1) Getting it out of my system: I told you so
The American Initial Coin Offering is dead.
As I predicted, years ago. In case you’re wondering why I make predictions years in advance, such as
- my 2013 prediction that the UK’s Help to Buy scheme would end badly, or
- my 2014, 2016 and 2017 predictions that the American ICO market would come crashing down due to regulatory intervention,
I make those predictions for days like today, when they finally come true.
Today’s post to my blog is the latest, and arguably best, post in my ICO Mania series. That’s because, today, I can prove that my bear case for crypto was absolutely correct in predicting major regulatory headwinds at a scale that few other lawyers, or investors for that matter, foresaw.
I take an ultra-conservative approach when it comes to token issuances in the United States, and have done so for years. This has not been an easy position to publicly maintain for the last half-decade. The great and the good of cryptocurrency, including numerous cryptocurrency foundations and their “billionaire” entrepreneur sponsors, BigLaw partners, Coin Center (more) (more), USV, a Cardozo/Consensys joint venture, a Coin Center/Consensys/Coinbase/USV collaboration, venture capitalists talking their books, and others have all insisted, at various points, that there is some magical workaround, some way that a token becomes useful-enough, which has the result that the registration requirements of U.S. federal law no longer apply.
I was right. They were wrong.
In the instant case, the two companies that settled – Paragon and AirFox – each agreed to register the tokens as securities within 90 days, and to pay a substantial fine. The SEC concurrently announced pathways to compliance for token issuers, unregistered token investment funds, unregistered exchanges and unregistered broker-dealers. All of this follows last week’s enforcement action against a founder of the decentralized exchange EtherDelta, who no longer runs it, yet was made to pay restitution and penalties.
These enforcement actions are an earthquake that should be felt by the entire cryptocurrency and digital asset space, all over the world.
There is nothing extraordinary or particularly interesting about these enforcement actions by themselves; one could describe the orders as being mundane. It is for this reason that these orders are notable; they all but destroy a narrative that I have often heard in legal and VC circles, accepted hitherto as gospel, that US regulators will “only go after bad actors” or “the most egregious frauds,” and that strength in numbers from the startup side of things will overwhelm regulators’ ability to cope or, Uber-style, convince the regulators of the errors of their ways.
This assumption and comparison – which I have heard dozens if not hundreds of times over the last five years from investors and entrepreneurs alike – is flat wrong. VCs everywhere with no legal training, enabled by too-clever-by-half associates and advisers, failed to appreciate the meaningful difference between a municipal taxi regulation and federal law, and underestimated the intelligence and professionalism of those enforcing it. They thus failed to see what is becoming increasingly clear: the SEC intends to go after anyone in the ICO space who violates U.S. securities laws, well-intentioned or not, honest or not, technologically sophisticated or not, VC backed or not.
“But the SEC is a law enforcement agency, they don’t decide what the law is,” I hear you say. Yeah, OK. Sure. Let’s noodle on that for a second. It’s possible that, rather than roll over and die, some extremely wealthy coin promoter is going to decide to use his or her resources and a not inconsequential percentage of what time he or she has left on Earth to fight the SEC all the way up to the Supreme Court, and seek to overturn 70 years of extremely solid precedent on the basis of “because blockchain,” unlikely though that is. To the extent that unlucky entrepreneur’s scheme fits the standard mold we’ve come to expect of ICOs in the American market, I do not believe that effort will be successful, although I wish him or her the best of luck, if for no other reason than the college tuitions of the lawyers’ children for which such an action will pay.
2) So what’s next?
Companies that think they have a compliance issue on the ICO front shouldn’t panic. What they should do is convene their boards and call a lawyer, immediately.
Crucially, startups should get psychologically prepared to put in a lot of time and effort on a compliance program. What exactly this will look like for a particular startup will depend on a number of factors, e.g. whether any tokens have actually been issued or whether only SAFT notes are outstanding, whether those tokens have been listed on public exchanges, the residence of the team and investors, and the content of marketing efforts undertaken to date. Depending on those factors a number of different pathways might be available, including registering the token as a security, eliminating any U.S. touchpoints and moving the project offshore, or winding the project down and refunding investors.
Digging in one’s heels and fighting is also a possible option, but one which I would consider inadvisable for most startups.
In practical terms, for most ICO startups, the party, at least in the United States, is over. The landscape that makes ICO business practices so much more attractive than traditional capital-raising models has changed irreversibly. Much of the ease with which current coin businesses operate, including low overheads and the ease of onboarding new users, is facilitated by deficient compliance processes and absent licensure. Most existing “coin” services infrastructure accessible in the U.S. has a long way to go before it is in a position to deal in regulated products. Many coin issuers and service providers may not have the resources to achieve compliance. This includes exchanges. Overseas exchanges, based on their past performance, are unlikely to try.
At the issuer level, registration and ongoing reporting is extremely expensive, for which reason I cannot see it ever being an attractive option for seed-stage firms. Additionally, to the extent that Palley’s view is correct (it’s a fact-based determination, but I agree with his view that most ICO tokens, as they are encountered in the wild, are securities under U.S. law) this also has implications for any and all altcoin exchanges servicing U.S. customers, who will either need to register as national securities exchanges or cease servicing the U.S. For real, though, not just by easily-circumvented IP blocking.
The knock-on effects for the rest of the crypto ecosystem will be substantial, as U.S. projects wind down or register, projects that have not yet issued tokens pivot to Europe and Asia, and years of legal wrangling begins to pick up the mess engendered by a couple of years’ worth of crypto-anarchic whataboutism, Silicon Valley move-fast-and-break-things-ism and plain old bad legal advice.
In terms of assessing projects who really took the “Fat Protocol” thesis on board and are too far down the line to pivot, if I were running an altcoin portfolio for a living, today I should mark any such assets – if U.S.-based and having seriously deficient securities compliance – to zero.
None of this, of course, should come as any surprise to anybody who bothered to take the time to read the nearly 75 years of U.S. caselaw that exists on this question. Historia magistra vitae est. One wonders how many billions of dollars of value are going to be destroyed as a result of our industry’s shortsightedness; losses which might not have been, if only people had cultivated respect for legal history and the law, paid a little less attention to the salesmen, and paid a little more attention to the skeptics.