Initial coin offerings introduced a new way for startups to attract investors, but in some ways regulators see familiar patterns — and challenges — emerging. At Orange Silicon Valley’s ICOnomics event on February 21, prominent voices from the regulatory, legal, and investment worlds will assess where those challenges exist.
One of the event’s guests will be Alabama Securities Commission (ASC) Director Joseph Borg. Borg, who also serves as president of the North American Securities Administrators Association (NASAA), has been paying attention to issues related to cryptocurrency and ICOs, but he also has decades of experience working with regulators during key historical moments where financial offerings sparked waves of opportunity, mania, and eventually legal consequences.
Ahead of the event, Borg fielded questions about how ICOs began to draw regulators’ attention, as well as how those ICOs vary and how startups should consider engaging regulators before they initiate new offerings. The conversation addressed state and federal issues that aren’t necessarily unique to tokens and cryptocurrency, but it also highlighted some of the nuances that are still being explored.
Orange Silicon Valley: Let’s get started on the basic stuff. What responsibilities do regulators have at the state and federal levels — whether that’s the U.S. Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC)? And at what point do cryptocurrency or initial coin offerings intersect with those responsibilities?
Joseph Borg: State securities regulators have some overlapping jurisdiction with the SEC when it comes to fraud in the markets, protecting what we call “Main Street investors” — or as SEC Chairman [Jay] Clayton likes to call them, “Mr. and Mrs. 401k.” So that’s where state regulators start. We’re their ground-level, local police on the securities beat, and besides licensing and registering broker-dealers, their representatives and investment advisers and their agents, a lot of our work has to do more with preventing financial frauds, Ponzi and pyramid schemes, or multilevel marketing investment scams. And when it comes to brokers, state regulators make sure brokers don’t steal money, sell unsuitable products, or sell unregistered products. Some states like mine have criminal authority as well.
Cryptocurrencies started around 2008-2009; nobody knew what they were. It was the province of a small, select group. And here we are in 2018 and we now have exchanges of one type or another like the Chicago Board Options Exchange [or CBOE, where bitcoin futures are now traded] and all of a sudden bitcoin and cryptocurrencies are hot commodities. Right along with that, we’ve got the ICO phenomenon. As has happened in the past, technology and new products outrun regulation. The hype starts, and everyone is told that they will become millionaires overnight. And when it collapses, “Main Street” investors want to know why they lost their life savings, their college fund money, or the next six months of mortgage payments.
So that’s what regulators on the state level do. We’re the first ones to hear about it from our citizens. We look at the complaints, and we do the investigations. And we cooperate with the federal agencies and the SROs (Self Regulatory Organizations), such as FINRA (Financial Institutions Regulatory Authority). The SEC really looks more at the bigger markets. Now the states don’t handle the registration or licensing of major exchange listed companies like Apple and Proctor and Gamble, the ones that are on the major markets. That’s mainly the SEC’s jurisdiction. The states do, however, have anti-fraud authority for insider trading, market manipulation, company misrepresentation and things like that.
So at what point did cryptocurrencies and ICOs become of interest? We’ve been looking at it from a state level — and the SEC and CFTC have been looking at it from a federal level — for quite a number of years. But the accelerated timeframe due to technology and the creation of the exchanges, I think, has brought it to the forefront.
I don’t think the states or SEC or the CFTC are against the concept of cryptocurrency with proper controls and regulation, except right now we need to define what it is. Is it a currency? Well FinCen [the Financial Crimes Enforcement Network] says so. So it’s a commodity? Well, the CFTC says so in certain cases. Is it a security? Yes, it is that in certain cases as well. The states look at it from the point of view of their laws as well.
Is a bitcoin a security? Probably not in itself. But if I represent to you that you should invest in bitcoin because it’s going to make money, it’s now a security offering, subject to registration along with licensing of those who want to offer it to investors.
OSV: Sure. That makes sense when expectation has been set.
JB: If I send out an e-mail that says — and this is an actual quote, because I got it on my phone — “Guaranteed $13,000 profit in 24 hours on bitcoin. Click here,” that’s a sales pitch. That’s an investment offering. That’s more than likely an unregistered broker-dealer. That’s an unregistered offer and sale by an unlicensed company and unlicensed agents. So yes, the product is the bitcoin. The pitch makes it a security.
Now, I can buy bitcoin all day long on my own from my neighbor if he has some for sale, assuming no representations or other promises, and I can put it in my portfolio, and I don’t have to worry about registration. I’m not selling to the general public. I’m not holding out for resale; I’m not buying for any other purpose; I’m doing it on my own — or, I mine it myself and I collect it. That doesn’t mean it’s a security. It’s how it’s used, it’s how it’s represented, what I intend to do with it, and how it’s going to be used that determines whether or not it’s a security. So to say that all cryptocurrencies are always securities is probably technically incorrect. To say that cryptocurrency, how it’s represented, how it’s sold, how it’s marketed can make it a security is absolutely correct.
Same with ICOs. No difference. What is an initial coin offering? Well, if you and I decide to create our own company and put our own money in it, and that’s what we’re going to do, and we’re not selling it out to the public, and we’re going to use that to start a new business, that’s just us. That means you and I could start a drugstore the same way tomorrow. Does that make it as a security? Probably not.
But that’s not the way ICOs work. So you’re going to get a pool of folks that come on in, and it’s either going to be — depending on how it’s sold or marketed — a security and/or a commodity. And let’s throw in one other factor from the state regulators’ point of view: In my state, not only do I have securities. I have money transmitters. Therefore bitcoin [and] cryptocurrency, if it is used as a medium of exchange to buy and sell, pay debts, or whatever, and it is used as a money transmission vehicle, then it’s not only a security — possibly — not only a commodity — possibly — but also subject to money transmission laws. And of course that brings in FinCEN, who always wants to know what’s going on in the market keeping an eye on money laundering, terrorist financing and the like, especially now in the cryptocurrency space.
OSV: So what would you say the trigger is for somebody who is doing an ICO? When do they have a responsibility to engage regulators?
JB: Technology has outrun regulation and at a very brisk pace. The ICO, which is actually an investment vehicle to start some new business for the purposes of making money down the road, is a security. That’s what you want it to do. Whether it’s in an ICO or shares of stock that you bought at a penny and hopefully it goes up, if you think about it from a conceptual point of view, there’s really no difference. What’s the purpose of an ICO? Tokens that you will exchange later on or something that’s of value.
OSV: What about accredited investor rules? Do they apply to cryptocurrency and ICOs?
JB: Accredited investor rules apply to securities. Therefore, if you have a cryptocurrency or an ICO to start one or a business, how are you selling it? How is it presented? What are you representing? What disclosures are you making? What are the risk factors? Is it understandable to the audience you are courting to invest their money? So yes, it may apply to crypto if you’re seeking a private placement to invest in a new cryptocurrency or something. So yes.
If done correctly with proper licensing, disclosure, and following all the rules that apply to accredited investors, then one can take advantage of the less stringent requirements. And again, the nuances are going to be more on “What’s the purpose?” And I think we’ve got a lot of work to do on the — quote — “What’s the purpose?” I’ve had too many folks want money transmitter licenses for cryptocurrencies, and I say, “Well, how is it going to work.” And I’ll say, “OK, so where’s the wallet? Who’s got control of the keys?” And they say, “Well, we’ve got all that, so they can call us.”
That’s when I say, “Guys, we have a problem with that.” And unfortunately those folks don’t get licenses. The focus is so much on getting the product out and to market, that the realities of “risk factors” to the buyers or investors is not fully considered.
They have the concept of what they want to do, but they’re only looking at it from a technology point of view and the process and operation, not the security/marketing-sales/risk/disclosure side of the equation and how do you protect the investors who are going to own those wallets of the ICOs for that matter. And I think that’s part of the issues that we run into.
OSV: So what are the responsibilities, whether it’s legally established right now, or even ethically speaking, that companies who are holding these ISO’s have to the investors? Does it come down to telling the investors this will increase in value. Does it come down to being up front if they don’t think it will go up in value?
JB: I’m oversimplifying it, but think of it in terms of “If this was an IPO — an initial public offering — instead of an ICO, what would I do?”
Well, I’m the company. I’m the new Apple, and I want to sell my stock. I get with Credit Suisse, Merrill Lynch Morgan Stanley and the like. They’re the brokers. They do the sales of the stock, but they have to keep all the records and have the licensed people, keep up with all the rules and regulations to sell to the public.
OSV: To what extent do you see companies that are doing ICOs doing that already, and are there best case scenarios out there in any significant numbers? Or do you see the vast majority not knowing how to engage and begin this process?
JB: I see quite a number that are trying it and not knowing how to do it right. As a practical matter, the SEC is coming down hard on this. Again, understand why. Well, they’re unlicensed, unregistered, selling to folks; then you have to comply with same level playing field and all the rules that somebody who wants to sell a new company technology. So from our point of view, I see ICOs as another product that’s being marketed as an investment to the public. This one just happens to be an initial coin offering instead of a share of stock, but the same rules would generally apply. There are some exceptions; accredited investors have less disclosures, and we are a country mostly of disclosure laws. Part of that disclosure means you can’t misrepresent.
Here’s another important item for ICOs to remember: Not only can you not misrepresent, but you can’t omit material facts. “Oh, I did forget to tell you that we’re broke. We’re burning through cash, and we probably will go out of business in six months if we don’t get our stuff done in a hurry.” That might be a material fact to me as an investor before I drop my $20,000 into an ICO to buy the tokens.
OSV: So what does this mean for ICO entrepreneurs?
JB: What I’m suggesting to the industry is — go educate your regulators at the federal and state level as to what you’re planning on doing before you do it, and find out whether or not you need to be licensed. And if you don’t want to do the license yourself, then you’ll have to obviously hook up with somebody who does have a license that can walk you through the process to make sure you’re in compliance with the securities laws, the commodities laws, the money transmitters laws as they may be. At this point there are very few regulations in place, and therefore the existing regulations that are in place do apply. I’m sure, as the entire space continues to develop, there will be new regulations or laws and working together now can help ensure that they will be the right regulations for the protection of investors and to promote greater capital formation.