SEC Small Biz Committee: Liquidify the private markets
The SEC Small Business Capital Formation Advisory Committee (SBCFAC) has thrown down the gauntlet. Per the SEC’s website, the SBCFAC, was established by the SEC Small Business Advocate Act of 2016, and is designed to provide a formal mechanism for the Commission to receive advice and recommendations on Commission rules, regulations and policy matters relating to small businesses, including smaller public companies. It’s latest meeting produced a clear message: it’s time to start providing liquidity in the private markets.
The onus is now on the full commission, flush with two new members, Mark T. Uyeda and Jaime Lizárraga, to heed their advice. Ten years after President Obama signed the bipartisan Jumpstart Our Business Startups (JOBS Act of 2012) that invited everyday Americans into the lucrative private capital markets, the work remains half done at best. Two JOBS Act titles, Title III, which became Regulation Crowdfunding (Reg CF) and Title IV, which drastically improved Regulation A (Reg A+) have shown the success of deregulation. The two titles enabled a paradigm shift in private company investing by allowing startups and small businesses to accept investment from retail investors. Reg CF caters to smaller and younger companies with a 12-month offer limit of $5 million. More mature companies use Reg A+, which couples higher SEC scrutiny with a 12-month offer limit of $75 million.
SEC expanded the private markets in 2021, but it must do more
In March 2021, the Commission expanded JOBS Act provisions that freed more capital. But issues remain. First among them is the lack of liquidity in the secondary market—where initial purchasers resell shares. The SBCFAC tackled that problem this month by reviewing the lack of secondary trading state preemption for both Reg CF and Reg A+.
The meeting opened with Commissioner remarks. Commissioner Hester Peirce spoke about how secondary market liquidity and investor protection complement, not oppose each other. “Secondary market liquidity marries capital formation and investor protection consideration. Issuer’s ability to raise capital turns in part on whether purchasers of their securities will enjoy strong secondary market liquidity.”
When presentations began, Ryan Feit, CEO and co-founder of crowdfunding portal SeedInvest relayed the frustration investors feel from their illiquid investments, even when values rise due to follow on rounds at higher per/share prices. “[W]hat happens is many startup and small business investors get burned out quickly. They make an investment or a few, and they’re excited about it, and then they actually realize that I might need to wait five to ten years to get any return out of this.” This ultimately leads to less capital for newer projects and ultimately good ideas not being funded.
SEC Small Biz committee members know stagnant secondary markets hurt the economy
Sara Hanks, a noted securities practitioner and SBCFAC member spoke about the tedious nature of complying with state-by-state regimes, which differ in fee structure, timing, notice requirements and the like. She mentioned possible solutions in the JOBS Act 4.0 Congress is currently considering.
Indeed, CEI filed comments in June on the JOBS Act 4.0 focusing on the importance of preempting state securities processes for secondary trading among a bevy of other proposals to improve private capital.
SEC Small Biz Committee member NASAA hates the private markets
Opposing any measure to provide private-market liquidity was a representative from the North American Securities Administrators Association (NASAA). This trade organization advocates for state-level securities agencies. The NASSA customarily opposes all access to private capital markets for retail investors and promotes additional burdens for accredited investors. It staunchly opposed the JOBS Act, filing numerous statements, comments, and press releases. At one point describing it as “an investor protection disaster waiting to happen.” Two members (Montana and Massachusetts) sued the SEC to stop implementation of Reg A+ with the NASSA in support as amicus curiae. They lost.
But this did not deter the committee, at least for Reg A+. They voted 9-1 in favor of a pilot program for Reg A+ to preempt state securities laws for secondary trading. The ball is now in the commissioners’ court. According to JD Alois of Crowdfund Insider, the committee should be “submitting a formal recommendation to the Commission in the coming weeks that outlines the need for preemption for Reg A+ securities.” The time has come for the SEC to act for small businesses. And Congress should complement this move by passing the JOBS Act 4.0.
The crypto world is recoiling under massive headwinds. Regulatory uncertainty and the current market downturn, including the spectacular crash of TerraUSD, has left the industry reeling. But while market corrections can shakeout unworthy projects and redirect capital more efficiently, unclear guidance about the rules is intransigent. Myopic federal guidance, particularly from the Securities and Exchange Commission (SEC) has hamstrung crypto development for years and hopes for a resolution exist but seem dim. Now the SEC kills crypto.
It didn’t have to be this way.
Four years ago this week, SEC Corporation and Finance Director Bill Hinman spoke at a San Francisco crypto summit and offered a path forward. Recognizing the emerging industry’s potential entanglement with securities laws, Hinman asked, “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”
He tentatively said yes, if the project was sufficiently decentralized. “If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract [security].”
Hinman halted the SEC killing crypto
Developers rejoiced dubbing his remarks the “Hinman Test.” Decentralization can be a messy concept that needs further clarity. But Hinman seemed to offer a way forward that captured crypto’s peer-to-peer ethos while prosecuting fraud.
Four years hence, crypto’s rules are less certain than ever and Hinman’s words are the subject of a vicious legal battle. The hope for a straightforward regulatory pathway for crypto is all but forgotten.
Even amid Hinman’s speech, then-SEC Chair Jay Clayton’s tenure lacked focus. A year after the Hinman Test, the SEC produced further crypto “guidance” so impenetrable Commissioner Hester Peirce likened it to a Jackson Pollock painting. Clayton also greenlit the Ripple/XRP litigation on his last day, which has become the SEC’s most arduous crypto battle.
Current Chair Gary Gensler has replaced Clayton’s vacillation with outright hostility. Gensler has unleashed a torrent of legal actions against crypto project developers like LBRY and doubled down on the Ripple case,projects with happy user bases and no hint of fraud. He’s called for plenary authority over crypto and hired scores more attorneys to evaluate each project under the vague and famously malleable Howey test. And he’s threatened virtual marketplaces like Coinbase, while forcing BlockFi and Celsius into fines and settlements to avoid protracted legal battles.
Gensler’s SEC kills crypto
Cynics claim Gensler’s “enforcement only” approach and attendant industry ire is worth the trouble to bolster his profile for ever higher government posts. Regardless of motivation, the results have immensely damaged this century’s most promising technology.
Observers inside and outside the Commission have offered alternatives to the Clayton-Gensler quagmire. Commissioner Peirce has suggested a regulatory sandbox. Academics have offered various solutions including a state-led regime. Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) proffered a legislative solution. None seem likely to be enacted soon.
For now, the judiciary offers the only refuge from the SEC’s regulatory onslaught. Ripple along with individual defendants Brad Garlinghouse and Christian Larsen have cornered the SEC into unforced errors and shifting justifications as discovery battles intensify before trial.
Ripple case shows SEC crypto hostility
Most prominently, the SEC’s turn from Hinman’s speech and the SEC’s unwillingness to reveal the intra-office machinations surrounding it has begot Amber Heard-like court performances. Magistrate Judge Sarah Netburn has grown increasingly frustrated with the SEC’s obduracy.
At one point during a hearing last week she sarcastically directed the SEC lawyer to pull up the speech and explain which parts were Hinman’s personal opinion and which were SEC policy, as the commission darts to-and-fro to avoid yielding information to opposing counsel.
Ripple has the resources to fight a protracted battle that may end at the Supreme Court. The Commission rarely faces spirited opposition, as years-long investigations followed by expensive litigation crush adversaries well before a ruling on the merits.
SEC is losing Ripple crypto case
For once the SEC seems to have the losing hand and not just in the Ripple litigation. Mr. Gensler’s reportedly abrasive style has caused a mass exodus of top-level personnel. The Fifth Circuit recently ruled its administrative law judge system of adjudication that denies defendants a federal court venue is unconstitutional in certain circumstances.
For the crypto world building the next generation economy, the SEC’s troubles are its gain. The industry should use the Crypto Winter to exert maximum pressure on Gensler. Reviving the Hinman Test – and actually applying it consistently – would be a start.
The attention of financial regulators in the US and globally seems focused on issues far afield from the core mission at a time when turmoil is roiling global markets. Inflation is at 40-year highs and the public is overwhelmingly concerned with pocketbook issues. Yet financial regulators seem fixated on carbon emissions and potential global temperatures decades hence. They should refocus on their core mission and leave environmental concerns to the political branches.
In one sense, the dodge is understandable. To discuss the current inflation crisis is to expose the embarrassing faux pas of those tasked with financial stability. Both Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell have meekly backtracked on prior statements about inflation’s cause and their expertise in containing it.
Conversely, discussing carbon-emission risks to the financial system that may materialize in the distant future yields glowing press and applause at international conferences.
Treasury Secretary Janet Yellen focuses on climate not finance
Secretary Yellen has taken the lead in her role as chair of the Financial Stability Oversight Council (FSOC), a product of the Dodd-Frank law. The council has extraordinary power to bypass Congress and act unilaterally to address “emerging threats” to US financial stability. In her first FSOC meeting Yellen called climate change an “existential threat.” And she urged a “rapid transition to a net-zero carbon economy.”
Federal Reserve chair Jerome Powell echoed Ms. Yellen’s sentiment, “One of our goals is to make climate change a part of our regular financial stability framework.”
Global Financial Regulators Fetishize Climate
Global financial regulators agree. In a July 11 speech Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision for the Bank for International Settlements (BIS), the global central banking authority, spoke in strikingly similar terms. Mr. Hernández de Cos described “a growing consensus that climate change is the most existential [challenge]” the world now faces. He too pushed for “Net Zero” carbon emissions citing the Glasgow Financial Alliance for Net Zero and the Net-Zero Banking Alliance.
The consequences of inaction would be dire warned Mr. Hernández de Cos. This includes a 1.5-degree Celsius rise in temperatures this century. He concluded his remarks citing the critical need for global cooperation and the necessity to hear from “a broad set of external stakeholders.”
The Public Cares about Finance not Climate
Those stakeholders apparently do not include the public, which must bear the brunt of the global climate push. The most obvious current stakeholders are the protesting Dutch farmers whose livelihoods are jeopardized from climate-related regulations.
In a recent poll, Americans placed economics at the fore of their concerns. The AP/University of Chicago poll found the top five concerns: 1. Inflation; 2. Gas prices/energy costs; 3. Gun issues; 4. Immigration; and 5. The Economy. Environment/climate change placed seventh at 17 percent—a four percent drop since December.
Financial Regulators’ Climate Fetish distracts from Crypto
Regulators’ climate fetish also threatens cryptocurrencies, which authorities already view suspiciously because of their decentralized, private nature. Earlier this month, researchers at the European Central Bank opined the European Union will likely ban Bitcoin. Even though assumptions about this topic usually come littered with fallacies. Financial regulators should focus on their core mission of financial stability and leave climate concerns to the political branches. As Agustín Carstens, head of the BIS stated last year, financial regulators core mission is to “do no harm” to their country’s monetary system or the citizens within it. Yet financial regulators’ climate fetish is doing just that at a time when their attention is urgently needed elsewhere.
Crypto insiders lauded Gary Gensler’s nomination to chair the Securities and Exchange Commission (SEC) last February. The MIT professor who had taught blockchain classes would bring an enlightened approach to crypto compared to the scattershot, perplexed style of his predecessor Jay Clayton. But a year in the professor gets an F in crypto guidance and leadership. He has encouraged the worst bureaucratic instincts of the federal government, deepened regulatory confusion, and thwarted any hope of progress during his tenure—all whilst claiming the mantle of little-guy defender and public-interest protector.
Not everyone agrees with this assessment. The powerful cabal of Washington and global interests that oppose everything crypto are likely pleased with Gensler’s performance. These include Democratic senators, well-placed financial regulators, and global central banking authorities.
Professor Gensler turns into Bureaucrat Gensler
Cynics contend this cabal comprise his real audience; those that can help the uber ambitious Gensler climb the bureaucratic ladder to Treasury Secretary or beyond. But even without questioning his motives, his tenure related to crypto has been a farce.
Gensler analogizes his role to that of football referees. “Imagine a football game without referees. Without fear of penalties, teams start to break rules. The game isn’t fair and maybe after a few minutes, it isn’t fun to watch.” Yet the dystopian present he has fomented invites a different analogy: The referees are the only ones who know the rules, won’t tell the teams what they are, but still call a penalty on every play—the players discovering ex post facto the play was verboten.
Former acting Comptroller of the Currency, Brian Brooks, described the scene recently in Congressional testimony: “What happens in the United States is you have a new crypto project and you walk into the SEC and you describe it in great detail and you ask for guidance and they say we can’t tell you and you list it at your own peril.”
Crypto doesn’t want Professor Gensler’s protection
This is particularly disheartening when the teams have plays the fans want to see. Although Gensler couches crypto edicts in protecting the populace against scams, many high-profile cases the SEC has prosecuted during his (and his predecessor’s) tenure had active, happy user bases. Kik, Telegram, and ongoing cases against LBRY and XRP/Ripple focused on selling “unregistered” securities via a security type (investment contract) absent in the federal code and defined through a three-part test by the Supreme Court a year after WWII ended.
Lawyer James Burnham opines the current Supreme Court zeitgeist would likely preclude such broad administrative diktat on crypto absent new Congressional mandate. But such agency reprimand would require a company spend gargantuan legal fees and endure years of litigation for even the chance to argue the case. The Commission understands its ability to bleed belligerents dry and force settlements before they obtain meaningful judicial review. As it stated in its 2018 budget request: “[T]he SEC’s litigation efforts also help the SEC obtain strong settlements in other cases by providing a credible trial threat and making it clear that the SEC will go deep into litigation and to trial, if necessary, in order to obtain appropriate relief.”
For his part, Gensler has directed the Enforcement Division to discourage meetings with investigatory targets and eliminate “unnecessary process.”
Thus, the status quo is worst of all worlds: rules that leave seasoned securities lawyers guessing, an agency that refuses any guidance besides lawsuits, or threats thereof, and an agency chair requesting scores more enforcement attorneys and “plenary” authority to protect people who in many cases do not want it.
Professor Gensler is not serving the public interest
Commissioner Hester Peirce described a previous era of “broken windows” theory compliance at the SEC as the “Sanctions” and Exchange Commission. Now it may better be labeled the “Sanctions and Enforcement” Commission.
Under Gensler, the SEC has declared a permanent crypto war. It has refused to approve any Bitcoin spot Exchange Traded Products despite myriad applications, new projects are refused guidance and told to take their chances, and the Chair recently gave a speech one commentator called the “the most aggressive and hostile stance re U.S. crypto regulation to date from the SEC.” An SEC this stroppy to crypto innovation may serve entrenched interests in Washington and other global financial destinations. It does nothing, however, for the American public. Those that think otherwise should go back to school.
The gulf between Securities and Exchange Commission Chair Gary Gensler’s rhetoric and the results of his leadership continues to widen. Mr. Gensler boasts fealty to working families in interviews and speeches yet thwarts their ability to climb the economic ladder.
The SEC may raise the accredited investor (AI) net-worth threshold from $1 million to $10 million, Bloomberg reports. Because of their wealth or other sophistication criteria, AIs may invest in private companies in ways others may not.
In December, the Commission indicated it would review the threshold “to more effectively promote investor protection,” in a little noticed regulatory agenda document. The scope of the proposed change apparently just became known. The Commission will seek public comment in April.
Raising Accredited Investor limits would harm startups in the middle of the country
The problems with this proposed change are countless. First, it would lessen opportunity for both investors and entrepreneurs. Most startups, especially in scaling industries like technology seek investment first from AIs under Regulation D 506(b) (Reg D). Raising the bar for who qualifies as an AI means less startup funding. And it would have disproportionate geographic and demographic consequences falling hardest on regions and entrepreneurs already struggling for funding.
Wealth in the United States and thus access to capital is mostly confined to a few elite coastal zip codes. Raising the accredited investor threshold would further solidify these venture-capital meccas. As described in a recent SEC Small Business Capital Formation Advisory Committee, which recommended expanding not contracting AI criteria.
Indeed, the Commission should question the whole concept of AIs. It excludes most Americans from participating in higher risks and higher rewards startup funding. Professor Usha Rodrigues calls this securities law’s ‘Dirty Little Secret’:
The dirty little secret of U.S. securities law is that the rich not only have more money-they also have access to types of wealth-generating investments not available, by law, to the average investor. . . .
[C]urrent law . . . discriminates on the basis of wealth, as a proxy for sophistication, or the ability to fend for oneself. Securities law thus in theory, as in practice, marginalizes the average investor without acknowledging that it does so, let alone justifying it.
Accredited Investor limits entrench social stagnation
In practice the rich get richer via access to the most promising companies when prospects fir massive returns are biggest. Raised thresholds would mean even less people would have the chance at generational wealth.
Yet raising the AI thresholds would not only harm the rich, its aftereffects would stymie the entire private investment market. The only way retail investors can currently play in the private markets is through Regulation Crowdfunding (Reg CF). In March 2021, the SEC loosened some Reg CF restrictions to make it more attractive. One move was to remove the investment cap for AIs. This allowed small money to follow smart money into Reg CF. Thus, an AI could place a bit bet on a startup and lots of retail investors could join that bet on the same terms. Raising the AI threshold will mean startups will get less traction with big investors. And retail investors won’t benefit as much from large investor due diligence.
Supporters of tighter restrictions like some state Attorney Generals and the North American Securities Administrators Association, justify raising the AI threshold on the basis of some fraudulent issuers. But this claim fails scrutiny. Accredited Investors use Reg D and Rule 144A. These two markets dwarf the public markets which raised $1.2 trillion. Reg D alone outpaced the public market (registered offerings) in 2019 with almost $1.5 trillion. These numbers would be impossible if investors feared fraud.
The crypto revolution has destroyed the rationale for Accredited Investor limits
The crypto revolution has also refuted arguments restricting the private markets. The Commission recently settled with virtual marketplace BlockFi for $100 million dollars. As Commissioner Hester Pierce stated, BlockFi had always paid out its promised returns so it’s hard to say who Mr. Gensler was protecting. If the end result is savers receive anemic rates the heavily regulated banking industry pays instead of the comparatively gargantuan returns of BlockFi, working families will clearly lose.
In fact, crypto shows the folly of artificially restricting anyone’s ability to invest in non-fraudulent assets of their choice as articulated by podcaster Nathan Whittemore:
[W]e need to be a lot more careful about who we view as someone who needs protection. In the [Elizabeth] Warren-Gensler mindset, anyone who is not an institutional investor needs to be protected. That may make sense to Gary who made $120 million off his time at Goldman. And in other parts of the very, very walled gardens of traditional finance. But it simply isn’t the case, when “retail” spent the last decade kicking the ever-loving s**t out of institutional investors in one of the biggest wealth creation moments in history. Maybe we think a little bit before we lump all retail investors into some paternalistic bucket of little guys who need protection. In fact, it is the first time in history that this was possible because crypto’s permissionless nature inherently obliterates barriers to entry. In other words, the first time in history that retail investors weren’t structurally pushed out or denied access to an investment opportunity. They completely beat nearly every professional investor to it.
SEC BlockFi settlement misfires for working families
The Securities and Exchange Commission (SEC) has a three-part mission: protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Chair Gary Gensler focuses on the first, “Every day, I am animated by working families and what the SEC means to them.”
Yet paradoxically, his zeal to enforce securities laws has had the opposite effect. Far from helping working families, he is quashing their wealth-creating opportunities.
The SEC’s latest foray into enforcement-policy-gone-wrong is the widely reported settlement with virtual marketplace and crypto lender BlockFi. Details reportedly include a massive $100 million dollar fine and promise to stop accepting new accounts. (At the time of settlement, 32 state securities agencies were also investigating BlockFi, collectively they will receive half the fine).
SEC BlockFi settlement didn’t end fraud it ended earning opportunities for working families
A reader unfamiliar with the Gensler-led SEC might presume the commission had just ended a major scam operation or stopped fraudsters raising capital by promising the unsuspecting lavish and unattainable returns on some pie-in-the-sky crypto venture.
Indeed, in speeches Mr. Gensler frames his enforcement push exactly this way:
Without examination against and enforcement of our rules and laws, we can’t instill the trust necessary for our markets to thrive. Stamping out fraud, manipulation, and abuse lowers risk in the system. It protects investors and reduces the cost of capital. The whole economy benefits from that. . . . It is critical that our enforcement program have tremendous breadth, be nimble, and penalize bad actors so we discourage misconduct before it happens. . . .
Some market participants may call this “regulation by enforcement.” I just call it “enforcement.”
Stamping out fraud, manipulation, and abuse, sounds great until one realizes BlockFi had done none of this. In a press release the SEC claims BlockFi failed to disclose the level of risk in its interest-bearing products. But no one was ever defrauded, as Commissioner Hester Peirce relayed in a statement, “While penalties this size are intended to deter bad conduct, here there is no allegation that BlockFi failed to pay its customers the money due them or failed to return the crypto lent to it. BlockFi’s misrepresentations about over-collateralization are serious, but the combined $100 million penalty nevertheless seems disproportionate.”
Virtual Marketplaces Provide passive income to impoverished people
What BlockFi was doing was providing working families an opportunity to generate passive income. These assets (Bitcoin and other crypto) that has seen startling market gains with the potential for much more. (One investment firm predicts Bitcoin will reach $1 million by 2030).
Working families could park their Bitcoin and other crypto holdings with BlockFi and earn between 5-10 percent APY. BlockFi relends these holdings at even higher rates and splits the interest with account holders.
Thus, working families benefited in two ways: (i.) any asset appreciation was theirs after they withdrew their holdings (of course any loss was too, but that’s a function of the supply and demand); (ii.) the interest earned in crypto was theirs as well.
These are game changing numbers for working families. Someone spending buying Bitcoin with their $1,200 stimulus check in April 2020 would have had $11,000 in October 2021. A BlockFi account would have provided an additional5-10 percent interest. The numbers are less now but history says they will rebound at some point.
SEC BlockFi settlement latest example of crypto hostility from federal government
The story has played out across the crypto world in the past four years (pre-dating Mr. Gensler). As the commission has attacked companies without a hint of fraud including Kik and Telegram and currently lawsuits against XRP/Ripple and LBRY. Non-fungible tokens (NFTs) are likely next.
In addressing securities professionals last November, Gensler chided them for their lack of public spiritedness. “You all have our own clients, to be sure. Working in a field such as finance that touches so many lives, though, you also have another responsibility: a responsibility to the public.”
A corollary to this exists. Bureaucrats should not harm the public by using their position to climb the ladder to more powerful positions. Cynics accuse Mr. Gensler of using crypto enforcement to do just that.
But whether he is actually animated by working families, his own ambition, or both, he only hurt working families.
Note: In a tweet thread by BlockFi’s CEO, the company announced today it will register its products with the SEC. And it may eventually accept new accounts.
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