Jai Massari and Trevor Kiviat are attorneys with Davis Polk. Chris Brummer is a Georgetown law professor
Any time spates of fraud and abuse disproportionately involve any particular kind of financial product, advocates for the investing public naturally assume that more regulation is necessary—especially when it comes to disclosure—in order to restore market integrity. Whether following the stock market crash of 1929 or the 2008 financial crisis, reform-minded critics have, with good reason, demanded in the wake of widespread market shenanigans more abundant, publicly available information to help enable investors to make better-informed capital allocation decisions and reduce their vulnerability to wrongdoers.
Policy makers and regulators have again turned to this solution as they consider Initial Coin Offerings (“ICOs” or “token sales”). Since their inception in 2013, ICOs have functioned largely as unregulated forms of fundraising that have driven a spectacular spike in funding, with an estimated $5.6 billion (USD) raised worldwide across 435 ICOs in 2017 alone, rivaling traditional venture capital funding. Yet they have also been associated with fraud, failing firms, and alarming lapses in information sharing with investors. So not surprisingly, concerned observers have gravitated to the expansiveness of the Securities Act—and its explicit application to nontraditional securities, otherwise known as “investment contracts”—with a belief that registration would tame digital asset markets and in the process bolster informed investor decision making.
Yet in our our study, What Should Be Disclosed in an Initial Coin Offering, we unsettle the all-too-common assumption that Securities Act registration and disclosure requirements, as they currently exist, offer adequate remedies for the increasingly obvious shortcomings of ICOs. Specifically, we contend that, as currently constituted, the Securities Act and its accompanying regulations offer, at best, only a partial remedy to the disclosure challenges that ICOs pose.
We cite two broad reasons. First, we evaluate the economics of ICOs offering “utility” and “non-financial” rights and argue that, even assuming total informational efficiency in ICO token markets, the price determinants of such will not be identical to those that inform the prices of traditional securities like stocks and bonds.
Our theory is that cryptoeconomics puts a twist on conventional financial pricing. Specifically, we assert that where tokens do not offer direct profit participation (as traditional equity securities do) or coupon payments and eventual redemption at par value (as traditional debt securities do), investment returns for a token will rest squarely on the ultimate commercial utility of the technology under development—and the ability of management to realize optimal results. It is this future utility value that must be ascertained and properly discounted for present-day purposes.
Second we take a walk through the major disclosure forms— Form S-1, crowdfunding’s Form C, Form 1-A for Regulation A+, and Rule 144A—to show that the New Deal disclosure regime developed over the last 70 years failed to fully anticipate the technological features presented by ICOs. As a result, disclosures required under U.S. securities laws—from private placements to full-fledged registered offerings—fail to provide investors with the information a typical investor would need to make a reasonably informed investment decision.
Specifically, we examine a number of factors that should impact pricing of (non-security) ICO tokens, but are arguably not addressed under traditional securities law disclosures including:
• Blockchain (as opposed to corporate) governance
• Token creation and mining
• Token “burning” operations
• Technology team (in contrast to executives and directors)
• Utility valuation (as opposed to financial statements)
• Technology source code
We also note the over-reliance on financial statements which, given the angel-stage qualities of many ventures, is inapplicable for retail investors and likely of less relevance (or protection).
Finally, we observe that these disclosure deficits are compounded by a lack of viable third parties to verify them. In short, a new mechanism for evaluating source code, and metrics for plain-English disclosures, are required in an age of digital assets.
Ultimately, we think these observations hold important lessons for policymakers. Subsuming ICO tokens into existing regulatory frameworks may prove helpful as a starting point for proper regulation and market stability. However, this starting point requires an additional longer-term process of rethinking key applications of both domestic securities concepts and financial economics to the sector. Getting rules right may not require starting from scratch, but it will require more than just extending an existing regulatory regime to a new asset class.
A full copy of the article (along with streams of charts tracking different disclosure forms) can be found here, and will be published in Cryptoassets, a book project supported jointly by the International Monetary Fund and Georgetown University’s Institute of International Economic Law. Comments on the draft are welcome and can be sent to [email protected]