Initial Coin Offerings: The New (Controversial) Way to Raise Capital

With Bitcoin exploding in market value to over $19,000 per coin at the close of 2017, investors are intrigued by the alluring concepts of cryptocurrency, blockchain, and the decision of whether to invest in startup companies utilizing cryptocurrency.[1] Recently, initial coin offerings (ICOs) have been the primary way for cryptocurrency startup companies to raise capital, and most notably, avoid the high costs associated with the traditional initial public offering (IPO). In 2017, over $4 billion was raised through the use of initial coin offerings, and that figure was forecasted to rise significantly.[2] This article will summarize what an initial coin offering is, why it is controversial, and what the near future may hold regarding regulation for this method of raising capital.

What is an Initial Coin Offering?

An initial coin offering is a means for cryptocurrency startup companies to raise capital through crowdfunding. There are two primary reasons to create an initial coin offering: first, to create a new kind of cryptocurrency (different from Bitcoin) that has its own blockchain, or, second, to fund a project that requires a new unique currency to be effective. Most ICOs involve the second type, known as token generation events (TGE). To begin the process of an ICO, the issuing company publishes a whitepaper detailing their company business model, projections, fundraising goals, what type of currency is accepted in the offering, company timelines, and other information to incentivize investors. Upon making the decision to participate in the ICO, investors use cryptocurrency (or fiat currencies like U.S. dollars (hereinafter, “cash”), in some cases) to purchase coins, or “tokens,” from the coin issuing company. Bitcoin is the most commonly used form of cryptocurrency by investors in ICOs. Tokens purchased by the investor do not necessarily represent shares of ownership in the company, but they are similar in varying respects. Technically, they reflect a percentage of the total amount of the initial cryptocurrency produced and can be redeemed or sold on secondary markets for cash value (or Bitcoin) once the issuing company meets its funding benchmarks and launches the venture.

In a nut shell, investors are simply being offered the opportunity to “get in on the ground floor” and purchase coins for a significantly lower price than the coin is projected to reach in the whitepaper. Should the company not meet its funding benchmarks, these tokens are supposed to be refunded for the principle price paid in the currency used by the investor. Ultimately, the decision to invest in an ICO depends on the investor’s prediction on whether the issuing company will successfully attain funding milestones to produce a viable cryptocurrency that will increase in value over time, or at least will be able to return all investments made by the investor should the benchmarks not be reached.

Ethereum is an example of a successful ICO that generated a substantial return on investment for those who participated.  Ethereum uses Ether as its cryptocurrency, which was issued in 2014 at $.40 per Ether, translating to roughly $18 million in Bitcoin at the time.[3] Ethereum’s project went live in 2015, and as of today the cryptocurrency trades at $873.72 per Ether, and is the second most successful cryptocurrency to date behind Bitcoin.[4] Returns like Ethereum make headlines across the nation, and are a focal point in driving investors to take a hard look into the “cryptocurrency bubble.”

Securities Regulation of ICOs

ICOs are quite similar to a traditional IPO, save for one major aspect: enforced regulation. On July 25th, the SEC issued its first sweeping statement (a “21(a) Report”) regarding the transfer and sale of digital currency like “tokens” sold in ICOs, declaring that the federal securities laws may apply to ICOs after its investigation into The DAO.[5]

The DAO was a decentralized autonomous organization (“dao”) that used distributed ledger or blockchain technology to operate as a virtual entity, and sold tokens representing interests in the company to investors in exchange for cryptocurrency. In the 21(a) Report, the SEC confirmed that cryptocurrency in the form of tokens or “coins” sold in ICOs can be a security, and that ICO issuers and  ICOs may be subject to federal securities regulation law.[6] How these laws will be applied and when further enforcement will go into effect are uncertain at this time, but the signs of SEC movement on the issues of cryptocurrency transactions are present.

At the Senate Committee on Banking, Housing, and Urban Affairs hearing on February 9, 2018, SEC Chairman Jay Clayton was quoted as saying, “You can call it a coin, but if it functions like a security, then it’s a security,” and, most notably, “A note for professionals in these markets: those that engage in semantic gymnastics … are squarely within the crosshairs of our Enforcement Division.”[7] In most types of ICOs listed today, if one were to apply the “Howey test” (from the landmark 1946 U.S. Supreme Court decision that helped clarify what defines an “investment contract,” which itself is part of the definition under the Securities Act of 1933 of a “security”), the tokens offered would most likely be interpreted by the SEC to be securities, in that they are “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[8]

Clayton’s comments in February echo the sentiments of his statement  from December 11, 2017regarding cryptocurrency’s treatment under the Howey test and the 21(a) Report, in which he stated, “In the 21(a) Report, the Commission applied the longstanding securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, we concluded that the token offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

Recently, there has been a growing number of public statements from prominent figures regarding online market trading regulation, which indicates a possible regulatory turf war between the SEC and the CTFC. On March 7, 2018, the SEC published a statement detailing considerations both investors and market participants should assess regarding online market exchanges for ICO-based coins and tokens.[9] In addressing investor considerations, the SEC urged investors to utilize national exchanges, broker dealers, or other traditional platforms that are heavily regulated. Specifically, the SEC made it clear that even though many of these online trading markets call themselves “exchanges,” they are, in fact, not as heavily regulated at this present time the same way as traditional national exchanges. Regarding whether or not all online trading exchanges shall be subject to regulation, the SEC states:

“Some online trading platforms may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offer trading or other services related to digital assets that are securities.  For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities.  These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.  In addition, a platform that offers digital assets that are securities may be participating in the unregistered offer and sale of securities if those securities are not registered or exempt from registration.” (Id.)

This statement suggests that certain circumstances and types of transactions occurring in the online market platforms will determine what kinds of regulation requirements will be enforced, but most importantly, that there will be forthcoming enforcement on a large scale.

The SEC’s statement was issued on the heels of an opinion from the District Court for the Eastern District of New York, which on March 6, 2018 held that the CTFC had standing to bring a lawsuit for fraud and to oversee cryptocurrency (including Bitcoin and the similar Litecoin, but not necessarily including ICO-based coins and tokens), for it is within the plain language definition of a “commodity.”[10] The CTFC initially determined in 2015 that cryptocurrency was a commodity, and this Federal District Court holding strengthens the CTFC’s claim to regulatory jurisdiction over cryptocurrency.

Both the SEC and the CTFC will issue regulations on cryptocurrency, and the turf war over this hot topic will ensue for the foreseeable future as the market for virtual currency continues to grow. On March 14, Congress held its first hearing on ICOs, where “House Financial Services Committee members asked questions about such topics as hacking, use of digital currencies by criminals, defining securities, and protecting investors.”[11] Also of note, the Governor of the Bank of England gave a statement in which he said, “The time has come to hold the crypto asset ecosystem to the same standards as the rest of the financial system. Being part of the financial system brings enormous privileges, but with them great responsibilities…In my view, holding crypto asset exchanges to the same rigorous standards as those that trade securities would address a major underlap in the regulatory approach.”[12]

This regulatory crackdown by the SEC and the CTFC comes as no surprise, as there are numerous market factors that triggered the initial SEC and CFTC investigations and that continue to command the regulators’ attention, including the explosion of token offering companies and investors participating in ICOs, the exponential increase in value of cryptocurrencies, and ICO scams that defraud investors.[13]

ICO Scams Defraud Investors

ICO scams are of particular concern to the SEC, as the underlying premise of the federal securities laws are to protect investors from being deceived, by mandating public companies to file numerous types of disclosures for investor transparency. These scams occur when news spreads that startup cryptocurrency companies forecasting massive growth are preparing to launch an ICO, which prompts scammers into setting up fake website domains and portals that deceive investors. The scammers will utilize social media sites like Facebook and Twitter to quickly capture non-sophisticated investors who are researching the ICO. Once the investor submits their cryptocurrency investment into the scammer’s system, any effort to try and reclaim that investment is futile as it recedes into the dark web.

Telegram is a current example of immense market backlash from scammers hijacking ICO market anticipation. Telegram is hosting a widely anticipated ICO beginning in March, but already has faced a prominent scam that stole millions of dollars worth of cryptocurrency from investors who thought they were buying into Telegram’s ICO. English and Russian versions of the actual whitepaper were leaked, and hosted by these scammer websites, of which Gramtoken.io was the most prominent. Gramtoken.io posted project road maps, copies of the whitepaper, and information regarding the ICO to trick investors into depositing their cryptocurrency into their system. Once Gramtoken.io reached its fundraising goal of $5 million dollars, the website went dark, and the investments through Gramtoken.io cannot be located.

The difficulty in protecting cryptocurrency investments is the driving force behind these scams and is a serious concern for investors. Cryptocurrency transactions are tremendously hard to track for several reasons. First, traditional financial institutions are not involved with cryptocurrency transactions, making traceability of the flow of currency unusual. Second, cryptocurrency transactions are happening on an international scale, which restricts what information the SEC, CFTC and/or other federal and state regulators can compile on the transactions, depending on where the issuing entity is located. Third, there is no central authority or market for cryptocurrency transactions and collection of user information at this time. Finally, law enforcement has no current ability to freeze any cryptocurrency transactions, as cryptocurrency is encrypted and cannot be held by a third-party custodian like a traditional security. Together, these factors significantly impede federal, state and private legal actions and remedies for investors in cryptocurrency transactions.

Celebrity ICO Endorsements and Differing Perspectives

On February 27th, Microsoft founder Bill Gates was asked for his opinion on cryptocurrency during a question and answer session on the popular website Reddit, and responded with, “The main feature of cryptocurrencies is their anonymity. I don’t think this is a good thing. The government’s ability to find money laundering and tax evasion and terrorist funding is a good thing. Right now, cryptocurrencies are used for buying fentanyl and other drugs, so it is a rare technology that has caused deaths in a fairly direct way. I think the speculative wave around ICOs and cryptocurrencies is super risky for those who go long.”[14] Other high-profile individuals have made public statements that appeared to be endorsing specific ICOs, especially pop culture celebrities. Floyd Mayweather, DJ Khaled, Paris Hilton, Jaime Foxx, and other celebrities have made public social media endorsements of a variety of ICOs.[15] These endorsements are problematic and could potentially lead to violations of securities law regarding proper disclosures and solicitations of investors if these celebrities are interpreted to be promoters of the ICO.

Conclusion

Initial coin offerings have become the most prevalent way for cryptocurrency companies to raise capital. With the advent of cryptocurrency (including ICO-based coins and tokens) taking markets by storm, it appears they are here to stay for the foreseeable future as well. The SEC’s statements are clear that securities regulation law will be applied to coins and tokens arising out of ICOs, but numerous investor rights issues regarding traceability, jurisdiction, and lack of central authority over all cryptocurrency render enforcement challenging. While ICOs in their current form are a hot ticket item for now, a massive legal and regulatory overhaul for United States cryptocurrency transactions is undoubtedly in the works.

 

[1] Coindesk, Bitcoin (USD) Price (last visited Feb. 26, 2018) https://www.coindesk.com/price/

[2] Forbes, ICOs In 2017: From Two Geeks And A Whitepaper To Professional Fundraising Machines (Dec.18, 2017) https://www.forbes.com/sites/outofasia/2017/12/18/icos-in-2017-from-two-geeks-and-a-whitepaper-to-professional-fundraising-machines/#40e99c4e139e

[3] Investopedia, Breaking Down Initial Coin Offerings (ICO) (Feb 26, 2018) https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp

[4] EthereumPrice, Ethereum (USD) Price, (last visited Feb 26, 2018) https://ethereumprice.org/

[5] Divisions of Corporation Finance and Enforcement, Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO (July 25, 2017) https://www.sec.gov/news/public-statement/corpfin-enforcement-statement-report-investigation-dao

[6] Id.

[7] Joseph Young, SEC Hints at Tighter Regulation for ICOs, Smart Policies for “True Cryptocurrencies”(Feb. 9, 2018) https://cointelegraph.com/news/sec-hints-at-tighter-regulation-for-icos-smart-policies-for-true-cryptocurrencies

[8] “In other words, an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 1104, 90 L. Ed. 1244 (1946)

[9] Divisions of Enforcement and Trading and Markets, Statement on Potentially Unlawful Online Platforms (Mar. 7, 2018) https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading

[10] Brenden Pierson, Virtual currencies are commodities, U.S. judge rules, THOMPSON REUTERS (Mar. 6, 2018) https://www.reuters.com/article/us-usa-cftc-bitcoin/virtual-currencies-are-commodities-u-s-judge-rules-idUSKCN1GI32C

[11] Kia Kokalitcheva, Congress holds first hearing on initial coin offerings, AXIOS (Mar. 14, 2018) https://www.axios.com/crypto-ico-congress-1521059028-8807c852-22de-461a-8c9e-8a8a9f85d452.html

[12] John D’Antona Jr., BoE Push for Cryptocurrency Regulation Can Boost Markets, TRADERS (Mar. 14, 2018) http://www.tradersmagazine.com/news/cryptocurrencies/boe-push-for-cryptocurrency-regulation-can-boost-markets-117387-1.html?ET=tradersmagazine:e3646:1189431a:&st=email

[13] Jon Russell, Scammers are cashing in on Telegram’s upcoming ICO, TECHCRUNCH (Jan. 20, 2018) https://techcrunch.com/2018/01/20/telegram-ico-scammers/

[14] Reddit, I’m Bill Gates, Co-chair of the Bill and Melinda Gates Foundation. Ask Me Anything (Feb. 28, 2018) https://www.reddit.com/r/IAmA/comments/80ow6w/im_bill_gates_cochair_of_the_bill_melinda_gates/

[15] Jonathan Burr, The Bubble in Celebrity Cryptocurrency Endorsements, CBS NEWS (Nov. 6, 2017) https://www.cbsnews.com/news/bitcoin-celebrity-endorsements-cryptocurrency-sec-warning/

Cryptocurrency Technology Is Driving Innovation

Interest in cryptocurrency and its underlying technology has steadily rose over the past several years. The final week of 2017 alone saw the debut of over a dozen new cryptocurrencies within the market. Moreover, Bitcoin’s explosive increase in value in 2017 from $1,000 to almost $20,000 has made “Bitcoin” and “cryptocurrency” household terms.[1] The accelerating rate of creation of new currencies and the fluctuation in value of various existing currencies have provided investors with substantial profit opportunities. Unsurprisingly, the financial services industry is making significant investments in the underlying block-chain technology. From individual programmers to large fintech firms, there is a race to secure the intellectual property rights for all aspects of block-chain and cryptocurrency technology.

Financial Services

The block-chain technology functions to increase security and decrease inefficiencies regarding cyber transactions. The software accomplishes this by securely hosting a transaction between two individuals without the requirement of a third party to transfer and record the exchange of funds (i.e. banks, credit card companies, etc.). The transactions are then publicly memorialized in a distributed ledger as a link in the chain’s archive. At its core, the block-chain model is a peer-to-peer system; because of this, the software has the potential to revolutionize the financial services industry by reducing the number of parties required to send and receive payments. This decentralized model is one of the characteristics that makes block-chain unique, and financial firms have recognized the tremendous value of the software.

As the value of the block-chain model became more apparent, the United States Patent and Trademark Office (“USPTO”) was flooded with new patent applications concerning block-chain and cryptocurrencies. At the end of 2017, Bank of America, Mastercard, Paypal and Capital One were leading the field in research and development, and represented the top four patent holding entities in the realm of block-chain and cryptocurrencies.[2] The primary technological focus of these top four firms has been financial forecasting, digital data processing and transmission of secure digital data.[3] In fact, Bank of America was recently issued its latest patent from the USPTO, which outlined a cryptocurrency exchange system that would seamlessly convert one digital currency to another.[4] It may be no coincidence that the top four firms leading research and development on block-chain are those that stand to lose the most from the elimination of third-parties in cyber transactions. It is important, at this point in block-chain’s development, that such firms secure a position on the new playing field if cryptocurrency does displace traditional transaction models.

Internet Data Usage

The sprint to secure intellectual property rights does not, however, solely focus on the current block-chain technology; firms are also looking ahead on how to improve the software and how to benefit from future developments and applications. Several firms are focusing specifically on the distributed ledger aspect of block-chain in order to create a personal virtual identity for each of the software’s users.[5] This concept has significant potential to allow individuals to begin to profit off of their personal data. Currently, websites such as Google, Amazon and Facebook track individual’s internet usage and gain considerable value from their personal data with little to no benefit to the user. The creation of an online avatar that hoards this data in a ledger, and makes it available only with the user’s permission, could bring significance to an individual’s internet browsing data. Users could begin to charge companies a fee to gain limited access to this information, even in miniscule amounts. Cryptocurrency effortlessly weaves itself into the system because currencies like Bitcoin are divisible to the hundredth of a millionth degree. This divisibility makes it possible for you to extract value from as little as 0.00000001 of a Bitcoin for a company to see that you have been looking at Volkswagens on Craigslist all afternoon.

This virtual identity system may not be too far off. In 2017, the state of Illinois launched a block-chain pilot for the digitization of personal data, such as birth certificates.[6] The system has the potential to be the framework for the digital identities discussed above, and could further establish an extraordinarily convenient method of sharing verified personal documents.[7] Although this system immediately raises the question of cybersecurity in the minds of most, block-chain technology is, in fact, vastly more secure than our current systems.[8]

Cyber Security

In 2017, Equifax saw one of the largest cyber security breaches in history. The current method of storing millions of individuals’ personal data is piling it together on the same system, which is then encrypted and secured. The issue, as illustrated by Equifax, is that once the security mechanisms are breached, the cyber burglar then has access to the entirety of the stored data.[9] Block-chain, however, stores each individual’s data separately in its own encrypted and secured space. If a hacker wished to steal data from a block-chain, they would be required to decrypt each of the individual’s data separately; in the case of Equifax, the hacker(s) would have been required to bypass 140,000,000 encryptions.[10] For this reason, cyber security firms are becoming increasingly involved in block-chain technology as well.

Mobile Applications

The cyber security and financial services industries are not the only industries honing in on the cryptocurrency craze. It is also worth mentioning the flood of new applications from the mobile software market. The rapid origination rate of mobile applications, no matter how redundant or superfluous they may seem, is compelling United States intellectual property filings. Cryptocurrency mobile applications can provide a wide range of services for their users: market information through applications such as zTrader, Bitcoin Checker and Bitcoin Price IQ; portfolio services through Cryptonator, CoinDex and Mycelium; and trading platforms through Coinbase, CEX.IO and CoinCap. More significantly, many of the most popular websites which provide mobile application support are beginning to accept cryptocurrency as a payment method. Notably, online retailer Overstock.com, online dating service OkCupid.com, electronics retailer Newegg.com, and travel booking agency Expedia.com are among the firms now accepting bitcoin as payment for their services.[11] Cryptocurrency also has the potential to transform the mobile gaming industry.

A dimension of mobile applications which has received a lot of negative publicity over the past few years is predatory in-app purchases. Many mobile gaming applications, which are typically marketed to children and teenagers, are free to download and play, but incentivize frequent micro-transactions from the user. These aptly dubbed “freemium” games result in cases of young users racking up a bill in the range of several hundreds of dollars, to their parent’s surprise. In fact, many applications offer purchases of in-game currencies up to $99 per transaction. This model may change, for better or for worse, with the rise of cryptocurrency. As discussed above, the Bitcoin is divisible to the hundredth of a millionth degree. The mobile gaming industry could see a transition from incentivizing young players to make frequent large transactions, to mobile games charging a fraction of a Bitcoin per minute (or second) of game time. The application would likely request access to your Bitcoin wallet and simply deduct fragments of a Bitcoin for as long as the game remains active. Whether this will be a welcome change is to be determined.

Conclusion

Cryptocurrency and block-chain technology are causing us to rethink our current financial and cyber-social systems. The characteristics that make block-chain unique—the decentralized model, distributed ledger, individual security, sense of virtual identity—are quickly being applied in new and innovative ways. The result is a surge in new intellectual property from forward thinking firms as we move into what may be an important technological shift for many of our country’s industries.

____________________________________________________________________________________

[1] Coindesk, Bitcoin (USD) Price, Coindesk (last visited Jan. 2, 2018) https://www.coindesk.com/price/.

[2] Jay Sharma, How Bitcoin Became a Game Changer Overnight, IPWatchdog (Dec. 4, 2017), http://www.ipwatchdog.com/2017/12/04/bitcoin-game-changer-overnight/id=90519/.

[3] Id.

[4] Nikhilesh De, Bank of America Wins Patent for Crypto Exchange System (Dec. 7, 2017, 3:00 UTC), https://www.coindesk.com/bank-of-america-outlines-cryptocurrency-exchange-system-in-patent-award/; the Bank of America patent granted by the USPTO is identified by United States Patent No. 9,936,790.

[5] Michael Mainelli, Blockchain Could Help Us Reclaim Control of Our Personal Data, Harvard Business Review (Oct. 5, 2017), https://hbr.org/2017/10/smart-ledgers-can-help-us-reclaim-control-of-our-personal-data.

[6] Michael del Castillo, Illinois Launches Blockchain Pilor to Digitize Birth Certificates, Coindesk (Aug. 31, 2017, 23:00 UTC), https://www.coindesk.com/illinois-launches-blockchain-pilot-digitize-birth-certificates/.

[7] Id.

[8] See Mainelli, supra note 5.

[9] See Mainelli, supra note 5.

[10] Id.

[11] Mariam Nishanian, 8 surprising places where you can pay with bicoin, Business Insider (Oct. 11, 2017 6:00 PM), http://www.businessinsider.com/bitcoin-price-8-surprising-places-where-you-can-use-2017-10/#expediacom-1.

SEC Proposes Regulation Best Interest for Brokers

On April 18, 2018, the SEC proposed “Regulation Best Interest,” which is the latest in a long and disputed line of proposed attempts by various governmental bodies to homogenize the duties owed by brokers and investment advisers to their respective clients. Professionals in the financial services industry and others should take note that they have until approximately July 23, 2018i to file a public comment on the proposed SEC rule, and investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.

BACKGROUND

For decades, customers of the financial services industry have been confused by (if not outright unaware of) the different “standards of care” that their “brokers” and “investment advisers” have owed them.

On the one hand, “[a]n investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care.”ii Investment advisers typically charge for their services via an annual fee assessed as a percentage of the “assets under management” (the so-called “AUM”) that the investment adviser “manages” for the client. The primary regulator of an investment adviser is either the SEC (usually for relatively larger investment advisers – i.e., those managing more than $100 million AUM) or a state securities commission (usually for relatively smaller investment advisers – i.e., those managing less than $100 million AUM).

On the other hand, brokers “generally must become members of FINRA” and are merely required to “deal fairly with their customers.”iii  FINRA Rule 2111 requires, in part, that a broker “must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [broker] to ascertain the customer’s investment profile” (the “suitability” standard).iv  Rather than a percentage of AUM, brokers’ compensation is typically derived from commissions they charge on each of the trades they execute for their clients. FINRA, a non-governmental organization, is the primary regulator for almost all brokers in the U.S.

At first blush, a layman retail client could easily be excused for struggling to understand the difference between the requirements of an investment adviser to “serve the best interests of its clients” and those of a broker to “deal fairly with their clients.” This confusion is exacerbated when a broker is also registered as an investment adviser, thus clouding what “hat” the advisor is wearing when dealing with a client.

Tortured Regulatory History

Regulator concern about this confusion has existed for decades.  In 2004, the SEC retained consultants to conduct focus group testing to ascertain, in part, how investors differentiate the roles, legal obligations, and  compensation between investment advisers and broker-dealers. The results were striking:

In general, [the focus] groups did not understand that the roles and legal obligations of investment advisers and broker-dealers were different. In particular, they were confused by the different titles (e.g., financial planner, financial advisor, financial consultant, broker-dealer, and investment adviser), and did not understand terms such as “fiduciary.”v

In 2006, the SEC engaged RAND to conduct a large-scale survey on household investment behavior, including whether investors understood the duties and obligations owed by investment advisers and broker-dealers to each of their clients. First, it should be noted, “RAND concluded that it was difficult for it to identify the business practices of investment advisers and broker-dealers with any certainty.”vi  Second, RAND surveyed 654 households (two-thirds of which were considered “experienced”) and conducted six focus groups, and reported that such participants –

…could not identify correctly the legal duties owed to investors with respect to the services and functions investment advisers and brokers performed. The primary view of investors was that the financial professional – regardless of whether the person was an investment adviser or a broker-dealer – was acting in the investor’s best interest.vii

In 2010, the Dodd-Frank Act mandated the SEC to conduct a study to evaluate, among other things, “Whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers relating to the standards of care for providing personalized investment advice about securities to retail customers that should be addressed by rule or statute,” and to consider ”whether retail customers understand or are confused by the differences in the standards of care that apply to broker-dealers and investment advisers.”viii A conclusion of that study was as follows:

[T]he Staff recommends the consideration of rulemakings that would apply expressly and uniformly to both broker-dealers and investment advisers, when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2).

In 2013, the SEC issued a “request for information” on the subject of a  potential “uniform fiduciary standard,”ix but never promulgated a rule after receiving more than 250 comment letters from “industry groups, individual market participants, and other interested persons[….]”x

Finally, on April 8, 2016, the U.S. Department of Labor adopted a new, expanded definition of “fiduciary” to include those who provide investment advice or recommendations for a fee or other compensation with respect to assets of an ERISA plan or IRA (in other words, certain “brokers”) (the “DOL Fiduciary Rule”). Many brokerage firms and others (such as insurance companies) made operational and licensing adjustments to prepare for the DOL Fiduciary Rule while various lawsuits were filed in attempts to invalidate the controversial rule. Most recently, the United States Court of Appeals for the Fifth Circuit vacated the DOL Fiduciary Rule on March 15, 2018.xi

“Suitability” Standard vs. “Fiduciary” Standard

The “suitability” standard of a broker is a far cry from the “fiduciary” standard of an investment adviser.  As the SEC has stated, “Like many principal-agent relationships, the relationship between a broker-dealer and an investor has inherent conflicts of interest, which may provide an incentive to a broker-dealer to seek to maximize its compensation at the expense of the investor it is advising.”xii  Put more bluntly, “there is no specific obligation under the Exchange Act that broker-dealers make recommendations that are in their customers’ best interest.”xiii

FINRA (including under its former name, NASD) has certainly striven to close that gap via its own interpretations and disciplinary proceedings, and has succeeded to a point.  Specifically, a number of SEC administrative rulings have confirmed FINRA’s interpretation of FINRA’s suitability rule as requiring a broker-dealer to make recommendations that are “consistent with his customers’ best interests” or are not “clearly contrary to the best interest of the customer.”xiv However, the SEC has highlighted that these interpretations are “not explicit requirement[s] of FINRA’s suitability rule.”xv

This lower duty of care for brokers (as opposed to investment advisers, who have a fiduciary duty) has had and continues to have purportedly large and definitive financial consequences for retail investors:

Conflicted advice causes substantial harm to investors. Just looking at retirement savers, SaveOurRetirement.com estimates that investors lose between $57 million and $117 million every day due to conflicted investment advice, amounting to at least $21 billion annually.xvi

A 2015 report from the White House Council of Economic Advisers (CEA) estimated that –

[…]conflicts of interests cost middle-class families who receive conflicted advice huge amounts of their hard-earned savings. It finds conflicts likely lead, on average, to:

  • 1 percentage point lower annual returns on retirement savings.
  • $17 billion of losses every year for working and middle class families.
SEC”S NEWLY-PROPOSED “REGULATION BEST INTEREST”

Despite the controversy over the DOL Fiduciary Rule and its recent, apparent defeat, the SEC has been working under the guidance of Chairman Jay Clayton since 2017 to finally rectify the confusion among investors as to the different standards of care applicable to brokers versus investment advisers.xvii

The latest development in that regard has been the proposal by the SEC of “Regulation Best Interest” (“Reg. BI”) on April 18, 2018.xviii  The proposed rule is significant in its proposed breadth. Subparagraph (a)(1) of the proposed rule would provide as follows:

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.xix

This is a sea change in the duty of care owed by brokers to their retail clients, as it would effectively enhance a broker’s duty of care to approximate that of an investment adviser’s (at least in regard to retail clients).xx

To satisfy the “best interest” obligation in subparagraph (a)(1), subparagraph (a)(2) of Reg. BI would impose four component requirements: a Disclosure Obligation, a Care Obligation, and two Conflict of Interest Obligations.xxi

For the “Disclosure Obligation,” subparagraph (a)(2)(i) of Reg. BI would require the broker to –

reasonably disclose[] to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation.xxii

For the “Care Obligation,” subparagraph (a)(2)(ii) of Reg. BI would require the broker to “exercise[] reasonable diligence, care, skill, and prudence to” do the following:

(A) Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;

(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and

(C) Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.xxiii

Finally, for the two “Conflict of Interest Obligations,” subparagraph (a)(2)(iii) of Reg. BI would require the following:

(A) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations.

(B) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.xxiv

Furthermore, Reg. BI would expand the SEC’s records requirement rules (i.e., Rules 17a-3 and 17a-4) to  provide that “[f]or each retail customer to whom a recommendation of any securities transaction or investment strategy involving securities is or will be provided,” a broker obtain and maintain for six years “[a] record of all information collected from and provided to the retail customer pursuant to [Reg. BI].”xxv

CONCLUSION

The SEC’s proposed “Regulation Best Interest” is a significant proposal that could have far-reaching impact across the securities brokerage and other segments of the financial services industries. Whether this latest regulatory effort to establish a more consistent standard of care for brokers and investment advisers will succeed is unknown, but the proposed rule is certainly an aggressive step in that regard.

All those interested will have until approximately July 23, 2018 to file a public comment on the proposed rule. Meanwhile, investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.

ENDNOTES

i   The specific date will be established once the proposed rule is published in the Federal Register.

ii   Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (“Study”), at iii, available at www.sec.gov/news/studies/2011/913studyfinal.pdf.

iii  Study at iv.

iv  FINRA Rule 2111(a), available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=15663&element_id=9859&highlight=2111#r15663, as of April 23, 2018.

v   Study at 96.

vi  Study at 97.

vii Study at 98.

viii Study at i.

ix  See Request for Data and Other Information: Duties of Brokers, Dealers and Investment Advisers, Exchange Act Release No. 69013 (Mar. 1, 2013), available at http://www.sec.gov/rules/other/2013/34-69013.pdf.

x   Regulation Best Interest, Exchange Act Release No. 34-83062 (April 18, 2018) (“Reg. BI Proposal”), at 20, available at https://www.sec.gov/rules/proposed/2018/34-83062.pdf.

xi  Reg. BI Proposal at 27.

xii     Reg. BI Proposal at 7.

xiii Reg. BI Proposal at 8.

xiv Reg. BI Proposal at 14, fn. 15.

xv Reg. BI Proposal at 8, fn. 6.

xvi Reg. BI Proposal at 20, fn. 28, quoting Letter from Marnie C. Lambert, President, Public Investors Arbitration Bar Association (Aug. 11, 2017) (“PIABA Letter”).

xvii    Chairman Jay Clayton, Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers, Public Statement, June 1, 2017, available at https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31.

xviii   See Reg. BI Proposal.

xix Reg. BI Proposal, at 404.

xx In a related SEC proposal regarding investment advisers that was also dated April 18, 2018, the SEC stated that “[a]n investment adviser’s fiduciary duty is similar to, but not the same as, the proposed obligations of broker-dealers under Regulation Best Interest,” and that “we are not proposing a uniform standard of conduct for broker-dealers and investment advisers in light of their different relationship types and models for providing advice[….]” See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. IA-4889 (April 18, 2018), available at https://www.sec.gov/rules/proposed/2018/ia-4889.pdf.

xxi Reg. BI Proposal, at 404.

xxii Reg. BI, subparagraph (B), Reg. BI Proposal, at 404.

xxiii   Reg. BI Proposal, at 404-405.

Subparagraph (b)(2) of Reg. BI would define “retail customer’s investment profile” as including, but not be limited to, “the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer in connection with a recommendation.” Reg. BI Proposal, at 406.

xxiv   Reg. BI Proposal, at 405.

xxv      Reg. BI Proposal, at 406-407

Pastore & Dailey Represented Mortgage Services Company in Financing Transaction

Pastore & Dailey represented a mortgage servicing company in a financing transaction designed to allow the company to service a multinational bank.   The transaction required expert and careful drafting and negotiation as it involved affiliates as well.   Goodwin Proctor’s San Francisco office represented the lender.

Suspension of Trading for Hong Kong Blockchain Firm

Last week, on January 8, 2018, the Securities and Exchange Commission (“SEC”) suspended trading of UBI Blockchain Internet, Ltd. (“UBI”) stock until January 22, 2018.[1] UBI, formerly JA Energy, is a Hong Kong-based technology firm focusing on the Blockchain technology underlying cryptocurrency.[2] Coincidently, one of the focuses of this over-the-counter traded company is on the application of the distributed ledger technology to trace food and drug products from the producer to the consumer.[3] According to UBI’s legal counsel, the motivation behind this innovation is to prevent counterfeit products.[4]

The erratic behavior of UBI shares caught the eyes of the SEC in early December as the company’s stock sky-rocketed in price. On December 1, 2017, shares of UBI were trading at $6.12, and just eighteen days later, the value had swiftly rose to $83.00 per share, and even selling as high as $115.00 per share.[5] The subsequent decline in value was just as precipitous. Within a week of its peak, the value of UBI stock had fallen to $29.00 per share and further down to $22.00 per share before the close of the 2017 year. The freeze on trading allows the SEC an opportunity to investigate the causes of the sudden and drastic changes in the firm’s stock activity.

The SEC is tasked with closely monitoring the trading activity of publicly traded companies. Spikes in value and in the volume of trades within the market, like those seen here with UBI, raise red flags for the SEC to act upon. Pursuant to Section 12(k) of the Securities Exchange Act of 1934, the SEC may temporarily suspend the trading in particular securities pending an investigation.[6] In the case of UBI, the commission cited two distinct justifications for its suspension: concerns with (1) the accuracy of assertions dating back to September 2017 regarding the company’s business operations; and (2) the unusual and unexplained market activity in the company’s Class A common stock since November 2017.[7] It remains to be seen whether the cause of the fluctuation was caused by SEC violations or by a frenzy as the market responded to UBI’s pharmaceutical application of the Blockchain technology.

_____________________________________________________________________________________________________________

[1] U.S. Securities and Exchange Commission, Securities Exchange Act od 1934: Release No. 82452,  https://www.sec.gov/litigation/suspensions/2018/34-82452.pdf (last visited January 14, 2018, 3:05 PM).

[2] Matt Robinson, Crypto Stock That Surged 900% in 2017 is Hit With SEC Halt, Bloomberg (Jan. 8, 2018, 10:39 AM), https://www.bloomberg.com/news/articles/2018-01-08/crypto-stock-that-surged-900-percent-in-2017-gets-sec-suspension.

[3] Cory Johnson, How One Mysterious Startup is Riding the Bitcoin Wave, Bloomberg (Dec. 27, 2017, 12:17 PM), https://www.bloomberg.com/news/articles/2017-12-27/bedwetting-to-blockchain-how-one-startup-rode-the-bitcoin-craze.

[4] Id.

[5] UBI Blockchain Internet Ltd., Marketwatch, https://www.marketwatch.com/investing/stock/ubia/charts (last visited January 14, 2018, 3:07 PM).

[6] See supra note 1.

[7] See supra note 1.

SEC Issues Report on the Application of Federal Securities Laws to Crowdfunding through Cryptocurrency

On July 25, 2017, the Securities and Exchange Commission issued a Report following their investigation of The DAO.  The DAO is an unincorporated organization that is just one example of a “Decentralized Autonomous Organization” –  a virtual organization embodied in computer code and executed on a distributed ledger or blockchain.

The DAO was formed in 2015 as unique form of crowdfunding whereby participants would vote on proposals and be entitled to rewards.  Between April and May of 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether.  Ether is a form of virtual currency.  These DAO Tokens gave the holder certain voting and ownership rights.

Token holders could vote on predetermined proposals deciding where The DAO invested its money, with each token holder’s vote weighted according to how many DAO Tokens he or she held.  On June 17th, 2016, an unknown individual or group attacked The DAO and appropriated approximately 1/3 of the total funds.  Although the funds were eventually recovered by The DAO, the SEC began investigating the attack and The DAO.  Ultimately, the SEC determined that an Enforcement Action was not necessary, however it issued a report laying out how the Securities Act and the Securities Exchange Act applies to The DAO and similar entities.

Section 5 of the Securities Act prohibits entities not registered with the SEC from engaging in the offer or sale of securities in interstate commerce.  Upon investigation of the circumstances surrounding The DAO, the SEC stated that The DAO qualifies as an “issuer” and thus must register as such with the SEC in order to sell DAO Tokens – which the SEC considers to be securities – in compliance with federal securities laws.  Given the SEC’s flexible interpretation and application of the Act, this Report is a caution to virtual entities that the federal securities laws are applicable and that the SEC intends to pursue enforcement of these laws in the field of virtual currencies and securities.

IRS Seeks Leave from Court to Serve Sweeping Summons on Bitcoin Exchange

In an ex parte Application for Leave to Serve John Doe Summonses dated November 17, 2016, the Internal Revenue Service requested of the United States District Court for the Northern District of California the authority to obtain the records of Coinbase, Inc. a bitcoin exchange located in San Francisco.

By its own terms, the request is speculative, relying on an undefined “likelihood” that the resulting summons will yield information identifying persons who have not properly filed or paid taxes due the United States. The only defined term upon which the request is based is IRS Notice 2014-21, which described the Services views on virtual currencies and offered the position that bitcoin (and similar devices) are not “currency” but, rather, are property under 26 U.S.C. §1221. Although the Notice reached this conclusion without analysis or authority, it is probably correct, at least for the moment. Only because bitcoins neither circulate nor are they customarily used and accepted as money in the country in which they are issued, they do not meet the definition of currency in the Bank Secrecy Act. 31 CFR 1010.100(m). Presumably, Treasury adopts this definition for tax purposes.

The request has alarmed the cryptocurrency community because it comes in the wake of absolutely nothing. No criminal case, claims of interviews with only three taxpayers who said they has used virtual currencies as a means of evading taxes, and not even a named suspect in the summons request. The report of the Treasury Inspector General for Tax Administration dated September 21, 2016 observes three critical issues:

  1. The IRS has no strategy concerning virtual currency;
  2. The Criminal Investigation unit of the IRS has undertaken no effort to inquire in matters concerning the improper reporting of bitcoin; and
  3. Notice 2014-21, so far the IRS’s only formal articulation of its position regarding bitcoin, characterizes bitcoin as property, not as currency, although the device is commonly accepted as currency by over 100 major organizations including Subway, Microsoft, Reddit, and Expedia. Many users of bitcoin are likely unaware of the Notice or uncertain of its arcane meaning.

Thus, for the IRS to use as its opening salvo into the matter of virtual currency what is described by its target as a “sweeping fishing expedition” gives every participant in a cutting edge technology pause to consider if the IRS should be able to leverage that enterprise to make up ground in its own investigative dilemmas. In short, should Coinbase become an involuntary source of data for the government absent more evidence supporting a wholesale compromise of the privacy of their customers’ information?

Preserving Loan Treatment of S Corporation Payments from Shareholders

The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.

Among the most prevalent and cherished characteristics of S corporations is the perception  by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.

On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.

In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.

All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged.  (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)

The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.

With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.

The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)

These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.

This article is not intended as legal or tax advice and is a discussion of general principles only. The reader should consult with a qualified professional concerning his or her specific circumstances before taking any action.

$3MM DECD Approval

Pastore & Dailey’s transactional team successfully concluded a $3 million loan financing transaction on behalf of client NewOak Capital, a specialized financial advisory firm based in New York City that provides consulting, analysis, and technology services to global banks, insurance companies, asset owners, and regulators.  The financing was provided by the State of Connecticut Department of Economic and Community Development (DECD) in connection with NewOak’s $13 million relocation project which established its credit services division, NewOak Credit Services, now located in the Matrix Corporate Center in Danbury, Connecticut.  Under the terms of the loan, the company plans to create up to 50 jobs during its first year and up to 100 jobs within three years.

 

DECD Small Business Express Program Financing Transaction

In April 2013, Pastore & Dailey’s transactional team successfully concluded a combination grant and loan financing transaction on behalf of a New Haven based manufacturer serving the aerospace industry.  The transaction was completed in connection with the recently established State of Connecticut Department of Economic and Community Development (DECD) Small Business Express Program which seeks to provide the maximum return on investments to state taxpayers in the form of job creation and capital investment.  The DECD funding will play a key role in the expansion and modernization of our client’s manufacturing facility located in New Haven, Connecticut as well as the creation of a number of new full-time jobs in Connecticut.