When the Means Undermine the End: The Leviathan of Securities Law and Enforcement in Digital-Asset Markets

Abstract

Machiavelli famously said that actions of all men, particularly of regulators, should be judged by the results. Paraphrasing Machiavelli, the end justifies the means. This Article addresses a situation where the means undermine the regulatory ends.

The focus of this Article is the Securities and Exchange Commission (“SEC”), the major capital-market watchdog. Created in the wake of the Great Depression, the SEC pursues a ternary set of objectives, including protecting investors, maintaining efficient markets, and facilitating capital formation. This Article examines a fundamental disconnect between the objectives of the SEC and the actual outcome of its policies in digital-asset markets—the agency’s enforcement efforts under the mantra of protecting investors and providing digital-asset markets with more information have produced an environment with less information. This disconnect between the SEC’s means and ends is relevant not only to cryptoasset investors but also to other purchasers such as consumers and users.

Using two hand-collected datasets, the Article shows that following an increase in enforcement, cryptoasset issuers have attempted to comply with securities law by resorting to private placements. This compliance option reduces market transparency and is harmful to the less sophisticated crypto-investors. In contrast, the more sophisticated crypto-investors rely on what the Article calls “the pure-information model” that exists independently of the SEC-enforced regulations.

To conclude, in actively enforcing pre-digital-asset law, the SEC has funneled crypto-issuers into inadequate and lackadaisical compliance with exemptions and created a status quo that is antithetical to the SEC’s core mission of protecting investors. This status quo is also harmful to crypto-issuers, who face higher capital costs. As no one wins in this scenario, a reform revising crypto-issuer disclosure is needed.

A. Introduction

The famous quote from Machiavelli’s The Prince states that “in the actions of all men, and especially of princes [i.e., the regulators], one judges by the result.” 1 In short, the end justifies the means. In this Article, I address a situation where the means undermine the regulatory ends. This dilemma between the ends and the means may materialize when large bureaucratic institutions with sprawling divisions in charge of various aspects of their respective statutory missions enforce the law without ensuring that enforcement actually comports with the missions.

The focus of our analysis will be the Securities and Exchange Commission (“SEC” or “Commission”), a leading capital-market watchdog performing a plethora of functions ranging from the oversight of securities exchanges, corporate reporting, and investment companies to enforcement and many others.2 Created in the wake of the Great Depression, the SEC pursues a ternary set of regulatory objectives of protecting investors, maintaining fair and efficient markets, and facilitating capital formation.3 Unfortunately, a fundamental disconnect may materialize between the SEC’s statutory objectives and the ways various divisions, particularly the Division of Enforcement, implement its overarching goals. This Article examines a crucial example of this harmful “schism” in the digital-asset (also “cryptoasset”) markets.4

Representing the fourth piece in my tetralogy of papers examining the regulation of cryptoassets, this Article contributes to the rich scholarship on financial innovation, enforcement, and digital-asset revolution5 and underscores the detrimental effect of the disconnect between the ends and the means on both investors and innovators. Namely, recent crypto-enforcement under the mantra of protecting investors and providing them with material information about digital-asset securities has resulted in a market environment with less information. This outcome is harmful to various purchasers of cryptoassets regardless of their intent: some intend to use the purchased assets and related services, while others acquire cryptoassets in search of profitable investment opportunities.

Many cryptoasset issuers (also “crypto-issuers”) rely on private placement exemptions that pose additional risks in crypto. My empirical analysis of two hand-collected datasets covering SEC enforcement and crypto-issuer filings in 2017-2021 supports this conclusion. It is likely that the SEC’s active enforcement of pre-crypto securities law has created a status quo that is antithetical to the Commission’s core mission of protecting investors, particularly the less sophisticated ones.

This disconnect could have been easily revealed ex ante if the SEC had employed basic game theory and predictive analysis. Using the process of backward induction and cost-benefit analysis,6 this Article shows that an information-less crypto-market was a foreseeable, although unintended, consequence of enforcement of the current securities laws. Put differently, how crypto-firms would react to enforcement and whether their response would inure to the benefit of investors, whose protection is one of the elemental statutory precepts of the Commission, were two easily predictable outcomes.

To resolve these issues, a formal rule is needed. Although in April 2021 one of the SEC Commissioners—Commissioner Hester Peirce—proposed a new rule on digital assets, 7 the Commission has not engaged in active rulemaking to date. Indeed, it is not individual Commissioners, but the Chair of the SEC who determines the overall agenda. Former Chairman Clayton seemed satisfied with a regulation-via-enforcement approach.8 On August 3, 2021, Chairman Gensler staked out his position grounded in the need for strong investor protection and an expanded statutory authority of the SEC over cryptoasset markets.9

While this paper agrees (and indeed emphatically argues) that both investors and innovators would be better off if the Commission promulgated even a basic rule on digital assets, it also aims to assist the regulator in designing a new approach without the unintended consequences and flaws of the current policies. Quoting Chair Gensler, “[a]t the heart of trust in markets is investor protection.”10 It is paramount for the regulators to avoid the fundamental disconnect between the typical means of investor protection (i.e., enforcement of unsuitable pre-crypto regulations) and actually protecting cryptoasset investors and achieving other objectives of the Commission. Regulatory routes that are contrary to the lofty ideals of protecting consumers and simultaneously facilitating capital formation, market efficiency, and transparency benefit neither the consumers nor the crypto-innovators and markets in general.

This Article develops as follows: Part B reviews the federal securities statutes and the prevalence of private placements vis-a-vis public offerings. Part C provides empirical analysis on crypto-offerings and crypto-enforcement from 2017 to 2021. Parts D and E explain why private placements are a predictable outcome of enforcement. Part F highlights the fundamental “fissure” between the Commission’s mission and the actual enforcement outcomes and discusses the need for better information disclosure, formal rulemaking, and investor protection. Part G presents conclusions.

B. Evolving Trends in Public and Private Offerings

As a method of protecting cryptoasset purchasers, conventional securities law has limited tools at its disposal. The basic edifice of securities law consists of the Securities Act of 193311 (also “the ’33 Act”) and the Securities Exchange Act of 193412 (also “the ’34 Act” or “Exchange Act”). The former is primarily concerned with investor protection: the ’33 Act applies in primary offerings, imposes essentially strict liability for material misstatements and omissions in public offering documents, and mandates gun-jumping and disclosure rules in public distributions of securities.13 The last-mentioned goals were aptly encapsulated by President Roosevelt in his message to Congress in 1933:

There is… an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public.14

The Securities Exchange Act, which was enacted a year after the ’33 Act for various political reasons,15 differs in some respects. The ’34 Act’s solicitude is disclosure through periodic reporting by registered and reporting companies and, ultimately, market efficiency accompanied by an antifraud liability (i.e., not strict liability) regime.16

Modern firms have been slowly moving away from public markets and, hence, the core Securities Act provisions. For instance, public markets were once dominated by initial public offerings (“IPOs”) viewed as a rite of passage and a token of corporate prestige.17 Today, many firms stay private longer and raise capital through exemptions from the registration provisions of the Securities Act.18 Other mechanisms such as reverse mergers were also tried, often by foreign firms, as a way to go public in the U.S.19 In 2020-2021, special purpose acquisition companies (“SPACs”) garnered headlines for the same reason.20

All of these techniques have something in common. For one, investors receive less information about issuers compared with the disclosures in IPOs. In IPOs, firms file Form S-121 that provides a comprehensive overview of the companies, their management teams, and financials. Second, issuers going public have to exercise caution in wording their disclosures lest they face strict liability under the Securities Act for material misstatements and omissions in registration statements.22 As sellers of securities, they also may be subject to liability for material misrepresentations and omissions in prospectuses under the standard that is essentially similar to negligence.23 In addition, there is the risk of fraud liability under Securities Act Section 17 and Exchange Act Section 10(b) and Rule 10b-5.24 This expected liability and limited safe harbors25 force the offerings’ “wordsmiths” to tread carefully.26 The byproduct of this edifice is higher costs of registered public offerings.

Third, despite this disclosure and liability regime, IPO market prices are not fully efficient and informative.27 Issuers typically engage reputational intermediaries such as investment banks28 to assist with offerings and provide some assurance to the market that the securities should be valued at least at the offering price. Despite the well-founded doubts concerning the accuracy of underwriters’ valuations and incentives, as well as underpricing,29 the market has traditionally regarded investment bankers as gatekeepers and reputational intermediaries.30

These features of public offerings are absent in other scenarios that do not follow this rite of passage under the Securities Act. Reverse mergers of 2007-2010, for instance, did not provide much information to investors, did not have adequate reputational intermediaries, and proved exceptionally risky, which prompted rule changes by securities exchanges.31 SPACs, which exhibit trends similar to those in reverse mergers, also pose risks, do not provide IPO-like disclosures, and tend to underperform public offerings. 32 Investors in SPACs essentially sign a blank check that signifies their trust in the reputation and acumen of the promoters of SPACs.

The third relevant phenomenon is private placements where information asymmetry is probably even wider and risks greater. These placements will be the main topic of our discussion. Not only scholars but also the SEC itself, even though it has designed and recently expanded the private placement exemptions,33 understand that these placements may be fraught with danger, particularly for smaller institutions and retail investors.34 We may argue whether the exemptions from the Securities Act are net-beneficial per se, whether they expose investors to unnecessary risks, or if the exemptions provide issuers with cost-effective means of raising capital and are thus valuable. Indeed, the SEC announced in June 2021 that it would review private placements in light of these concerns.35 The fact of the matter is that investors in private placements are exposed to greater risks, asset variability, and adverse selection (unless investors can negotiate for more disclosure from issuers) than investors in registered public offerings.36

Disclosure under the most popular private exemption, Regulation D,37 is essentially voluntary when all participating purchasers are accredited, which they often are.38 If there is less issuer information than in registered offerings, it is harder for the market to ensure that security prices are informative, particularly when securities are illiquid and trading thin and inefficient, as is the case with restricted, privately placed securities.39 In addition, private placements are not subject to the full scope of the Securities Act liability regime.40

Despite these risks, reduced liability under the Securities Act, and possible adverse selection, private placements have become the norm in the capital-raising arena.41 The next Part demonstrates that the major trends in digital-asset offerings do not differ from those in legacy capital markets—crypto-firms increasingly raise capital through private placements. The main distinction is that in crypto-markets this trend may be explained, at least in part, by SEC enforcement. Let us now review how this has happened in crypto.

C. The Three Years of SEC Enforcement and Issuer Filings

Digital assets exist on the border with or outside the perimeter of legacy capital markets and institutions and embody a sizeable aspect of the fintech revolution.42 These novel instruments create unprecedented opportunities for entrepreneurs and enable them to raise capital at low cost.43 They also offer numerous financial services and attract not only persons seeking new ways to invest but also those who use cryptoassets to obtain access to goods and services. Despite the surrounding controversies, opaque asset quality, and crypto-market volatility,44 digital assets may evolve into a fundamental pillar of future finance.45

Many countries have already acknowledged this potential of digital assets and either brought them within the ambit of securities and commodities regulation or developed targeted rules on crypto. 46 The recent successful examples are the European Union’s MiCAR47 and Switzerland’s law on digital-asset securities (also “security tokens”).48 European companies have already availed themselves of these new cost-effective opportunities.49

In contrast to Europe, the United States has yet to provide a regulation tailored to crypto-markets.50 Instead, its main financial market regulators rely on and enforce the existing pre-crypto securities and commodity regulations.51 The SEC in particular has been a remarkable national and international leader in terms of the magnitude and scope of its crypto-enforcement.52 Since mid-2017, the SEC has been essentially regulating digital-asset markets via enforcement.53

This Section suggests that there may be a temporal nexus between extensive crypto-enforcement by the SEC and an increase in cryptoasset offerings under the exemptions from the Securities Act. This connection indicates that the SEC may have nudged cryptoasset developers toward compliance with the exemptions.54 As discussed further in this Article, in doing so, the SEC has not fully taken into account the differences in the nature of either the persons who purchase cryptoassets or the assets per se.

The SEC’s enforcement efforts were massive and conducted on a global scale.55 In The SEC and Game Theory56 and in Global Crypto-Enforcement,57 my co-authors and I researched all crypto-related actions brought by the SEC between mid-2017 and the end of December 2020, as well as foreign enforcement.

The SEC undeniably was a global champion.58 It did not lose a single case against crypto-firms, and most enforcement actions resulted in settlements, demonstrating the strength of the Commission vis-a-vis individual crypto-defendants and respondents.59 The SEC targeted domestic and foreign crypto-issuers and market actors such as exchanges and other gatekeepers. The penalties and disgorgement awards that the SEC obtained in court and in administrative proceedings were considerable.60

The enforcement actions followed two general trends: prosecuting bad actors and enforcing the registration provisions of the Securities Act (and the Exchange Act in cases involving broker-dealers and unregistered exchanges). In the first subgroup, the SEC initiated actions against malevolent, fraudulent parties. In a typical case, defendant engaged in an initial coin offering (“ICO”) to raise capital and misrepresented the future possibilities (and/or omitted specific contractual details) of its crypto-project.61 In 41 out of the 87 cases in the database, the charges involved the antifraud provisions of the Exchange Act and the Securities Act.62 Fraud generates real economic costs, and these enforcement actions were indubitably justified by the need to curb the animal spirits of predatory innovators.

Yet, as many as 24 cases, i.e., more than a quarter, concerned primarily registration violations under the Securities Act, namely Section 5.63 In those cases, non-fraudulent issuers and other parties sought capital for various cryptoasset projects (or assisted with asset trading). The total civil penalties and disgorgement in those cases reached approximately $1.4 billion.64

In the Section 5 crypto-actions, the SEC habitually emphasized that because the cryptoasset issuers did not follow the Securities Act’s registration requirements, investors were deprived of material information (i.e., the information that a reasonable investor would likely view as significant and altering the total mix of available information)65 that would have enabled them to make informed decisions.

Recall that the SEC’s mission and, consequently, enforcement are built on investor protection and disclosure. Indeed, it is commonly assumed that the SEC tends to overemphasize consumer protection and harm prevention.66 True to form, SEC Staff reiterated these objectives in digital-asset cases.67 In the application for a temporary restraining order against Telegram, for instance, the SEC underscored that because the issuer did not register the offering, investors were deprived of material information.68 The complaint filed against Ripple Labs in December 2020 also suggested that “[b]ecause Ripple never filed a registration statement, it never provided investors with the material information…,”69 and that “[r]egistration statements relating to an offering of securities… provide public investors with material information about the issuer and the offering….”70

The global cryptoasset market, however, did not seem to either agree with this assumption or appreciate that last-mentioned aspect of the SEC’s regulation via enforcement. In National Crypto-Enforcement and International Consequences, my co-authors and I run event studies around the dates of enforcement actions using a sample of 2800 cryptocurrencies.71 Our preliminary findings indicate that the cumulative abnormal returns were negative starting around mid-2019. This is precisely when the SEC turned its attention to the violations of the registration provisions of the Securities Act.

Before 2019, there were only eight cases brought solely under Section 5 of the Securities Act, and three out of those cases concerned not developers-issuers but unregistered broker-dealers and an investment fund. By contrast, after mid-2019, there were as many as 16 cases under Section 5, and the issuers of cryptoassets were targeted in 14 of them. In short, National Crypto-Enforcement and International Consequences suggests that early SEC antifraud enforcement in digital-asset offerings was a welcome intervention, whereas the actions focused mainly on Securities Act registration and disclosure violations had a negative effect on cryptocurrency prices.

Based on these three studies, one should not be surprised that crypto-issuers have responded with some form of compliance, have relocated (or threatened to move) to other countries72 with more accommodating regimes in pursuit of regulatory certainty and arbitrage profits,73 geofenced U.S. markets and investors,74 or discontinued their projects.75 The following analysis centers on the firms that stayed in the U.S. and illustrates a temporal nexus between enforcement and attempted issuer compliance, namely, light-touch compliance with Regulation D.

To establish how crypto-issuers changed their behavior following SEC enforcement, I searched the following SEC forms:

• D (the short form filed after private placements pursuant to Regulation D),76

• 1-A (the comparatively detailed form filed before Regulation A offerings, which I refer to as “mini-public” offerings),77

• F-1 (the form used by foreign private issuers registering securities under the Securities Act),78

• S-1 (the document filed mainly in IPOs and in public offerings by smaller firms),79

• and S-3 (the form used mainly in seasoned offerings by larger reporting issuers registering securities under the Securities Act).80

The timeframe of the research covers the period from January 2017 through July 2021. The following search terms were used: cryptocurrency, initial coin offering, coin, security token, digital asset, token, and SAFT (“Simple Agreement for Future Tokens”). My research assistants and I searched EDGAR and Bloomberg Law’s EDGAR database. Our primary objective was to identify firms that solicited capital from investors. For this reason, we excluded all funds and pooled investment vehicles from the results.

The search generated 338 results, including forms filed for:

1) cryptoassets labelled “coins” and “tokens,”

2) investment contracts under SAFTs or similar agreements which gave investors the right to receive tokens at a later date, and

3) “conventional” securities such as common or preferred shares of stock in tokenized form, as well as securities convertible into security tokens at a later date.

Since this analysis focuses on cryptoasset offerings and present and future right to receive cryptoassets, I excluded the third category (i.e., tokenized “conventional” securities) from the data. A list of the most important offerings of “conventional” securities is included in Part D. Overall, the total number of forms in the final dataset was 275. To ensure consistency, I reviewed all forms, prospectuses, and offering circulars in the dataset.

An additional factor to consider was that the technology and its applications were evolving, and some developers had already changed their underlying projects in a way that might ward off regulatory scrutiny. “Yield farming” was an important example.81 Yield farming allows decentralized finance projects increase their popularity, liquidity, and user base through offering cryptoasset-holders some form of return on their “deposits.”82 These emerging practices have yet to encounter formal interactions with the SEC. To the extent that they ever did (or would), their developers would file one of the forms required by the SEC, which should be captured by my research methodology.

Table 1 summarizes the data on all filings. The data exhibit a significant increase in Form D filings and several (mostly unsuccessful)83 attempts at registering securities with the SEC, as well as Regulation A offerings. In 2019, crypto-placements slowed down, which coincided with the general decrease in ICOs and other token offerings after the initial boom.

Table 1: Summary: Total Filings

How were these filings associated with the SEC’s crypto-enforcement policies? There were two crucial events that link the filings to SEC enforcement. The first was July 25, 2017, the date of the Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, commonly known as the “DAO Report.”84 In the DAO Report, the SEC communicated for the first time that digital assets could be securities and that this question should be examined under the 1946 Howey test.85 The Supreme Court Howey test is exceptionally capacious and sweeps in multiple financial instruments, including many cryptoassets.86

Another important benchmark was the Munchee order.87 In Munchee, the SEC issued a cease-and-desist order against Munchee, Inc., a crypto-issuer. Although the SEC did not impose a civil penalty on the firm, the issuer returned the $15,000,000 it had raised to the investors, which de facto shut down the project.

As demonstrated below, the DAO Report and Munchee were potent policy signals concerning the future trajectory of enforcement. These signals were supported by the rising enforcement intensity at the end of 2017. Figure 1 measures this enforcement intensity by using the proxy of the average civil penalties, disgorgement orders, and prejudgment interest, as well as settlements where issuers agreed to pay rescissory damages and return funds to investors. For simplicity, I refer to these payments as the “losses” of defendants and respondents. Figure 1 breaks down enforcement intensity by quarter and indicates that the average enforcement “losses” increased sharply in the last quarter of 2017.

Fig. 1: Enforcement “Losses” by Quarter

Although the largest increase in “losses” falls on 2020, a careful reading of the 2020 enforcement actions in the database indicates that those cases mostly concerned the violations that allegedly occurred in 2017-2019 or earlier. Self-evidently, there should be a positive amount of time between defendants’ and respondents’ actions and SEC enforcement.

Table 2 presents another summary of all enforcement actions initiated by the SEC between mid-2017 and December 2020 and contrasts it with the annual numbers of actions.88 The Table excludes the Telegram case, which was an outlier that produced a record-high $1.2 billion disgorgement award and a significant fine.89

The actions in Figure 1 and Table 2 cover not only ICO issuers but also the whole cryptocurrency ecosystem, including trading and offerings. The defendants and respondents were crypto-issuers, crypto-exchanges facilitating trading in tokens and coins, broker-dealers assisting with placements and trading, a rating agency, several funds investing in crypto and selling securities to investors, promoters of crypto-offerings, and three crypto-related firms that engaged in cryptocurrency-related businesses and Ponzi schemes.

Table 2: SEC Actions and Average “Losses” (Penalties and Disgorgement)90

Table 2 makes clear that the average “losses,” including penalties, disgorgement, undertakings to pay rescissory damages, and other undertakings usually agreed upon in settlement orders, rose considerably in 2019-2020. Nevertheless, the first spike, which was the possible trigger for issuer compliance and filings in 2018, was in 2017.

The overall increase in enforcement activity starting in the last quarter of 2017 preceded the rising trend in filings under Regulation D, viz., an exemption from the registration regime of the Securities Act. Table 3 shows the average numbers and the changes in Form D filings from 2017 through 2020. There was a clear spike in the first half of 2018, which followed Munchee. During this period, the average number of filings increased 3.0 times the average for the whole sample and 2.1 standard deviations from the mean.

Table 3: Form D Filing Trends

Figure 2 more demonstrably illustrates this trend.

Fig. 2: Form D Filings

It is possible that in the hot crypto-offerings market issuers preferred to “hide” from the SEC in the light-touch regime of Regulation D. Even though the doctrinal questions about whether cryptoasset were securities and whether the SEC had jurisdiction remained unsettled,91 the market opted to preemptively comply with securities law through exemptions instead of having to face off with the Commission.

Figure 3 not only substantiates this point but also shows that crypto-issuers were reluctant to pursue public offerings (Form S-1 and Form F-1 filings), as well as “mini-public” offerings under Regulation A (Form 1-A filings). Moreover, there were only one registration statement on Form F-1 which was declared effective by the SEC and three offering statements successfully qualified under Regulation A. Forms 1-A for offerings involving tokenized conventional securities have been excluded from this chart and will be discussed in Part D.

Fig. 3: Filing Trends and Successful Offerings on Forms 1-A and F-1

Clearly, private placements have dominated the capital-raising landscape in crypto92—issuers have preferred private placements under various exemptions from the registration provisions of the Securities Act. There also seems to be a temporal nexus between this increase in private placements and the intensity of SEC crypto-enforcement.

Placing these two trends in juxtaposition to each other suggests that, since in private placements a significant part of the informational value added of the Securities Act is lost,93 this status quo should be inherently at odds with the stated regulatory goals of the Commission. In fact, on several occasions the Commission reiterated that cryptoassets and their sales were risky.94 Presumably, this means that the SEC must strive to promote a fair market providing more rather than less information to investors in cryptoassets. What happened? The next Part inquires whether the SEC could have anticipated (and prevented) this denouement.

D. A Predictable Conclusion or Why Crypto-Issuers Avoid Public Offerings

1. A Simple Predictive Analysis

It is reasonable to assume that something within the sizeable polychromatic bureaucracy of the SEC triggered the law of unintended consequences—a concept not formalized in legal doctrine but developed by economists, including Adam Smith and Friedrich Hayek.95 Regulators, naturally, possess imperfect knowledge of the welfare implications of their policies.96 And yet, the shift toward private placements should have been foreseeable. That is, it could not have been a black (or even grey) swan if someone applied simple cost-benefit analysis97 and backward induction, i.e., backward reasoning anticipating the possible range of outcomes of the original moves and choosing the best course of action accordingly.98

To predict the moves of market participants, the SEC could consider the participants’ expected payoffs and incentives within the framework of the available regulatory options and their enforcement. Game theory (particularly its evolutionary branch) demonstrates how law shapes our expectations, actions, and choices.99 For example, as rational market participants, firms should pursue the outcomes that generate better payoffs over those with lower payoffs.100 Logically, firms would compare their expected payoffs under the available regulatory alternatives.101 All issuers may choose between the following compliance routes: seeking financing through a public offering and registering securities with the SEC or relying on various exemptions under the Securities Act.102 In the latter case, issuers may seek capital from wealthy investors and venture capital firms103 and/or resort to exemptions from registration, such as Regulations D104 or A.105

2. The Costs and Risks of Registered Crypto-Offerings

As we have seen in the previous Part, registered crypto-offerings are a road almost never taken. A few crypto-issuers filed Forms S-1, and some thereafter withdrew them more than a year later. Only one foreign firm successfully issued digital-asset securities and filed Form F-1 in the four-year period. Often, crypto-issuers that became registered and reporting companies per the terms of their settlement agreements with the SEC did not follow up with Securities Act registration statements. Instead, they filed the simplified Exchange Act Form 10.106

Table 4: Forms S-1 and F-1 (January 2017-July 2021)107

Issuers understand that when engaged in a public distribution of securities they would face multiple costs ranging from drafting, marketing, and approving offering documents by the SEC to resource allocation, the opportunity cost of time, and expected litigation costs. Digital-asset markets reduce some of these costs: crypto-offerings are disintermediated;108 the suppliers of innovations are no longer traditional financial intermediaries109 but smaller developers seeking decentralized access to investors and lower transaction costs; smart contracts110 deliver digital assets to investors’ wallets, obviating the need for transactional intermediaries; and the role of an investment banker changes. In a more democratized capital raise, global marketing and social media events111 do not need investment bankers set up roadshows with their clientele.112

One major regulatory obstacle, however, is the opportunity cost of time. The SEC itself acknowledges that “[a] lengthy waiting period prior to a registered offering combined with a potentially uncertain registration process are particular concerns for smaller issuers contemplating a registered public offering….”113 Many crypto-issuers are indeed smaller firms. More importantly, the nature of cryptoassets further increases firms’ opportunity costs of time and relevant risks.

Open-source platforms and software allow modifications and inspection by the user community, while code disclosure through repositories such as GitHub is common.114 As markets reward issuers that disclose their code,115 the entrepreneurs have an incentive to be transparent. Technological development, however, is fast-moving and interdependent. This contraposition of publicity with the speed of innovations and technological interdependency suggests that a specific technology may become obsolete quickly, that hackers may learn about the weaknesses in the code and exploit them,116 and that developers’ competitive advantages may be eroded rapidly.117

Developers are thus faced with the problem of infinite appropriability which does not allow them to extract monopoly rents from technologies.118 These considerations should reinforce the need to raise capital quickly to stay ahead of the curve and to use the capital to accelerate the pace of innovations ad infinitum.119

A typical timeline in a public offering, however, is comparatively long because the SEC Division of Corporation Finance routinely provides comments to issuers120 before the SEC declares a registration statement effective.121 While the SEC may not examine closely statements of every seasoned issuer, it does tend to review registration statements filed in the course of IPOs. In this sense, cryptoasset offerings may be just like IPOs closely scrutinized by the SEC.

After the offering, the issuer as well as its directors and officers, among other parties, would face the enhanced liability for material misstatements and omissions in the registration statement and prospectus under the Securities Act.122 In technology-related offerings, this liability regime presents additional risks. When lawyers for a cryptoasset issuer describe the code, unintentional “slippage” between the code and the descriptions may trickle down into offering documents.123

Securities law also mandates that issuers provide an accurate, complete, and comprehensible “plain English” depiction of their projects, businesses, and risks to investors.124 There are even a twenty-year-old Handbook on plain English disclosure and a separate government initiative.125 Translating a novel code into plain English may pose serious challenges to innovators and exacerbate the risk of inaccuracies. When this happens, the issuer becomes exposed to liability under the Securities Act.126

This risk is greater if developers, regardless of how well-intentioned and diligent they are, misunderstand the multifaceted objective realities of a complex project and/or miss bugs in the code.127 Moreover, as cryptoasset prices often are inordinately volatile, downward price movements, whether or not associated with issuer’s underperformance and reckless representations, may trigger class actions.128

One may argue that firms whose securities are publicly traded, as well as firms offering securities, must internalize these costs. The raison d’etre for the disclosure and securities liability regimes is that the issuer is considered a low-cost information provider that can supply investors with valuable private information129 and should be prevented from generating negative externalities (and passing them onto investors) by virtue of inadequate disclosure.130

In crypto, however, the main information is already disclosed without interjecting the requirements of the Securities Act. Namely, the community can review the main assets of issuers, i.e., their code, before making investment decisions. As mentioned above, technology ensures information transparency and immutability; the code is often open source and publicly released beforehand; smart contracts are designed to be self-executable; and applications and organizations built on blockchain131 aim to be decentralized and autonomous.132

There are also crypto-gatekeepers that offer open-source protocols for token issuance, advisory services, and audits.133 Zeppelin, providing audits of smart contracts, system architecture, and codebase,134 is an apposite example. Ethereum Foundation suggests multiple sources assisting in application development, debugging, and testing of smart contracts, as well as actual issuance.135 Through repositories such as GitHub, experts and market participants can review the code and assist firms and investors with assessing the code, testing, debugging, and improving code quality. Community members and researchers review codes, red-flag bugs, and detect vulnerabilities.136 In addition, predictive market mechanisms are currently being developed.137 The crypto-community is thus an important self-monitoring organism that aggregates and processes raw data (i.e., the code) for the benefit of all market participants, including investors and issuers.

These realities suggest that the firm is not the sole information intermediary through which market participants access the data to evaluate the project and the issuer.138 Conventional brick-and-mortar companies never provided similar access to their assets. This novel environment may also explain why the whitepapers (i.e., offering documents) circulated as part of ICOs were full of aspirational statements and soft information.139 It is possible that the crypto-market expected that issuer information might be incomplete in some material respects and should be supplemented by running independent code analysis.

This diminished role of issuers vis-a-vis the code and data analysis is not unique to crypto. Professor Henry Hu, for instance, developed a “pure information” model140 for other complex data-driven financial instruments. In his model, the issuer that has furnished information to investors is the traditional information “intermediary.” The issuer “digests” the information for investors and presents its own view of reality through the limited depiction tools of conventional disclosure regulations within the confines of the plain English reporting.141 In contrast to this orthodox model, in a “pure information” environment, the issuer is no longer the arch conduit for information because “the investor may… be able to see for himself, to download the objective reality in its full, gigabyte richness.”142 Professor Hu’s post-financial-crisis analysis of information disintermediation is also applicable to distributed ledger technology and crypto.

3. Regulation A Offerings

As this analysis suggests, crypto-issuers understandably give a wide berth to public offerings. Similar arguments may bear down on Regulation A (“mini-public”) offerings. Congress designed this regime to help issuers economize on the costs of IPOs and seasoned public offerings. Although not particularly appealing at first, Regulation A has grown in popularity over the years.143 The Regulation offers Tiers 1 and 2 with different regulatory requirements and capital limits144 that have made Tier 2 offerings more popular than Tier 1.145

Similar to registered offerings, Regulation A is accompanied by a heightened liability risk. Although Securities Act Section 11 is not applicable, Securities Act Section 12(a)(2) and Section 17 apply, and, naturally, so do Exchange Act Section 10(b) and Rule 10b-5.146 In addition, Regulation A eligible securities are conventional equity and debt, as well as convertible securities.147 Cryptoasset classifications, however, are infinitely diverse and evolving.148 Consequently, either only the crypto-firms whose digital assets can be easily analogized with conventional securities would be able to avail themselves of this regime, or the firms would need to spend resources on drafting comparisons that might be plainly unnecessary from the perspective of crypto-investors.149

The next and more serious problem is the cost of time. The sweeping reforms of 2020 may mitigate this concern through the new mechanisms such as testing the waters and gauging market interest ahead of raising capital.150 These new provisions should be uniquely beneficial to future developers in the fast-changing world of technology.151 Yet, in practice, the SEC has been very slow in qualifying crypto-offerings.

The timeline in Regulation A digital-asset offerings has been anything but short. To give a few examples, in the spring of 2019, practitioners complained that first Forms 1-A were filed as early as 2017;152 that the SEC did not qualify a single offering statement;153 and that when the Commission did approve one offering after an extensive review, that issuer had to eviscerate the offering documents by replacing the references to tokens with customary “preferred stock.”154

It is possible that the SEC struggled with a steep learning curve in fintech and crypto. It is equally plausible that the SEC Staff approached untested, novel, and volatile digital assets carefully. While gaining experience, the Staff channeled digital-asset issuers toward more familiar equity securities.155

By July 2019, this threshold was crossed, and the Commission qualified in rapid succession the first and second Regulation A digital-asset offerings.156 Even these successful registrants, however, had to wait for about nine months before the SEC gave the green light to their token offerings.157

While it is understandable why the regulator has proceeded with caution in qualifying offerings of innovative products, these timing concerns imply that issuers must first gain access to interim bridge financing. Indeed, the first two Regulation A crypto-issuers had raised capital through private placements and had been backed by institutional investors and venture capital firms.158 Without capital, crypto-issuers may lose their competitive advantages in the open world of technology.

The following Table summarizes Regulation A crypto-offerings and shows how rare and time-consuming successful filings have been.

Table 5: Form 1-A Filings (January 2017-July 2021)

For comparison, several companies that filed Forms 1-A for offerings of conventional securities in tokenized form were also rarely successful.

Table 6: Form 1-A Filings for Tokenized Stock (January 2017-July 2021)

4. Ongoing Reporting Obligations

4.1. Liability and Reporting

In addition to the expected costs of time, drafting, marketing, liability, and regulatory approvals, the other outlays would stem from compliance with the ongoing reporting obligations under the Exchange Act. The Exchange Act reporting obligations apply to issuers that have conducted public offerings and, on a smaller scale, to Tier 2 Regulation A issuers.159

Just like in the above-discussed primary-offering scenarios, data-driven issuers may find it “difficult to capture [in periodic reports] a highly complex objective reality with very rudimentary English Language and accounting, visual, and other tools on which depictions must primarily rely.”160 These difficulties transform into higher costs of drafting reports—a particularly thorny issue in financial innovations since some reporting regulations date from the 1970s-1980s161 when digital assets were science fiction.

The limitations of (possibly) outdated plain-English disclosure as applied to complex financial products suggest that ambiguities and inaccuracies are almost invariably bound to be incorporated in issuer reports. Similar to the risks in registration statements, the discrepancies between the code and the language of reports would expose innovators to a heightened risk of securities class action litigation and SEC enforcement.162

The main plaintiff’s tool under the Exchange Act is Section 10(b) and Rule 10b-5, i.e., the antifraud regime. Since the ’34 Act does not have the same strict liability provisions as does the Securities Act, the liability risk for the “slippage” between the code and the reports should be lower. For example, the antifraud provisions of securities law have heightened pleading requirements, including factual specificity and pleading scienter with particularity (a well-developed topic that is beyond the scope of this paper).163 Nevertheless, there is always a nonzero probability of investor class actions (or SEC enforcement).

The expected problems with the Exchange Act periodic disclosure would not end there. Recall that the Exchange Act centers on disclosure and market efficiency, which are impacted by the accuracy and informativeness of issuer reports. Scholars have questioned how effective U.S. reporting regulation is in application to complex financial innovations.164 The rules are not easily amenable to adaptation,165 rely heavily on prescriptive line-item reporting,166 and may produce either overcomplicated or over-simplified disclosures167 of low utility. In the end, both the issuers and the market consuming issuer information may struggle with unsuitable disclosures, get lost in the “information thicket”168 of too much data, and find it challenging to present and to process reports.

The data presentation and processing obstacles of the overly-prescriptive rules may manifest in behavioral biases such as the Heisenberg effect, a well-known phenomenon describing situations where measurements impact the systems being measured.169 Just as we develop theories and measurements that, in turn, impact our behavior,170 SEC-prescribed specific line items “heavily influence what data fields market participants actually use in their decision making.” 171 Insofar as market participants are not impartial bystanders but willing participants in a market, they are operating within it while simultaneously trying to understand the underlying rules and play by them.172 In doing so, they are guided not only by the knowledge of regulations but also by individual biases and perception of risk.

A cautious crypto-issuer seeking to comply with a prescriptive obligation might follow the rule to a tee, even when it was substantively obsolescent or even irrelevant. The pressure of such periodic reporting obligations would weigh on the firm’s management and, as research suggests, enervate the velocity of innovation.173 The issuer would innovate less and spend more on compliance, possibly above the level that was efficient and socially optimal, i.e., when an efficient information output occurs at the intersection of marginal costs and benefits.

4.2. Decentralization and Reporting Obligations

The SEC, to its credit, is consistently striving to keep up with the market and valences of risk by amending the issuer disclosure obligations under Regulation S-K.174 In relevant parts, the reforms recognize the imperative to modernize reporting according to the realities of new businesses and the technology-based economy.175

However, the rules have yet to acknowledge an important quality of digital assets—there are circumstances where issuers do not control their cryptoassets, including asset circulation, pricing, and, ultimately, investors’ return after a platform launch and asset delivery.176 All the while, the issuers would be subject to disclosure obligations.

By way of example, in the two major cases of 2020, Telegram and Kik,177 defendants raised capital, promised to distribute future cryptoassets to investors, and claimed that the cryptoassets’ pricing, circulation, and valuation would be independent of the issuers and that platforms would be decentralized.178 If such autonomy, independence, and decentralization became reality, the securities sold by the issuers to investors to raise capital for their projects could expire, whereas the distributed cryptoassets would survive.179 The cryptoassets would be akin to commodities with prices determined by market forces, encoded formulas, and other independent mechanisms.180 Ether is an apropos illustration: it started off as a financial instrument used for raising capital for Ethereum and its ecosystem and is now deemed a cryptocurrency and commodity.181

In these cases, the original crypto-issuer would lack material nonpublic information that might secure its economic advantage over the rest of the market. Cryptoasset developers may be perplexed (perhaps genuinely) about the very purpose of mandatory periodic reporting. Telegram, for instance, seemed puzzled as to why the future holders of the native tokens of Telegram’s blockchain would need issuer reports after the launch of the open-source decentralized public blockchain. 182

Provided markets were efficient, 183 the issuer without material inside information would be unable to move the needle on asset prices. Simultaneously, issuer reports would not make secondary market trading more informative or supply investors with valuable information. Reporting obligations in these cases would embody a pure social cost until the issuer could terminate or suspend its reporting obligations.

The current rules by their very design cannot capture the moment when a security ceases to exist, and a commodity emerges in the manner described above. The regulations concerning reporting obligations have been developed for traditional companies and presume the need for a nonzero amount of time between the offering and the termination or suspension of issuer reporting obligations. 184 The purpose is to ensure that securities are not traded in an information-less market, because it is the issuer who is the presumptive source and lowest-cost provider of material information to the market.

Self-evidently, whenever crypto-projects are not sufficiently decentralized and independent for the initial securities to “expire,” crypto-issuers’ compliance and reporting costs remain analogous to those of conventional firms. There is, however, one exception—a typical crypto-issuer would anticipate that its project at some point would become decentralized once the work was completed. As a result, its reporting and corporate governance costs would be modified (and possibly increased) by the need to continuously examine whether the assets were sufficiently decentralized and whether it was safe to terminate the reporting obligations without risking SEC enforcement and/or securities class actions.

Consider a pertinent example: Blockstack, the first Regulation A crypto-issuer, included in its offering circular a paragraph stating that it would engage in an ongoing determination process as to whether its tokens were securities.185 Its 2020 Annual Report pursuant to Regulation A reiterated that “[t]he board of directors… will be responsible for regularly considering and… determining whether the Stacks Tokens no longer constitute securities issued by us under the… securities laws….”186

Periodic reporting thus effectively necessitates that issuers’ boards of directors regularly examine whether the underlying cryptoassets remain securities. Accountants and auditors need to ponder how to reclassify the firms’ cryptoassets on the balance sheet and how to record transactions on the cash flow statement. Simultaneously, the firms’ counsel have to verify the level of asset and platform decentralization while grappling with the uncertainties as to what is a security, which is not defined through a formal rule or guidance on crypto but on the bases of the functional and all-embracing “investment contract” test developed by the Supreme Court in Howey in 1946.187

Boards and attorneys would undertake these inquiries with an implicit understanding that should they make a mistake, the SEC’s interpretation of securities law would not be easily challenged in court.188 Only after making these complex determinations would the issuer look to the current rules on suspension and termination of reporting obligations. In short, the costs of public and Regulation A offerings, the resultant liability regime, and the reporting obligations are considerable.

5. The Inherent Uncertainty of Benefits

And what about offsetting benefits? A rational issuer would attempt to balance its costs against the expected benefits of an offering. In this analysis, the benefits could be more uncertain and harder to quantify than the foregoing costs.189 Let us begin with an analysis of securities law liability. Companies pursuing public and “mini-public” offerings face liability under Securities Act Sections 11 (in registered offerings) and 12(a)(2). Both grant security-purchasers a cause of action for material misstatements and omissions in offering documents.190 The risk of fraud liability also lingers.

An issuer, however, should also consider that compliance may mitigate the risk of an SEC enforcement action for failure to register digital-asset securities under Securities Act Section 5 and lower the risk of liability under Securities Act Section 12(a)(1) for offering and selling securities in violation of Section 5.191 The issuer would try to measure and/or equipoise these two sets of liabilities, which is, admittedly, a complex assessment.

A recent series of actions against a major fintech firm, for instance, suggest that legitimate crypto-companies present a hard nut to crack for plaintiffs alleging fraud on the basis of statements describing digital assets and their utility.192 Specifically, in an October 2020 order on a second motion to dismiss,193 Judge Hamilton of the U.S. District Court for the Northern District of California pared down the plaintiffs’ complaint, dismissing many allegations of fraud.194 In that action, the defendants were less successful in their motions to dismiss the claims concerning unregistered securities offered and sold in violation of Section 5.195 From this and similar actions, an average crypto-firm may infer that the Securities Act exposes crypto-issuers to a serious liability risk.

The SEC’s follow-on action, filed on December 22, 2020, lends support to this panoramic assessment. In its complaint, the SEC did not even make any allegations of fraud but charged the defendants with offering and selling securities in violation of the registration provisions of the Securities Act.196 Consequently, compliance with the Securities Act’s registration provisions and exemptions may be, but only may be, net-beneficial from an individual issuer’s perspective. I do not want to draw conjectural generalizations because each inquiry is fact-specific, and because issuers can look to various exemptions from registration.197

The other purported advantages of registered and Regulation A offerings are rooted in the presumption that issuer disclosure is typically associated with lower agency costs and information asymmetry, cumulating into better access to public investors and a lower cost of capital.198 In crypto, this presumption has yet to be proven empirically. Dozens of articles on crypto-offerings examine mainly voluntary disclosure by crypto-issuers,199 meaning that the economic benefits of mandatory disclosure are not yet formally quantified. Some empiricists have even suggested that crypto-markets do not react positively to securities regulation and/or are not fully sensitive to its purported protections.200

Germane anecdotal evidence, albeit unreliable, is informative: One of the first Regulation A issuers, Blockstack, planned to raise up to $40,000,000 in its July 2019 Tier 2 Offering.201 Its first semiannual report showed, however, that the issuer had raised only $15.5 million.202 There, of course, could be temporary delays with Blockstack’s project,203 or other factors at play. We also lack a counterfactual. Would Blockstack have raised more capital had it structured its offering abroad in a crypto-friendly jurisdiction or under Regulation D? Would Blockstack have raised more capital if it had done an IPO, because Regulation A had long been deemed an ugly distant cousin of public offerings?204 Was it about the first-mover disadvantage?

It is easy to engage in a simulation heuristic in this and similar cases. Instead, we need (and lack) reliable data on registered and Regulation A crypto-offerings and their effect on the amount of raised capital, the cost of capital, liquidity, and returns. For their part, crypto-issuers would be more willing to incur the costs associated with public offerings if they could determine the resultant net payoffs.

In addition to the lack of data, the other variable that interferes with this analysis is the pure-information environment of cryptoassets. If the maxim of a market is that investors have access to the underlying publicly available data, then the market is less dependent on and in need of the SEC mandatory integrated disclosure system under the Securities Act and the Exchange Act.

If market participants expect that digital-asset issuers provide only a fraction of material information, the market should shift its focus to the variables observable outside of issuer reports and financial statements. To name a few examples, the value of cryptoassets may depend on the network effect, adoption by users, developer activity, network and product functionality, decentralization, listing and liquidity, scalability, and other factors, many of which are objective facts and public information accessible through alternative data feeds,205 and some of which may be outside issuers’ control.206

By contrast, disclosures within the control of issuers may be simply irrelevant. A pertinent example is corporate governance, communications between boards and equity-holders, proxy rules, and voting procedures.207 For instance, a promoter floating financial instruments giving access to a decentralized autonomous organization (“DAO”) or a decentralized finance application could envision that the code and the partnership-like community would replace legacy corporate governance arrangements and bylaws.208 This change not only raises corporate law questions but also requires reporting adjustments.

The old accounting and financial statement rules may also be off the mark. Digital-asset startups (and even more mature crypto-companies) may not have voluminous historical financial information to share with investors. Their assets are their code, talent, network, and reputation. The source code underlying cryptoassets is an intangible asset, whose valuation is always opaque. Cryptoassets depend on relevant security protocols ensuring long-term asset safety and operation, the future use of the assets and/or platform, the network effect, the replication of the technology by competitors, secondary market trading, the quality of pre-launch audit, and other factors.209 Accounting tools and generally accepted accounting principles have not been designed with these factors and analyses in mind, which may lead to information losses from this adaptive incongruence, require coordination between accountants and tech experts, and make conventional issuer disclosure less relevant to investors. Even the SEC acknowledges that some disclosure rules date “back to a time when companies relied significantly on plant, property, and equipment to drive value.”210

Another example of irrelevance is the rules on securities description. Recall that these rules require that unusual financial instruments be described in a manner “comparable” to the well-known species such as debt and equity.211 For one, the diverse and evolving array of cryptoassets may not be easily analogized with traditional securities.212 Even if issuers can draft comparable descriptions, these statements may not produce tangible benefits in the market where crypto-investors are risk-takers, tech-enthusiasts, professionals, and expert institutions.213 Furthermore, crypto-investors may be interested in the brand-new financial instruments precisely because they are not traditional bonds and equity, help to diversify away the risks associated with the legacy capital markets, and/or allow for speculation. It is important to first determine who the investors are before assuming that they need a generic level of protection designed for an average conventional investor.

A caveat is in order: this is not to say that all mandatory disclosure has no place in crypto-markets. An apropos example is the amended rules expanding human capital reporting. In August 2020, the SEC supplemented the previous rules targeting primarily directors and officers214 with more principles-based guidelines.215 The 2020 amendments should enable investors to compare and contrast Item 101 (which is more principles-based and covers human capital resources) with Item 401 (which is more prescriptive and focuses on directors and executives). This approach should allow investors gain valuable insights into the issuers’ broader human capital policies and objectives, as well as unique circumstances and risk profiles.216

The role of human capital in crypto is indeed paramount and instantiates an intersection of the past and the future. It hearkens to the original SEC disclosure rules that assumed that investors were more interested in “the incentive structure facing the seller, typically a corporate promoter… than… the characteristics of the company being floated.”217 In the same vein, today’s crypto-investors put considerable store in the reputation of the promoter’s team and care about their incentives.218 The reason is that the ultimate projects are innovative and often unpredictable, and their success depends entirely on the abilities and adequate incentives of the developers.219 To the extent that mandatory standardized disclosure reduces the costs of searching, comparing, and verifying the information about issuers, it should generate efficiencies.220

It is important to understand, however, that not all regulations are relevant to crypto-entrepreneurs and crypto-investors, and that issuer compliance with the Securities Act registration and the Exchange Act reporting rules and, consequently, their enforcement may fail to generate investor benefits comparable to those in legacy markets. When investors do not realize the full benefits from mandatory disclosure, they may be less likely to reward issuers for compliance. This shortage of investor benefits and issuer payoffs catalyzes a feedback loop dampening crypto-firms’ incentives to pursue costly public (or “mini-public”) offerings. On balance, it is not surprising that cryptoasset issuers should prefer private placements. This outcome is ex ante foreseeable and results from the current structure of securities law.

E. Issuers’ Preferences: Private Placements

If crypto-issuers surmise that the payoffs from public offerings are negative more often than not, they will be driven away from public distributions toward alternatives such as private placements.221 Regulation D, the most popular exemption, reduces the costs of compliance and resolves, inter alia, the above-discussed timing and opportunity cost concerns. By way of example, there is no qualification or regulatory review of placement memoranda by the SEC, and an issuer merely files a very limited in substance Form D222 within 15 days after sale.223

On the disclosure side, issuers face an obligation to provide non-financial and specified financial information only to non-accredited investors who do not meet certain income, net worth, investment, and asset requirements.224 Even conventional issuers, however, rarely sell Regulation D securities to non-accredited investors.225 For digital-asset firms, this limited mandatory disclosure requirement should also be moot for the following reasons: Crypto-firms advertise their offerings broadly and through social media,226 which has been associated with better chances of offering completion, future employment, and higher asset liquidity.227 These mechanisms qualify as “general solicitation,” which means that only accredited investors can purchase such securities (that is, if the issuer wants to stay compliant with Regulation D).228

Central to issuers’ costs in private placements, therefore, is the definition of accredited investor and the requirement to verify that all purchasers are accredited.229 The verification process is complex and often necessitates the use of intermediaries.230 Mistakes are costly because the SEC has already initiated Regulation D enforcement actions related to verification errors by crypto-firms.231 Yet, Regulation D placements are not subject to the same liability provisions as registered offerings,232 and Regulation D still offers less expensive compliance options.

The 2020 reforms should make private placements even more appealing to crypto-firms. For example, the 2020 Final Release sent a policy signal emphasizing that verification of the investor status should be principles-based, and that the Regulation offered non-exclusive examples.233 Depending on the future implementation of this policy commitment, issuers may enjoy more control over their selected verification methods and, consequently, the costs of their offerings. To name a few other cost-reducing changes, the reforms add anti-integration rules,234 enable issuers to run concomitant offerings to investors in the U.S. and offshore,235 introduce “demo days,”236 and permit issuers to more broadly “test the waters” before determining an exemption for their actual offering.237

Although it is possible that the SEC under Chair Gensler will revisit some of these reforms,238 the current regime is favorable to innovative firms in such competitive and time-sensitive industries as fintech. Having a more cost-effective vehicle to promptly raise capital in the U.S. and abroad should profit developers seeking funding. Issuers now may gauge the future demand for their securities and, if the prospective demand is insufficient, swiftly pivot, modify their projects, and look to alternate sources of capital.

The SEC concatenated these supply-side reforms with the new rules expanding the definition of “accredited investor.”239 Having more prospective accredited purchasers, ceteris paribus, moves the demand curve, strengthens investor competition, and may increase the price investors are willing to pay for securities, 240 thus lowering the cost of capital for firms. In other words, these reforms should allow issuers to raise capital faster and tap larger cohorts of accredited investors. Note that these benefits will accrue to issuers without any additional disclosure obligations or expensive reporting and compliance. Logically, Regulation D should remain the favored exemption for crypto-firms.

F. The Fundamental Disconnect Between the Statutory Goals and Enforcement

1. Doubtful Investor Sophistication

As the preceding Section demonstrates, the current status quo rooted in private placements is the optimal and preferred option for crypto-issuers. But is it likewise profitable for crypto-investors, whose protection is the chief statutory objective of the Commission? For one thing, all markets axiomatically benefit from information,241 and a well-known downside of conventional privately placed securities is information asymmetry and illiquidity.242 Even though private placements give investors access to possibly high-growth, high-performance investment opportunities,243 this access is accompanied by risk.

Does the pure-information environment where crypto-investors have access to the code, i.e., the main asset of firms, override these problems? Not necessarily. Although highly informative, the pure-information model does not guarantee that investors do not need or rely on issuer information, only that material crypto-issuer disclosure may not fit within the rules prescribed by the Commission in registered offerings and that the code and other relevant data are often publicly available.

Even with blockchain transparency and code disclosure, investors in private crypto-placements must be sophisticated enough to understand which data an issuer has in its possession and possibly wishes to conceal, the nature of the projects, and which questions to ask to elicit disclosure when necessary.244 Only then can they appropriately negotiate for relevant offering terms245 and “fend for themselves,”246 meaning that the securities laws’ registration and reporting become unnecessary.

Unfortunately, it is questionable whether stereotypical Regulation D investors are sophisticated enough. Since the early days of private placements, “accredited investors” were supposed to be “persons [with the] financial sophistication and ability to sustain the risk of loss of investment or fend for themselves.”247 The ultimate proxies embedded in Regulation D, however, are limited to wealth, income, investments, and assets.248 These metrics do not necessarily translate into investor sophistication and capacity to make appropriate inquiries.249 Scholars observed over the years that wealth, for instance, was an imperfect yardstick for measuring sophistication.250

The added concern in digital-asset markets is not merely the financial sophistication of investors but the complexity of the market for technology and financial innovations.251 Various cohorts of crypto-investors may either lack the required technical knowledge to assess innovative projects or ignore the hard information—the code—disclosed by issuers.252 Even sophisticated hedge fund managers, such as Mark Cuban, may make mistakes and invest in floundering and unaudited projects.253

A commonplace scenario may be illustrated as follows: Take a sophisticated but not yet wealthy PhD student with almost no assets and low income. With her computer engineering degree, she would be well-qualified to assess the technology and source code. Alas, under the current regulation, the student would be cut off from participating in many digital-asset placements under Regulation D.

Consider, in turn, a retired musician254 with a net worth of $1,200,000, i.e., an “accredited investor” under Regulation D.255 Having read dazzling whitepapers and feeling overwhelmed by the information from multiple social media sources, the musician, a neophyte in crypto, might buy low-value securities in reliance on soft information, overpaying for the assets of low value and opaque quality.256

The less sophisticated investor may miss certain encoded features (or their absence) and bugs, rely on the naked representations made by zealous self-promoting developers, and overemphasize soft information without evaluating the underlying technology.257 Taking into account only basic technical signals, she could be “unable to assess the true quality of the code,”258 even when it was disclosed to the public. Although code audits could help her ascertain the true asset value (and many but not all projects are audited), 259 tech experts might pay attention only to the relevant technology and cybersecurity risks, missing inaccuracies in the issuer’s soft information and false promises on which our less sophisticated investor relied.260

A final wrinkle is that the more sophisticated investors may have no incentives to enlighten their less sophisticated brethren regarding the underlying value of the assets. An obvious reason is that the more sophisticated may participate in the projects early on, simulate demand, and dump the assets onto the unsophisticated. Economic models also suggest that the sophisticated are not incentivized to inform the myopic about the true asset values and simply opt out of the unnecessary features of products and services.261

The above-discussed 2020 amendments to Regulation D may exacerbate these concerns by opening access to crypto-markets to more entities and individuals without the necessary level of sophistication. For example, one new category is persons holding professional designations or certifications that should enable them to evaluate the merits and risks of investments.262 The first designations and exams on the list are administered by FINRA.263 Naturally, these new provisions call for a reevaluation of the exams to make sure the knowledge of technological innovations is adequately tested, before allowing such investors to participate in digital-asset offerings as accredited investors and increasing their risk exposure.

A related concern is that these professionals licensed by FINRA264 are not only accredited investors under the new Rule but also parties providing professional services to others. By virtue of being licensed professionals, they must fully understand the crypto-market and its private placements variety to adequately advise their clients. As knowledgeable financial ramparts and gatekeepers, these licensed brokers and investment advisers can reduce the information gap between crypto-issuers and the less sophisticated investors. Naturally, their knowledge should be tested through exams and licensing requirements. In fact, similar approaches have been already implemented in foreign jurisdictions.265

Another example of possibly vulnerable accredited investors is small institutions meeting the asset or investment threshold of $5,000,000266 or having equity owners who are accredited investors.267 Neither of these criteria is sufficient to ensure their sophistication. The SEC itself, for instance, acknowledged that owning $5,000,000 in assets could be a weaker measure of investment acumen than having $5,000,000 in investments.268 However, the 2020 reforms did not replace the $5,000,000 asset test and added to the list “any entit[ies] owning ‘investments’ … in excess of $5 million that [were] not formed for the specific purpose of acquiring the securities being offered.”269

While the asset test is admittedly weak, the investment test also does not guarantee the technological sophistication of investing entities. The term “investment” is defined in a rule promulgated under the Investment Company Act and generally includes “securities, real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes, and cash and cash equivalents.”270 Having a $5,000,000 stake in a local shopping mall does not translate into being properly sophisticated in investing in digital-asset securities, even when the securities are collateralized by real estate.

2. Commissioner Peirce’s Proposal and Standardized Disclosure

2.1. The Positive Value of Relevant Disclosures

Under these conditions, a disclosure reform in crypto is needed. Based on the analysis in Parts D and E, there are two first-order conditions for this reform: providing a modernized set of relevant disclosures and accounting for the pure-information data distribution in crypto-markets. Both can be achieved without superimposing the gamut of the Securities Act onto the novel assets and nudging crypto-issuers toward private placements via enforcement.

As yet, there is only one proposal that aims to ensure this outcome—Commissioner Peirce’s 2021 Proposal (“Proposal”). Its principal provision is that “the Securities Act of 1933 does not apply to any offer, sale, or transaction involving” a cryptoasset (specifically, a token).271 The Proposal gives developers up to three years from a crowdfunding event to project completion. This safe harbor helps to solve the timing, opportunity cost, competition, the need for interim financing, and other issues that contribute to the decision to pursue more expedient private placements as opposed to public offerings in the fast-evolving, pure-information environment of crypto-markets.272

More importantly, the Proposal grapples with the information asymmetry typical of private crypto-placements and puts forward a set of disclosures relevant to both developers and crypto-investors. For one, it mandates source code disclosure.273 Although there are incentives to voluntarily disclose the code, 274 the absence of a baseline mandatory rule opens the possibility for secretive (and possibly fraudulent) actors to solicit capital from investors without fully revealing the main asset and justifying their lack of transparency by the need to preserve a competitive edge.275 A formal rule would create the necessary baseline, whereas proprietary and competition issues could be handled through contract between an issuer and investors.

The other proposed disclosures would tackle the discussed challenges of the ossified rule-based line-item approach. To recap, crypto-project valuation depends on the factors that are not directly implanted in the current regulations. Those factors include, inter alia, the network effect and platform membership. Under the Proposal, material items, such as transaction history, token economics, asset supply, and transaction history verification, are mandatory disclosure points.276 A warning legend is also recommended to alert the unsophisticated to the dangers of the novel crypto-instruments277 (provided, of course, that investors actually read these legends).

Furthermore, the proposed notice filing and periodic reporting provisions278 should facilitate information dissemination to broad swaths of public markets (i.e., investors, professional traders, and market analysts), which should jumpstart market efficiency mechanisms.279 In turn, promoting and understanding efficiency, which correlates with the availability of information and its processing by the market, “should allow the design of more effective reform”280 in cryptoasset markets.

The next proposed provision appertains to the incentive structure of crypto-firms and their human capital. Recall that these data are crucial to all investors and of particular value to crypto-markets.281 The Proposal duly addresses these topics by asking the developers to disclose prior sales, lockup agreements, insiders’ preferential rights and options to buy, as well as the qualification of the promoters. The Proposal bolsters these disclosures via the provisions on the sales of tokens by insiders and on related transactions.282

Finally, the Proposal fits into the existing regulatory framework by ensuring a transition from the safe harbor to a general registration of securities on Form 10 if a crypto-firm is unable to achieve its end goal,283 i.e., when the firm cannot develop a mature and sufficiently decentralized network. If, however, the developers successfully complete their project, they can cost-effectively exit the temporary safe harbor by filing a report accompanied by an opinion by outside counsel concerning network maturity.284 This mechanism solves the above-discussed “Blockstack problem” in corporate governance.285 Namely, it should reduce the costs and uncertainty crypto-issuers and their boards are currently confronted with—the imperative to regularly review whether the tokens are securities under the Howey test.286

2.2. Critiques and Modifications

Despite its potential, the Proposal is a stepping-stone in some respects. For instance, given the centrality of reputation and expertise in crypto, a sensible amendment would be to add the data on developers’ competency and business history in addition to the disqualification provisions identifying bad actors.287 Such standardized disclosures would help the global crypto-market to pinpoint actors who had led failed projects and to decide whether to trust these actors again. Crypto-markets find the information about the past experience of developers exceptionally important.288 Since crypto-entrepreneurs can unrestrainedly move from one jurisdiction to another, having more detailed upfront disclosures would help investors economize on relevant global search costs. This is one area where the pure-information modus vivendi of crypto can be supplemented with issuer disclosures.

Similarly, the Proposal could benefit from more specific reporting of the sales of more than 5% of tokens by insiders, who are principally defined as the initial development team.289 Taking a more expansive approach and including various financial backers who might seek an early exit on the basis of their access to inside information would be a valuable amendment ensuring market integrity and transparency, as well as investor protection.

The other paragraphs that warrant further consideration concern gatekeepers. Here, the Proposal includes a contradictory proposition. Laudably, it recommends upfront disclosure of listing and trading venues.290 This approach is firmly rooted in the research on crypto-markets, the importance of liquidity,291 and the need for gatekeeping,292 reassuring investors that reputational intermediaries would stand sentinel in crypto-offerings.

Yet, the Proposal simultaneously defeats its very purpose by excluding marketplaces and persons engaged in transactions for the account of others from the definitions of “exchange” and “broker,” respectively. Properly regulated gatekeepers, however, are something that the cryptoasset market urgently needs to realize its self-regulatory potential.

Self-regulation—the ability to mitigate some of the discussed risks without much regulatory intervention—is feasible, ex hypothesi, when a market has gatekeeping mechanisms and reputational intermediaries lending credence to issuer representations and ensuring proper monitoring.293 Many crypto-gatekeepers, however, display fundamental limitations that may prevent them from properly monitoring the digital-asset market.

For example, among the major gatekeeping mechanisms are the canonical transparency of blockchains, their security, and the quality of consensus protocols. To date, however, these developing technologies have exhibited a number of constraints, including potential governance conflicts within the community and emergence of controlling groups.294

The other group of crypto-gatekeepers are similar to those in legacy markets and include, broadly speaking, broker-dealers, crypto-exchanges, and rating agencies. Many of these institutions have become known for variable (and questionable) quality services, susceptibility to conflicts of interest, market manipulation, fraud, technological failures, and weak reputational capital.295 Broker-dealers and online trading platforms in particular have been a cause for concern that has called for regulatory attention.296 The reliability of crypto-exchanges as vetting mechanisms, liquidity providers, and trading venues varies and depends on the strength of their underlying technology and trading protocols. Alas, in the past three years, reports from regulators and journalists warned that crypto-exchanges did not have the ammunition to deal with conflicts of interest, exhibited operational vulnerabilities to hacking and manipulative trading, attempted to evade U.S. regulation, and crashed locking out thousands of users.297

If the Proposal is promulgated as is in this fluid and unstable milieu, a cascade of events may ensue: Placing domestic and foreign broker-dealers and exchanges outside the purview of U.S. securities law and regulatory agencies may expose U.S. markets to the risk of fraud; transaction costs may rise; the self-regulatory potential of the crypto-market may be undermined; and the onus of ensuring asset valuation will be placed squarely on investors. These problems emphasize the need for developing proper guidelines for crypto-gatekeepers.

In designing these new rules for the digital-asset market, it is crucial not to fall into the regulatory trap that Anita Krug explored—a misbalance between the overemphasized upstream, investor- and disclosure-focused regulation and the underemphasized downstream “regulation of those who provide securities-related financial services....”298 This is precisely what the Proposal does by focusing on the upstream regulation of issuers and investors and ignoring the value of downstream services, which are a crucial component of securities law, “a perceived source of regulatory weakness [and] a route through which to create a more robust and stable financial regulatory system.”299 Instead of an outright acceptance of the Proposal’s laissez-faire approach or the current one-size-fits-all tactic (i.e., imposing conventional pre-crypto regulations on new species of gatekeepers), the SEC would benefit from more research on the development of reputational intermediaries and crypto-gatekeepers.

In other respects, however, Commissioner Peirce has put forward a robust agenda targeting the crucial inefficiencies of the current enforcement-based status quo, i.e., the information-less world of unregistered placements. As the crypto-market’s infrastructure matures (and the downstream regulations are in the works), the SEC can easily guarantee that crypto-issuers provide some level of standardized disclosure, without which investors (mainly the unsophisticated ones) are faced with the lack of “digestible” and relevant issuer information, and issuers with only a few cost-effective options.

3. The Risks of Voluntary Disclosure

This Section lays out the key arguments for a disclosure reform, like the one proposed by Commissioner Peirce. The dominant theme here is the potential failure of the oft-cited justifications for the lenient disclosure regime in unregistered offerings. The familiar rationale behind this regime rests on the issuers’ incentives to voluntarily provide information,300 as is explained by the following game-theoretic arguments:

[T]he willingness of a party to agree voluntarily to a [disclosure] term in a contract may signal the party’s type. Imposing a mandatory term may prevent this signaling and thereby reduce the amount of information transferred.301

“Good” firms in private placements without mandatory rules are expected to disclose their inside information.302 By taking voluntary actions to reveal private information, they signal, inter alia, their transparency, management’s quality, and profitability.303 Bayes’ rule dictates that this disclosure by the good actors affects the beliefs of investors about these issuers’ quality.304

To a degree, this approach works in crypto-markets. Research on crypto-offerings suggests that investors reward more transparent issuers with a lower cost of capital, higher offering success, and better liquidity.305 Alas, although issuer information is valued by investors, it is also possible that the nature of cryptoassets per se may adulterate the standard incentives for accurate voluntary disclosure.

First, when disclosure erodes competitive advantages and increases the risk of hacking,306 a crypto-issuer may find it best not to disclose. In that case, issuer’s silence or under-disclosure neither signifies low project quality nor suggests how good or bad a particular project is vis-à-vis similarly situated issuers.307 Under these conditions of imperfect signaling, investors cannot properly distinguish between high- and low-quality firms or reward good-quality issuers with a lower cost of capital. A set of standardized disclosures would help both issuers and investors reduce adverse selection,308 while the risks to the issuers’ competitive advantages could be handled contractually, between issuers and investors.

Second, as I argued elsewhere, an investment contract to develop and deliver cryptoassets is often akin to bonds.309 It is not the bond-purchasers but the shareholders of an issuer-developer who bear the costs of disclosure.310 In cases where developers-shareholders cannot receive the entrepreneurial surplus, giving them “a pro rata claim on the expected positive cash flow generated by the project,”311 their incentives to incur disclosure costs may be insufficient, resulting in a suboptimal information environment.

Third, while sophisticated parties such as individual hedge funds and venture capital firms have the bargaining power to negotiate for better disclosure and other provisions constraining agency costs and information asymmetry312 and examine the code directly, our concern is with smaller, less sophisticated crypto-investors. These parties may be unable to bargain for and receive comparable and adequate disclosures.

Their unsophistication should weaken “unravelling” in the crypto-market (i.e., the process where once some issuers disclose, others follow suit). For unravelling to work, investors must have “the ability… to infer the other player’s information from that player’s silence.”313 When no inferences can be drawn concerning the unobserved nature of a crypto-project and its founders’ silence, there should be fewer incentives to disclose.314 The resulting lack of comparability and inadequate issuer reporting should expose investors, particularly the unsophisticated ones, to risk, raise the discount investors apply to crypto-assets, and in the end, increase the cost of capital for digital-asset issuers.

To date, crypto-markets have approached these issues mainly through two vectors: (1) third-party auditing and review by the community and crypto-gatekeepers,315 and (2) developers’ reputation.316 I have already emphasized that the depth of community reviews and gatekeeping may vary and that audit firms are typically not subject to regulatory oversight.317

The second vector is similarly imperfect because the value of reputation and trust are the strongest in long-term interactions where retaliation for misbehavior has a positive probability. If a bad issuer wished to do a crypto-offering only once, as some developers do, the investors, the users of the assets, and the developer community would have fewer chances to retaliate against that actor and downgrade its reputation.318 The firm could inveigle purchasers into its short-term project by making exaggerated and aspirational claims and even disappear with the “loot,” which may be both money and private information. Evidence from early ICOs corroborates this paradigm and shows that embroidered and inaccurate statements were both common319 and associated with crowdfunding success.320

The final variable in our map of private crypto-placements and the need for information is the positive correlation between a lower risk of securities law liability and decreased voluntary disclosure.321 A rational firm establishes its optimal level of reporting by weighing the private costs of reporting against the costs of nondisclosure.322 Compliance with exemptions from the Securities Act entails a lessened liability regime compared with public offerings323 and shields issuers from the strictures of Securities Act Section 5.324 In essence, the issuer’s main risk concerns engaging in fraud, using manipulative or deceptive devices, and/or making material misstatements or omissions with scienter.325 As discussed elsewhere, this liability framework places the onus of pleading the elements of fraud on plaintiffs and, thus, may be more costly to investors than Securities Act claims.326 This reduced liability may dampen issuers’ motivation to disclose.

To summarize, it is reasonable to assume that crypto-issuers seeking capital through private placements are incentivized to disclose less rather than more information, ergo, the market for digital-asset offerings may be affected by the improper fit of the disclosure regime of the Securities Act and the lack of information in private placements. The ramifications of the reduced disclosure should be harmful to investors, primarily unsophisticated investors. The only appropriate solution is a rule ensuring some level of uniform disclosure and reporting by crypto-issuers.

G. Conclusion

Our narrative is complete. Through empirical and policy analysis, this Article has explored a fundamental disconnect between the statutory objectives of the Commission and the actual outcome of its policies in digital-asset markets. The SEC regulates crypto-markets via enforcement and ignores the significant pure-information component of cryptoassets.

Avoiding enforcement, crypto-issuers attempt to comply with securities law by resorting to private placements, which do not entail mandatory disclosure in most offerings. Consequently, while compliance with the private placement exemptions staves off SEC enforcement and lowers the offering costs of crypto-issuers, it also channels their behavior toward less transparent markets.

Cryptoasset purchasers are exposed to the information asymmetry of private placements aggravated by the unique risks of crypto. This information-less environment is particularly harmful to less sophisticated investors who may be unable to elicit voluntary disclosure from issuers and ensure that the disclosed information is adequate and material to their cryptoasset purchases. All the while, more sophisticated cryptoasset purchasers rely on the pure-information model that exists independently of the SEC regulations and the Securities Act.

The means (viz., enforcement) undermine the end (i.e., protecting investors and facilitating fair and efficient markets). Taking these arguments further, in pursuing regulation via enforcement, the Commission may have funneled crypto-issuers into de facto information-less, perfunctory, and lackadaisical compliance with exemptions. The investors do not receive the promised informational benefits of securities law, while the SEC spends its enforcement resources on promoting the status quo that does not benefit the very persons the Commission was created to protect.

Finally, if investors are unable to evaluate cryptoassets and run comparisons across crypto-projects, they apply higher discounts which raise the cost of capital for all crypto-issuers. No one wins in this scenario. To resolve these problems, a reform ensuring a basic standardized crypto-issuer disclosure regime is urgently needed.