities largely unavailable to the general public. Public Markets - Despite the apparent ease of access, historically, participation in Public Markets has been low. While apps like Robinhood have increased participation, the financial regulations and requirements, as well as significant fees from many brokers (especially outside of the U.S.), continue to be barriers to access.
- Under the hood, these markets remain extremely inefficient. This was evident last year, when numerous retail trading applications were forced to halt trading of Gamestop due to settlement periods and cash-on-hand requirements. The inner workings of this inefficient system are rarely exposed to the public but continuously add costs to our day-to-day lives.
- The majority of money in Public Markets is invested through index funds, pension funds, and other pools of money. These can be beneficial to individuals, allowing them to indirectly own shares and participate in financial gains but are also harmful as they give companies like Vanguard, Blackrock, and State Street tremendous voting power. Did you know that a 2016 study showed these three investment funds, if counted as a single shareholder, would own majority stakes in 88% of S&P500 companies? This voting power allows these firms to hire and fire the directors of the world’s most powerful companies.
Private Markets - Most private investment opportunities are only available to accredited investors — this is largely due to fears that investors with less know-how are more likely to fall victim to scammers and other deceitful market participants.
- Private Markets offer some of the largest returns on investment, with many angel investors and venture capital investors getting outsized returns when compared to hedge funds and participants in the public markets.
- There is a severe lack of liquidity for shareholders in Private Markets. They often have to personally find a buyer or wait for an exit event, such as an Initial Public Offering, in order to gain monetary compensation for their investments.
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The Blockchain Future At its core, Blockchain or Distributed Ledger Technology allows for records or ledgers to be kept and maintained by the public instead of by institutions or governments. This means that you no longer need to rely on a bank to tell you how much money you have in your account or to transfer money between accounts, and you no longer need the government to issue cash. All these transactions can be done in the open, in public, allowing all participants in the financial system to instantaneously conduct transactions and record them on a public ledger. The effects of this technology will be considerable. - Initial Coin Offerings (ICOs) provide a new way to raise funds. ICOs can be a mixture of crowdfunding, Regulation D raises, pre-purchasing products, and regular venture capital investments. Tokens issued by companies can easily be sold to anyone in the world with a cryptocurrency wallet and can represent equity in a company, be redeemed for goods or services, or be paid back as loans with interest. This will allow startups to raise capital across borders and in a way that appeals to a wide range of potential investors or backers.
- Secondary Markets can be built, allowing for the sale of tokens issued by private companies to provide liquidity for investors or backers. One of the primary barriers to investing in startups, outside of legal regulations, is simply that it requires individuals to lock up their capital for 7-11 years. Having a way to easily realize a return on investment in a shorter time period should lead to additional investment and innovation benefiting the whole economy.
- Modernizing public stock markets will allow individuals to take back control of the firms that control their lives. Those who own shares through their 401k, mutual funds, or index funds could potentially vote on corporate governance issues and push for major companies like Apple, Microsoft, or Google to act in a manner that aligns with their social and environmental views.
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Legal Considerations The primary area of consideration that needs to be addressed when analyzing the application of blockchain technology to capital markets is securities laws. Securities laws determine what you can sell to the public and who you can sell it to. The Securities and Exchange Commission (SEC) is the relevant governing body in the United States and has been proactive in attempting to limit the use of new technologies like the blockchain to circumvent securities laws. In addition to securities laws, other considerations to account for include commodities laws, especially for utility tokens such as Ethereum; as well as tax laws, for anyone currently investing in cryptocurrencies. Unfortunately, countries have been very inconsistent in their regulation of blockchain technologies so we will be focusing primarily on the regulatory environment in the U.S.
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Past Cases While the industry and technology are still in their youth, there have been early legal cases — primarily resulting from the ICO boom of 2017 — that provide some indication as to the severity and potential penalties for those who fall foul of the law when operating in this space. - Telegram — In October 2019, the SEC filed an emergency action to prevent an allegedly illegal offering of $1.7B worth of securities by Telegram. In 2018, Telegram had sold 2.9 Billion tokens called grams, with the funds being used to upgrade its messaging system and launch a blockchain network. In 2020, a court issued an injunction to prevent the sharing of the Grams and, later that year, Telegram settled with the SEC, agreeing to return $1.2B plus interest to investors (the other $500M was purported to have already been returned to investors) and to pay an $18.5M fine. The company was banned from dealing with digital tokens for three years without the express approval of the SEC.
- Kik Interactive Inc — In June 2019, the SEC filed a complaint against Kik for selling 1 Trillion Kin tokens, raising $100M, to grow its messaging service. A court found that this was an illegal sale of a security contract and Kik had to pay a $5M penalty.
- Plexcoin — Plexcoin was a project that advertised itself as the next cryptocurrency. It was meant to be a more liquid version of Bitcoin, with backers getting a credit card and being able to spend the tokens on the Visa network. (At least these were the claims of the company.) Plexcoin also claimed, using Bitcoin as a reference, that investors could see returns of 1,300% in a month. After raising $15M through an ICO, AMF, the Quebec financial watchdog, issued orders to seize the funds, and shut down the website and social media of the company. Plexcoin founders were charged and sentenced to two months in jail and a $100K fine. The SEC also pursued the case and successfully froze all assets associated with the ICO.
We can see here that financial authorities — particularly the SEC but also foreign regulators — will take quick and decisive actions to protect the public from unregulated offerings. The potential penalties for launching an illegal ICO range from fines against the company, to personal fines and potentially criminal sentences, like jail time, for executives. Overall, these cases show that although tokens and the blockchain are a new technology and a new way to sell securities, ICOs must comply with the existing regulatory framework.
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The DAO Case From April 30 to May 28, 2016, The DAO sold 1.15 Billion DAO Tokens for 12 Million Ether in a transaction valued at approximately $150M. The DAO was supposed to allow for a new form of investing whereby those who held tokens could vote on how to invest the $150M. The DAO would invest on behalf of its “stakeholders” then split the profits relative to the token holdings. Its plan was to provide an alternative to corporate finance. A flaw in The DAO’s code led to $50M being stolen, making the project a quick target for the SEC, which released a full report analyzing the legality of the project in 2017. - The SEC determined that The DAO was an unincorporated organization illegally selling securities (DAO Tokens) without registering the sale with the SEC.
- The SEC found that The TAO co-founders, who controlled which projects would be voted on, and who initiated the unregistered offering, were legally liable for the actions of The DAO.
- The SEC determined that any platform that allowed for the sale of DAO tokens, which were considered a security, was therefore an exchange that needed to be registered with the SEC.
- The SEC interestingly did not comment on whether the attack, which exploited a vulnerability in the smart contract, was a crime. Instead, SEC officials said that they viewed the attack as someone taking advantage of poor contractual terms, with the contract being in the form of computer code.
The idea that DAOs can be fully decentralized, with nobody taking responsibility for the actions of The DAO appears to be something regulators will not allow. Fundamentally, the position of the SEC appears to be that it will allow DAOs, or any other investment vehicle, so long as there is someone they can hold accountable — similar to how they need someone who is in charge of a Bank, Hedge Fund, Venture Capital Fund or any other financial institution.
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Evolving Concepts As the legal system is trying to catch up with blockchain technology, there are some areas of the law and fundamental concepts that are evolving and should be considered. - Legal Jurisdictions — When a crime is committed, it is normally clear where in the world that crime was committed and who is responsible for enforcing the laws. In the case of blockchain projects, an illegal offering in Singapore could be sold to investors worldwide and it’s unclear how countries will co-operate to enforce their regulations.
- Transformation — One of the most unique aspects of blockchain is how a single token can transform over time, even becoming a different type of asset. It can be argued that when Bitcoin was first launched it was a security offering, similar to stocks. However, at some point, it changed from a security to a currency that was used to buy and sell goods. Then, as transaction prices got higher, Bitcoin became a commodity, like gold, used as a store of value, while investors traded other cryptocurrencies more often. Previously, it was easy to classify a financial instrument as currency, commodity, or security; however, tokens seem to evolve and play different roles at different points in their lifespan.
- Innovation — It is clear that the strong enforcement by the SEC in 2017 led to a decrease in U.S.-based innovations within the cryptocurrency industry. Many major projects are based outside the U.S., allowing people to innovate and operate more freely. SEC Commissioner Hester Peirce has been advocating for a Safe Harbor that will give a three-year grace period for projects that don't fit within the existing legal framework. During those three years, the SEC will work with project leaders to ensure that their offering complies with regulations. Regardless of this plan, it is clear that there is a balance between innovation and regulation that needs to be made by the SEC and other foreign regulators if they want technologies to be created and grown in their jurisdictions.
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Given the information gained from this newsletter, let us know: | Do you think the SEC should prioritize encouraging innovation or regulating new technologies to protect consumers? | | | | |
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 |  | Liam Gill is a founder, lawyer and investor.
He previously founded Fumarii Technologies, which became a top 20 ranked cloud computing service (Yahoo Finance! 2019) valued at over $30M. He holds an LLB Laws (UK), MSc Management and Master of Laws and currently practices law at Zargar Lawyers + Business Strategists in Vancouver, Canada.
|   | | Editor | Eduardo Garcia is a writer and editor based in New York. He is writing an illustrated book about climate change that will be published by Ten Speed Press, an imprint of Penguin Random House. Bylines in The New York Times, The Guardian, Slate, Scientific American, and others. In one of his previous lives, Eduardo worked as a Reuters correspondent in Latin America for nearly a decade. | |
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