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5 Major Takeaways from SEC’s New Investor Protection Rule – Thought Leaders

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5 Major Takeaways from SEC's New Investor Protection Rule - Thought Leaders

It seems that the controversies surrounding SEC’s newly adopted Regulation Best Interest rule (Reg BI), would continue to take center stage, even though it goes into effect next summer. The regulation is the culmination of a decade-long process that started in 2010, immediately after the great recession. The Dodd-Frank Act passed that same year authorized the SEC under section 913 to enact a fiduciary standard and best of interest rule to govern broker-dealers and investment advisors when engaging with private investors.

In the aftermath of the introduction of Reg BI, stakeholders, state regulators, investment advisers and broker-dealers have weighed in on various factors that could undermine or aid its effectiveness.

5 Key Takeaways 

  1. Brokers Dealers required to adhere to new “best interest” standard
  2. Sets up U.S. Department of Labor (DOL) to synchronize rule-making (later this year)
  3. Big win for broker dealers  → even bigger for financial services
  4. The New Common Reporting Standards (CRS) Says Broker = Advisor → confusion between  broker vs fiduciary advisor
  5. Reverse focus on protecting brokerage role than consumer = more confusion 

However, before we highlight these takeaways, let’s first take a look at the substance of the fiduciary standard clarification rule.

The Takeaways from SEC’s Regulation Best Interest Rule

SEC intends to subject broker-dealers, who currently are only required to meet suitability standards, under fiduciary standards.

On one hand, fiduciary standards presently govern the relationship between financial advisors and their clients. And it expects the former to only offer services that are in the best interest of the latter. On the other hand, suitability standards require brokers to ascertain that the investment they recommend suits their clients.

In essence, the rule looks to extend the fiduciary rule on broker-dealers who are increasingly taking up the roles of financial advisors, when their primary duty is to sell an investment product for a stipulated commission. Under the suitability standard, it is legal for a broker to recommend an investment product that avails him a good commission, so long the product is suitable to the customer.

While this is a given, it also presents a conflict of interest. It’s possible that there are cheaper investment products with similar features to the one the broker recommends, but with a less attractive commission. This conflict of interest is what the Reg BI looks to eliminate, as it requires brokers to place the client’s interest above theirs.

To do this, the rule would enforce brokers to explicitly disclose important information such as incentives and commissions that could influence their recommendations. More so, it would, to an extent, ban industry practices, like incentives in the form of vacations, that could spur brokers to betray the interests of their clients.

Knowing fully well that brokers could find a way around this requirement by disclosing conflict of interests with technical terms or in a voluminous document, the SEC also introduced another requirement that could counter such practices. The requirement states that brokers must outline conflict of interests and their compensation structure in plain English and in a concise manner on a document called form CRS.

Also, brokers would document the history of legal or disciplinary actions taken against the firm offering the investment product or its financial professionals. Another vital feature of the rule is Care Obligation. This requirement entails that financial advisors to make sure that they diligently and carefully ensure that their recommendations are in the best interest of their clients.

The last requirement is the Conflict of interest obligation. It requires the management and mitigation of commissions that could represent a financial conflict of interest.

Dissecting the Implications of The Regulation Best Interest Rule

As expected, critics left and right have dissected SEC’s Reg BI, and the prominent argument that many have brought up is the fogginess of the rule. For one, some critics have condemned SEC’s reluctance to clearly define what it means by “Best interest”, the actions that would suggest that an investment advisor is not compliant, and how to mitigate financial conflict of interest.

Chances are that broker-dealers would look to find a way around this rule, at least until SEC starts enforcing disciplinary actions against non-compliant investment advisors. Besides, Reg BI does not seem to have enforcement muscle. It is unlikely that non-compliance would lead to class action lawsuits and litigations.

Furthermore, there is an outcry that SEC’s rule has done nothing to clarify to investors the roles of Investment advisors and broker-dealers. Note that a majority of brokers-dealers are registered with the SEC. Technically, this means that they could assume the roles of Registered Investment Advisors (RIA), and yet, they are not fiduciaries.

More concerning is the fact that the Form CRS requirement would do little to change the status quo. This notion stems from the fact that studies showed that consumers found it difficult to understand the contents of CRS forms.

While responding to many of the criticisms leveled against Reg BI, SEC’s chairman, Jay Clayton stated that “differing views were expressed regarding whether the standard should be more principles-based or more prescriptive — and in particular, whether to provide a detailed, specific, situation-by-situation definition of ‘best interest’ in the rule text.” 

As such, after careful consideration, the agency concluded that the principle-based approach adopted for the rule “is a common and effective approach to addressing issues of duty under law, particularly where the facts and circumstances of individual relationships can vary widely and change over time, including as a result of innovation,”

Judging from the details of Reg BI discussed above, there is no doubt that the rule has elements of the fiduciary rule that the Obama administration proposed through the Department of labor. The difference is that the latter was looking to classify all investment professionals as fiduciaries. In other words, a client could decide to sue his investment advisor or broker once he notices any discrepancies that would suggest that his interests were not best served by the actions of his investment manager.

Recall that this rule hit a roadblock under the present administration, as the securities industry challenged its viability in court. And while DOL has also indicated that it is pushing for a new fiduciary rule, there is no guarantee that its future proposal would have the same grit as the previous one. This assertion is probable, considering the likelihood that Eugene Scalia, the attorney that led the case against DOL’s previous fiduciary rule, would emerge as the new Labor Secretary.

Also, it is important to note that the Certified Financial Planner Board of Standards plans on enforcing an ethics code that would entail that its 84,000 members adhere to fiduciary standards, irrespective of the regulatory frameworks that govern them. Interestingly enough, this code’s implementation date coincides with that of Reg BI’s.

More importantly, some states are contemplating on taking matters into their own hands by imposing separate fiduciary rules that would correct the apparent flaws of Reg BI. For instance, New Jersey’s security bureau has released a rule proposal that explicitly classifies brokers- dealers as fiduciaries. Other states that have taken a similar path are Nevada and Massachusetts.

In response to this development, SEC’s chairman, Jay Clayton, stated that “I and many others believe a patchwork approach to the regulation of the vast market for retail investment advice will increase costs, limit choice for retail investors and make oversight and enforcement more difficult. I am hopeful that our regulatory colleagues will continue to work with us to minimize inconsistencies and maximize the effectiveness of our collective efforts.”

However, regardless of the loopholes of Reg BI, and the controversies that spurred responses from state regulators, I believe that the SEC’s proposal is a step in the right direction in order to protect investors. 

For investors, it is a matter of asking the right questions: 

  1. Who pays your broker’s commission?
  2. How much he gets paid for encouraging you to buy an investment product. 
  3. Are you a fiduciary?
  4. How does a broker apply investor protection rules? 

 

The information provided here is personal opinion and provides only a subjective opinion of the rules and regulatory guidance provided by the SEC. It should not be read as legal or compliance advice. Consult with your compliance professional for further details.

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Constantin is a venture partner at BitBull Capital, CBO at ABOTMI, and has been a cryptocurrency investor since 2012. He has 10+ years experience in corporate leadership, technology and finance. He contributes to the digital asset space, sharing and value economies.

Thought Leaders

Solving the Liquidity Puzzle for Security Tokens – Thought Leaders

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Solving the Liquidity Puzzle for Security Tokens - Thought Leaders

There is a wide consensus in the financial industry that blockchain technology is going to disrupt the securities market. However, despite the claims, there is no double-digit annual growth of securities on blockchain, which would be expected from a disruptive technology. The reason for that are regulatory roadblocks that don’t allow delivering the biggest promise of digital securities – liquidity for previously illiquid securities. In this article we break down this problem and present a solution.

What are security tokens/digital securities?

From a legal perspective, security tokens are common securities and are subject to the same regulations. The difference is that records about securities ownership are stored on blockchain instead of paper-based or other forms of records. That’s why they are often called digital securities.

Innovative technology significantly improves operations with securities, making them digital and automated. In particular, transfer of digital securities is much easier and may happen in minutes or seconds instead of weeks, spent on signing physical contracts, doing compliance checks and updating government registers.

Why liquidity is so important for security tokens

Liquidity of an asset defines how easy it can be sold. For example, publicly listed securities are highly liquid, while real estate and startup equity are highly illiquid. Although security tokens have multiple advantages, greater liquidity is a principal one. For this reason, they often represent ownership in traditionally illiquid assets.

Mass adoption of security tokens first and foremost requires interest from investors, which will create incentives for businesses to issue digital securities instead of traditional ones. For investors, lack of liquidity is the biggest problem of securities that are not listed on exchanges as it makes investments in them riskier and makes investors wait for decades until they pay off. Therefore, unlocking liquidity of security tokens is crucial for their mass adoption.

Why is liquidity in the conventional meaning of the word is out of reach for security tokens

In the narrow sense of the world, securities are considered liquid if they are traded on a stock exchange. For this reason, lack of regulated secondary markets is considered the main limitation. However, this ignores the fact that there are already operating exchanges for security tokens: tZERO, Open Finance, MERJ, GSX – but very few tokens are listed there. Furthermore, Open Finance is on the edge of delisting all security tokens because their trading does not generate enough fees to support operations.

Therefore, the problem is not in the lack of marketplaces. It is in fact that listing on an exchange is overly complicated. It requires registering the offering at competent authorities, having minimum trading volume, minimum market cap, being under increased reporting requirements, which often include annual audit. Basically, it requires becoming a public company. These requirements will arise not only in the case of listing on a classical exchange but any kind of regulated market. This means that listing on a regulated trading venue is not feasible for most security token issuers.

Such a flawed understanding of the problem stems from crypto origins of security tokens. They were seen as a regulated continuation of utility tokens and cryptocurrencies, for which listing on exchange is much easier, so it became a synonym for liquidity. This myth should be debunked in order for the market to move to more realistic sources of liquidity.

How is liquidity for security tokens possible?

To answer this question, we need to go back to an original definition of liquidity, which is the ability to quickly sell assets at any moment. It has two main components: complexity of conducting the transaction and how easy it is to find a counterparty.

The former problem is solved by blockchain technology. Its main benefit for private securities is that it vastly simplifies conducting the securities transaction, making it possible to do everything online in a few minutes. Conventionally, transfer of securities would require signing physical agreements, reporting changes to the government register, settling a transaction via a wire transfer, and doing manual compliance checks on individuals engaged into the transaction.

Complexity of the transfer also impacts the number of potential counterparties. When the transfer is complicated and expensive, it becomes not feasible to transact small amounts. This cuts off smaller traders and investors from the market, making it even harder to find a counterparty.

The problem of finding a counterparty is traditionally solved by an order matching mechanism of exchanges, which for security tokens is not feasible. Therefore, the key to unlocking liquidity is in creating an efficient way to find counterparties for transactions that would not be considered a regulated market. 

This way is already known. It is a bulletin board for P2P transactions. As these transactions are private and do not involve an intermediary, they don’t require regulation. However, there are a number of nuances and requirements for such a venue not to be regulated, which will be covered in a separate article.

To the author’s knowledge, at the time of writing there is no venue that enables legally compliant and efficient P2P liquidity for security tokens.

What impact unlocking the liquidity of security tokens will have on capital markets?

Currently, venture investors may sell their shares only if businesses they invest into go public or are acquired. This has two implications, which both lead to money being used inefficiently and slow down the economic growth.

Firstly, it means that only businesses with the potential for IPO are worth investing. Businesses that can offer a solid yield but don’t offer “disruption” and outsized returns are deprived of funding. These are often businesses with a need for high capital investments – manufacturing, agriculture, physical infrastructure etc. The problem with a lack of capital investment is covered in a widely discussed article in Andreessen Horowitz blog “It’s time to build”.

Secondly, illiquidity makes VCs prioritize growth over profitability because when most investments don’t pay off even a 10x exit from successful ones may be not enough. It creates incentives to scale even when the business model is not tested enough, leading to extremely large companies, such as WeWork or Uber, struggling to deliver a profit.

The plague of private markets has impacts on public markets as well. It leads to the emergence of the IPO bubble, when more than 80% of newly public companies are not profitable. It is problematic because public securities are considered less risky, and thus fit into portfolios of retail funds and pension schemes, harming them by being overpriced.

Thus, solving the liquidity problem will have a drastic impact not only on the VC industry but on the entire economy.

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HODL Your Hoopla Over SEC Changes For Exempt Offerings – Thought Leaders

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HODL Your Hoopla Over SEC Changes For Exempt Offerings - Thought Leaders

Last week the The U.S. Securities and Exchange Commission released a proposal – that has yet to become regulation – to simplify how exempt offerings are done. Shortly thereafter, a flurry of articles and newsletters made their way through the digital asset industry – many of which suggested their platforms were already being modified to fit the new rules. While the SEC has proposed changes, time will tell whether the proposal is adopted  – and if so, whether there will be changes to the final draft that will be published to the Federal Register.

The US exempt offering framework includes tools such as Reg D, Reg A, crowdfunding (a.k.a. Reg CF)  – essentially everything that is not a public or retail offering. This framework has seen little in the way of changes or modernization since the Securities Exchange Act of 1934. There has been significant public criticism of the current rules for exempt offerings, largely because they reserve access for only the wealthiest Americans to invest in private funds, companies, and other offerings.

If passed, the proposed changes could allow for the average person to invest in earlier stage deals – such as Uber or WeWork – before they reach their lofty valuations and dumped into the public markets. Enabling SPV (special purpose vehicles) and harmonized reporting (ie combing Reg D and Reg CF into one, not two reports), and increasing the total amount that can be raised would help streamline compliance for issuing firms. Additionally, the changes could also enable crowdfunding to become a viable capital formation tool for investing in such asset classes as real estate.

Currently, US offering exemptions such as Regulation CF (crowdfunding) are quite restrictive, limiting the total amount you can raise to $1.07M USD per 12 month period and includes significant restrictions per investor.  The US SEC appears to be following the lead of other jurisdictions such as Canada where regulators proposed similar changes, or Europe where regulations were updated last year, increasing the limits for the EGP (European Growth Prospectus) to €8M EUR, a little over $9M USD. According to the new proposal, companies would be able to raise up to $5M USD. While $5M is still a relatively small amount of capital, it does allow early stage companies to build their tribe with a broader investor base.

The SEC proposed similar changes to Reg A, increasing the upper limit to $75M USD. This could make Reg A viable for many later stage companies where larger Series B, C, or even D rounds demand more capital than what is currently available in Reg A.. This also opens up these investment opportunities to the retail investor, previously these deals were only available to the wealthiest corporate venture firms, private equity shops, and high net worth individuals.

Further changes include allowing accredited investors to participate in crowdfunding. Previously, if you used a crowdfunding exemption, you could not accept funds from accredited investors and would actually have to use another exemption, such as Reg D, simultaneously. This typically forces companies into more paperwork, legal fees, and an increased risk of getting something wrong – which could result in regulatory or civil actions. The proposed changes would enable companies to combine accredited and retail investors into one offering.

Aside from accredited investors, the changes also open the doors to institutional and corporate investors, including the SPV (Special Purpose Vehicle).

An SPV is a corporate entity created for a specific purpose – usually for reasons such as limiting liability, tax efficiency, investment, or capital formation. For example: In order to tokenize a piece of real estate, you might form an SPV, and transfer the deed to the real estate into this company. The purpose of that company/vehicle is to hold the deed of this real estate and maintain a accurate record of who the owners are, SPVs are commonly used for investment funds as well.

Combined, SPVs, corporate investors, accredited investors, and major institutional investors can move large amounts of capital. However, they weren’t able to invest in crowdfunding offerings in the US. This created an interesting paradox for companies raising capital, if you could get the big fish interested, you would avoid the crowd – but, if your offering didn’t look good enough for professional investors, your last resort may be crowdfunding. The crowdfunding industry as a whole has faced a lot of criticism from professional investors for low returns and low deal quality, this is likely to change when retail investors have access to the same deals as larger institutions.

Finally, the new crowdfunding regulations propose several major changes to how much each investor can put into any one offering. Currently, investors who do not meet the accreditation thresholds were limited on how much they could invest based on the lower of their income or net worth. The new regulations would change this to the greater of those two. These changes are expected to not only fuel innovation, they are likely to bring in a lot of smart money as well.

For example, an investor with a net worth of $750,000 and an income of $150,000 couldn’t qualify as an accredited investor. This person has a Phd in bioscience and finds a startup with a revolutionary innovation in the field of bioscience – they are not qualified as an accredited investor and barred from investing. Ironically, they can be an advisor to any institutional investor on why this particular startup is so hot – but under the current rules, they are not qualified to risk their own money.

While these changes are welcomed by most market participants, they are not a sure thing. This proposal for a new exempt offering framework is not yet regulation, it still has to make it’s way through the government and be entered into the Federal Register. Looking back at the proposals for crowdfunding in the US we can see how different a proposal can be from the regulation – and there are still a lot of lobbying dollars that want to see the status quo maintained. It is important to not make important business decisions based on this proposal – rather, look at these changes as a larger trend among securities regulators globally.

We’re seeing securities regulators trying to make easier for distributed capital formation. Crowdsales and crowdfunding are actually becoming something that the regulators across around the world are working together to harmonize their frameworks. By combining the crowdfunding regulations from jurisdictions around the world, early stage companies would be able to access global capital and build a global investor base, without being forced to break the rules like most of the ICO and STO issuers are doing today.

Perhaps the most exciting thing about the SEC’s proposed changes is how they demonstrate a very coordinated effort among securities commissions globally. As this new era of capital formation emerges, businesses will be able to combine and leverage the regulatory frameworks of multiple countries. That being said, for US based offerings, we still have to wait for the new regulations before knowing what they will look like, or their impact on the digital securities industry.

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Why EU blacklisting the Cayman Islands matters for the STO industry – Thought Leaders

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Why EU blacklisting the Cayman Islands matters for the STO industry - Thought Leaders

On February 18th the European Union added the Cayman Islands to its tax haven blacklist. While this has not made the news in the security token industry, it has had major implications. Due to the strict demands of AML & KYC in many jurisdictions, regulators are focusing more resources on beneficial ownership, tax transparency, and enforcement.

For companies raising capital, the blacklisting means you should not take money from a Cayman fund if you’re a European issuer. In the EU, a lot of the investment in security tokens, real estate, and private equity comes from or through Cayman fund structures. Cayman is also where a large portion of American VC funds are domiciled.

The current tax haven blacklist also includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands, Vanuatu, and Seychelles.

Any company taking funds from a Cayman domiciled fund, or working with a platform/issuer/bank in that market should be aware that being associated with a blacklisted country could create significant new risk exposure for your project, and possibly yourself. These changes are effective immediately. Until recently, most firms could fly under the radar but the EU is also rolling out a public registry of corporate ownership. This will not only make non-compliance much easier to spot but also increases the ability for regulators in the EU to investigate and enforce.

The regulation could impact people working at (including directors, officers, or significant shareholders) a company that received funding from a Cayman source after the blacklist date. Enforcement severity changes by country but can include criminal charges, company seizure, and known associates may end up on a variety of sanctions and watch lists. Not to mention the reputational damage.

This is a good example of why a good AML program does not only consist of face matching a document and pinging an API to name match a sanctions list – you are opening up your venture, and most likely yourself, to massive liability. Your legal and regulatory obligation is to take a risk based approach. What that looks like can change by country, transaction value, activity history, etc., so AML program needs to be dynamic, robust, and comprehensive enough to catch things like narrative sanctions.

For example: The most popular security token platforms today only use KYC for digital onboarding of natural persons – not corporate entities. However, when you look at the investors in their previous token issuances you can see that most of the funds are coming from corporate accounts, corporation owned wallets, but the on-chain transaction and KYC is done by an individual. These platforms are missing the technical capabilities to spot transactions coming through blacklisted jurisdictions such as Grand Cayman.

iComply recently helped a virtual asset exchange pass the audits needed to offer their users the ability to spend virtual assets, such as Bitcoin and Ethereum, with a Visa card. This process involved independent audits from Visa, their banks, and regulators – each wanted to see the client demonstrate how they would be able to identify these risks and fulfill the requirements of a whole web of regulations.

Now that they have passed the audit, they are first to market with a very compelling offer compared to their competition who still have months of development on their AML systems before their applications will go through. Using iComply to get ahead of the regulations has also put them ahead of their competition.

We can expect the same for the security token market. Token issuers need to pay close attention to their AML compliance – Telegram had to refund over $1B USD over AML, has spent millions in court with the SEC, and the OCC has not even started with them yet…after that, how many of their “not investors” will be ready to jump onto an investor class action lawsuit? We have already seen this with the recent OCC case against MYSB in New York, or with the SEC and AirFox in Boston.

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