by Jossey PLLC | Aug 7, 2021 | Crypto, SEC
DeFi regulation, just say no
A new form of consumer finance could upend the entire banking and finance system that’s plagued by expensive fees, limited “bankers hours,” public mistrust, bailouts and insider government favors.
But Congress and the U.S. Securities and Exchange Commission (SEC) may kill the movement – decentralized finance, or DeFi – in the name of our own protection. Regulators should prosecute fraud, but also acknowledge the limits of their effectiveness and allow DeFi to mature without the burden of governmental compliance.
People are on the verge of cutting out the middleman in finance. Just as Bitcoin decentralized money transfers, DeFi could decentralize all of finance, from lending, borrowing and exchanging to more exotic forms of interest collection.
DeFi applications are not banks, they shouldn’t be regulated like them
DeFi eschews heavily regulated, fee-collecting intermediaries to allow peer-to-peer money flows. In just three years, it has grown from an idea on Meetup to a $50 billion industry. Yet DeFi’s astounding growth has also attracted opportunists looking to fleece naïve newcomers. Hackers and rug pullers – developers creating new products and then absconding with the loot – have plagued the growing industry. According to one source, fraudsters stole $83.4 million between January and April this year.
Sen. Elizabeth Warren (D.-Mass.) fired off a letter asking SEC Chairman Gary Gensler what more Congress could do to empower the commission to rein in DeFi. Mr. Gensler needs no persuading. He has repeatedly made requests for additional authority to bring non-security cryptocurrencies under the SEC’s ambit. Dan Berkovitz, a commissioner at the SEC’s sister agency, the Commodities Futures Trading Commission (CFTC), recently agreed. While praising financial intermediaries, he described DeFi as a “bad idea, and “Hobbesian,” and questioned its legality.
The message from the Biden administration and its appointees is clear: Without us, scams will proliferate and retail investors will get hosed.
DeFi regulation is favored by all the wrong people
Bringing a nascent industry under the government’s thumb does have benefits for politicians and regulators. It provides politicians steady campaign contributions and lobbying perks. Regulators get employment, prestige and often lucrative post-public service landing spots. Industry incumbents use the rules to keep barriers to entry high.
But big government hasn’t been great at preventing fraud. Since the federal government started regulating the financial sector in earnest in the 1930s, the government’s track record has been downright dismal. A landmark study by future Nobel laureate George Stigler showed the rates of return in the 1950s mirrored those of the pre-SEC 1920s, dispelling the myth that 1920s Wall Street was rife with fraud and abuse.
Decades later, two scholars lamented, “[Ex]amination of the securities violations…reveals that no amount of technical exemption requirements will hinder the fraud artists from their endeavors…Fraudulent and deceptive schemes have unfortunately continued unabated and independent of formal registration or exemption requirements.”
Even Congress’s own research arm, the Congressional Research Service, is skeptical the SEC framework can remedy market manipulation.
Prosecutors should focus on fraud not DeFi regulation
Regulators should focus on prosecuting fraud and allow the industry to grow past its infancy without smothering it first with massive federal disclosure mandates. Many scams and rug pulls had glaring red flags, like anonymous developers and promises of outlandish returns like 10,000 percent interest. The market will weed these scammers out.
As the industry matures, industry gatekeepers will develop standards that imbue credibility. These standard setters will include trade associations, code auditors, insurance markets and standards bodies that provide reputation scores to counter the proliferation of bad actors.
Regulators should prosecute scams harshly. Federal courts have buttressed CFTC jurisdiction to prosecute crypto fraud. Politicians will score points and regulators will avoid blame by taking the path that gives them the most power and control. But some humility on the limits of their effectiveness would be welcome.
Previous attempts to rein in finance’s bad actors fell flat. The notorious Dodd Frank financial regulation law passed after the 2008 financial crisis has utterly failed. The push to regulate DeFi will, as well. At best, it will send DeFi underground.
Regulators should allow DeFi to flourish as it upends the decades-old order and renders entrenched industry players irrelevant. Suffocating DeFi in the name of investor protection will kill its promise and continue the entrenchment of massive industry insiders as overlords of the U.S. financial system.
By Jossey PLLC via www.thecrowdfundinglawyers.com
A version of this article first appeared in Coindesk on July 23, 2021 https://www.coindesk.com/washington-should-let-defi-succeed
by Jossey PLLC | Jul 10, 2021 | SEC
SEC Chair Gensler is harming retail investors
In a rush to protect retail investors, new Securities and Exchange Commission Chair Gary Gensler is promoting ill-considered policies that will undermine everyday investors. That means business as usual at the SEC, continuing a pattern of failing to trust retail investors while favoring established players.
Whether it’s app-based trading, cryptocurrencies, or reckless tweets, politicians have fretted this year about tech-savvy predators conning retail investors, and now Gensler is charging in. During recent congressional testimony and other public appearances, Mr. Gensler claimed that legal gaps threaten investors. Thus the Commission must “freshen up” rules, promote an “active policy agenda,” and urge new congressional action.
That doesn’t bode well.
SEC Chair Gensler continues the Commission’s insular ways
Mr. Gensler’s protective instincts continue a pattern of mistrust of technology and outsiders that harms those the Commission is most keen to protect. For example, the private markets cater to accredited investors the Commission believes can “fend for themselves” without mandated and costly disclosures. This market aggregates around $1.5 trillion per year; all the risk and rewards go to the already well-off. It’s why one wealthy investor’s $300,000 Coinbase investment morphs into $680 million, while “protected” investors scrounge for public-market scraps.
But in fact, when given the opportunity retail investors have traversed the private markets just fine. Congress passed the JOBS Act of 2012 to open the private-market door slightly to retail investors, mainly through Title III (internet-based equity crowdfunding). Due in part to COVID online crowd-based capital raising has exploded recently both in investors and investment, without any incidents of fraud.
Equity crowdfunding’s success came despite strong Commission opposition. Commissioners then were convinced fraudsters would con everyday Americans and the Commission would get the blame.
SEC aversion to innovation is nothing new
Commissioner Luis Aguilar stated, “I cannot sit idly by when I see potential legislation that could harm investors. This bill seems to impose tremendous costs and potential harm on investors with little to no corresponding benefit.” Then-Chair Mary Schapiro joined, attacking the crowdfunding provision as enabling “fraudulent schemes designed as investment opportunities.” The bill’s sponsor Rep. Patrick McHenry (R-NC) later described Ms. Schapiro’s actions as “being sideswiped by a regulatory body at the eleventh hour.”
In fact, the Commission has never welcomed innovation. Large companies excel at navigating the complex SEC-mandated compliance. This leaves investors with more information but less choice. It also breeds familiarity between regulators and businesses that distort priorities. In fact, massive frauds have occurred under the Commission’s nose while it racked ever higher but meaningless enforcement “wins.” The list of boondoggles it missed despite red flags and whistleblowers could be a corporate Hall of Shame, including Enron, Lehman Brothers, and Bernie Madoff.
As Gensler’s fellow Commissioner Hester Peirce has stated, “Entrepreneurship and innovation do not have the happiest of relationships with regulation. Regulators get used to dealing with the existing players in an industry, and those players tend to have teams of people dedicated to dealing with regulators.
SEC Chair Gensler’s crypto ambitions
The huge new opportunities for innovation and wealth creation include app-based trading and cryptocurrency. Regarding crypto, Commission chair Jay Clayton appeared habitually perplexed, fumbling to appoint a crypto ‘czar’ and seemingly most concerned to avoid leadership on this dynamic issue.
Yet the Commission under Mr. Gensler seems poised to take an even more restrictive approach than his predecessor. In a recent interview, Gensler refused to rule out banning so-called ‘payment for order flow.’ This mechanism allows apps to offer commission-free trading. Of course, this trading isn’t costless, tradeoffs lurk as with “free” Facebook accounts. But instead of letting users decide, Gensler opined, “transparency may not be enough.”
The news is even worse for crypto. Gensler also advocates for a new federal regime to oversee crypto exchanges and a new wave of crypto prosecutions. This is disappointing, because he has substantial crypto competence, having taught a course on ‘Blockchain and Money’ at MIT. But it does align with the federal government’s wide-ranging assault on crypto, from the Federal Reserve stating a Central Bank Digital Currency is a ‘very high priority,’ to Senator Sherrod Brown (D-OH) seeking to regulate away private currencies, to onerous digital-wallet rules, to the IRS war on gains. For years, the Commission has repeatedly blocked Bitcoin exchange-traded products.
Retail investors will bear the brunt of SEC Chair Gary Gensler’s reforms
Mr. Gensler’s would-be “reforms” will lead to costs borne most by everyday Americans. Gensler, whose net worth exceeds $100 million, won’t be affected. But he will undermine others seeking financial success through America’s still-dynamic entrepreneurial spirit. This stratifies wealth in our society while effectively discouraging innovation.
What Mr. Gensler should do is re-focus the Commission on prosecuting wrongdoers within its midst and spare innovators his regulatory weapons. The Commission should punish fraud, but it must abstain from protecting people from technologies they embrace and risks they willingly take as with app-based trading and crypto investing.
By Jossey PLLC via www.thecrowdfundinglawyers.com
Real Clear Markets ran a version of this article on June 22, 2021 https://www.realclearmarkets.com/articles/2021/06/22/eager_to_protect_small_investors_gary_gensler_leaves_them_scraps_782067.html
by Jossey PLLC | Jun 13, 2021 | SEC
LBRY prosecution via the Securities and Exchange Commission (SEC).
The SEC continued its punitive push against blockchain companies that sold native tokens with its recent LBRY complaint. The crypto company promotes an “open, free, and fair network for digital content” and boasts 10 million users. Someday it could someday rival YouTube, Amazon, and other video-content providers. But first it risks bankruptcy in legal fight with the government that lacks victims.
LBRY offered LBRY Credits (LBC) to software developers for network contributions and sold LBC on exchanges to encourage use and fund operations. The SEC claims LBC are unregistered securities despite their actual and widespread network utility. The suit seeks a permanent injunction, disgorgement of “ill-gotten gains,” civil penalties, and other remedies. If successful, the Commission will stifle innovation and entrench incumbents whilst harming platform users the Commission claims to protect.
LBRY prosecution reinforces SEC investigations as the punishment
The SEC investigated LBRY for three years before filing suit. These inquiries are notoriously painful; described by one seasoned securities lawyer as “living in hell without dying.” Thus far the company claims the process has cost thousands of manhours and one million dollars in legal fees. But a few things are missing from the complaint. First is any claim of injury by platform users. Second is any discussion of LBRY’s decentralized nature.
Decentralization is a factor previously suggested by former SEC Corporation Finance Division Chief Bill Hinman as an escape hatch from securities-related burdens for networks where public benefits were absent. LBRY claims decentralization via hundreds of contributing developers around the globe, many unknown to the company.
Instead, the Complaint rests on the decades-old Howey test that covers a security type called “investment contracts.” In short, that LBRY sold LBC (contribution of money); the company has contributed to platform success (a common enterprise); and LBC may rise in value with continued success (expectation of profits), LBC is a security and thus LBRY is in legal limbo.
LBRY prosecution shows SEC Crypto Policy is a mess
The move against LBRY, and the higher profile Ripple action, are the SEC’s latest steps to bring crypto companies under its ambit. Unfortunately, the Commission has chosen costly years-long investigations as its primary interface with these new technology players. Its most prominent non-enforcement action was the widely panned 2019 staff “guidance.” The thirteen-page document, which Commissioner Hester Peirce likened to a “Jackson Pollock painting,” only heightened calls for crypto clarity.
At present, the Commission leaves crypto entrepreneurs few good options: (i.) create a functioning platform with a native currency and wait for a dreaded SEC inquiry; (ii.) go through a costly registration or qualification process with perpetual reporting obligations and annual six-to-seven-figure compliance costs; or (iii.) move to a different jurisdiction and don’t sell tokens to U.S. citizens.
Permissionless, open source blockchain projects, which die without developer buy in and mass adoption don’t gel with these options. Decentralized networks by their nature don’t have central points of authority but usually rely on founding teams and seed capital to gain traction.
The SEC’s unending prosecutions of blockchain companies has real consequences
The consequences of the SEC’s enforcement-first paradigm are stark. It discourages those creating the future economy from starting U.S. blockchain companies or allowing its citizens full access. Also, it creates roadblocks for founders trying to lure developers and programmers into new projects. And it impedes the network effects new blockchain projects need to thrive. Finally, it squelches competition. Finally, mass adoption and regulatory capture allow tech giants to collect economic rents. Consumers seeking decentralized, censorship-resistant alternatives have fewer choices.
Unfortunately, a putative SEC victory against LBRY will continue its winning streak against token upstarts. Other high profile nonfraud defendants Telegram and Kik surrendered after millions in legal fees and federal court defeats.
Yet the story here is worse. LBRY only sold most LBC after its network was live and functioning. Because as Commissioner Peirce previously stated, “Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.”
Given the lack of Commission clarity for decentralized platforms, the path ahead offers little room for innovation for those lacking the budgets and stomach for years-long legal fights. Yet, the SEC will no doubt tout a putative court victory as a win for consumers and another fulfillment of its investor-protection mandate. But LBRY’s millions of users would disagree.
By Jossey PLLC via www.thecrowdfundinglawyers.com
A version of this post originally ran on the Competitive Enterprise Institute blog on 4/12/2021 https://cei.org/blog/lbry-cryptocurrency-prosecution-shows-secs-misplaced-priorities/
by Jossey PLLC | Mar 15, 2021 | Crowdfunding, SEC
New SEC crowdfunding rules go live today. Some questioned whether the Biden Administration would try to kill the rules approved last November. But that did not happen, and now entrepreneurs and private investors can engage more freely, although further improvements await.
Crowdfund Capital Advisors summarized the new changes below:
Regulation Crowdfunding changes before and after
New SEC crowdfunding rules leave questions unanswered
Although new SEC crowdfunding rules vastly improve the status quo, questions remain. Foremost are how special purpose vehicle (SPV) rules will work. In theory, SPVs should ease messy cap table issues and other hurdles linked to unaccredited investors. But the Commission’s rule-heavy approach may kill this innovation before it blooms. At the least, the Commission’s crowdfunding-vehicle exception will force issuers into a cost-benefit analysis.
While supporting the crowdfunding-vehicle concept, critics panned the costs and complexity. Wefunder, the largest portal by volume, will not support it. As envisioned, one raise may require multiple crowdfunding vehicles. The SPV also saddles issuers with cost burdens, substantially increasing upfront outlays for an already expensive option. Even with proxies, the need to gain permission from security holders for transactions will burden administrators. There are also additional disclosure obligations and questions about who will manage the vehicle and distribute paperwork. These issues will hamper and may foreclose crowdfunding-vehicle use altogether.
The marketplace may have solved this ‘messy-cap dilemma’ on its own. Wefunder created a ‘custodian’ model that reduces Reg CF investors to one line. Other portals followed. The SEC has not publicly commented on the new structure, which may signal tacit approval.
SEC should further improve crowdfunding rules
As I have written in ‘Fixing the JOBS Act and Inviting the Tokenized Future, the Need for Congressional Action,’ many more fixes remain. These include:
- Regulate sales not offers.
- Exempt Secondary Trading for Regulation A+ and Regulation CF.
- Preempt state filing requirements and notice fees for Regulation A+ and Regulation Crowdfunding.
- Exempt Regulation A+ and Regulation Crowdfunding from the 12(g) Rule.
- Raise the Regulation A+ Offer Limit to $100 million.
- Raise the Regulation Crowdfunding Offer Limit to $20 million.
- Simplify or eliminate individual limits for Regulation A+ and Regulation Crowdfunding.
- Limit financial and reporting requirements for Regulation A+ and Regulation CF.
SEC is unlikely to pursue new crowdfunding improvements
Unfortunately, further improvements to the SEC’s crowdfunding rules are unlikely. The election brought a leadership change at the Commission. Gary Gensler will assume the chair once confirmed. Senators did not query Mr. Gensler about the new crowdfunding rules or the JOBS Act in general. But both Democrat-appointed Commissioners voted no. Acting Chair Allison Herren Lee and Commissioner Caroline Crenshaw released statements claiming the new rules lacked investor protection and were unnecessary. For what its worth, Mr. Gensler forcefully stated his investor-protection priorities during his confirmation hearings and his MIT tenure. This likely foretells his posture toward private-capital expansion.
Finally, the Commission has already declared priority shifts. On March 4 it announced an Enforcement Task Force Focused on Climate and ESG Issues. This followed a March 3 release of 2021 Examination Priorities, a February 5 announcement of a new Acting Deputy Director of Division of Enforcement, and a February 1 new Senior Policy Advisor for Climate and ESG.
Commissioners Hester Peirce and Elad Roisman have objected. The Republican-appointed duo questioned what the flurry of climate-and-ESG-focused moves may mean. They averred new standards in this highly charged space may only arise via Commission vote. Regardless, the PR blast assuredly ends momentum for further private-capital changes.
New SEC Crowdfunding Rules will improve entrepreneurship
The new SEC crowdfunding rules will open opportunities for investors and startups alike. The rules will help the already booming alternative-capital industry grow. While further boosts are now unlikely, the industry can blossom before future revisits.
By Jossey PLLC via www.thecrowdfundinglawyers.com
by Jossey PLLC | Mar 3, 2021 | Crypto, SEC
US crypto policy remained clouded after Gary Gensler’s Senate testimony yesterday. President Biden nominated him to chair the Securities and Exchange Commission (SEC). Surprisingly, crypto policy appeared sparingly in the three-hour hearing, which also included the Consumer Financial Protection Bureau nominee. The hearing centered on issues arguably outside financial-regulator purview like climate policy and the gender and racial composition of boards. (Another large portion featured senators and nominees repeatedly thanking each other for pre-hearing meetings.).
Mr. Gensler did discuss US crypto policy. But he shrouded his remarks in the familiar non-answer answers that define these hearings and prevent observers from gaining insight.
US crypto policy will focus on investor protection
Unsurprisingly, Mr. Gensler did repeatedly state investor protection would be his central focus. This aligns with SEC culture. Investor protection always comes first, even though it is one prong of the commission’s tripartite mission. The SEC exists to protect investors, maintain fair orderly, and efficient markets; and facilitate capital formation.
Indeed, Congress became so frustrated with the Commission’s investor-protection focus, it intervened. In 1996 Congress amended Section 2(b) of the 1933 Act to require the Commission to “consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation.” This move had little effect.
Mr. Gensler favors government surveillance
Beyond his testimony, observers may glean insight into Mr. Gensler’s crypto-policy stances elsewhere. As a former chair of the Commodities Futures Trading Commission and a professor at MIT teaching blockchain classes, such material exists. At the CFTC, Mr. Gensler created a “holistic trade surveillance program” as opposed to prosecuting wrongdoing after the fact. A recent op-ed noted Mr. Gensler has “frequently emphasized the need for modern [government] surveillance of markets.”
Micro-surveillance of crypto where change happens quickly will likely stifle innovation and harm the burgeoning tokenized economy. (Mr. Gensler’s 2018 graduate-level blockchain course doesn’t even mention DeFi, a now central part of crypto infrastructure.).
However the technology changes, Mr. Gensler believes regulators should cram it into existing cubbyholes and strictly surveil it. As matter of human nature, this is understandable. Like his predecessor, Mr. Gensler has little appetite for taking blame should some scandal arise during his tenure. Better to play it safe.
US crypto policy suffers from clear guidance
But that attitude has a flip side. US crypto policy has to date been a dismal, dreadful thing. Regulators express it though speeches (often at high-dollar conferences, off-the-cuff remarks, and confusing ‘guidance.’ Things got so bad, the Commission deemed career SEC bureaucrat Valerie Szczepanik its Crypto Czar.
But in typical government fashion, that meant to clarify only obfuscated. After industry clamor for clarification Ms. Szczepanik produced a universally panned 13-page word salad. Indeed, it even drew a rebuke from Commissioner Hester Peirce, who compared it to a “Jackson Pollock painting.” And Mr. Gensler seems unlikely to change the Commission’s take-it-slow-and-don’t-get-blamed culture.
US Crypto Policy needs bold action, it won’t come from the SEC
Mr. Gensler is obviously knowledgeable about crypto. And seems aware of its vast potential. Moreover, viewing his online lectures he is a likable fellow. But his penchant for government surveillance and regulatory minutia means real crypto guidance must arrive from the political branches (itself an unlikely scenario given the new administration’s Treasury pick).
Mr. Gensler wants to be the ‘cop on the beat.’ And that’s fine. But what US crypto policy defined rules. And less Enforcement Division constantly looking over its shoulder and handwringing about investor protection.
By Jossey PLLC via www.thecrowdfundinglawyers.com
by Jossey PLLC | Feb 4, 2021 | SEC
The Arizona State Corporate and Business Law Journal’s Winter 2021 issue features an article by Paul H Jossey, founder of thecrowdfundinglawyers.com.
Read the full article: https://bit.ly/2O6W6br
By Jossey PLLC via www.thecrowdfundinglawyers.com
