Thought Leaders
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.
AML (anti-money laundering) refers to the laws, regulations, and policies that are used by financial-based institutions to monitor and screen customers’ source of funds, and to ensure that the funds are obtained legally; AML acts as a deterrent for criminals wishing to hide and move illegal money.
A subset under the larger AML umbrella is KYC (know-your-client/customer). KYC is the collection of data by financial institutions to know its customers better and establish a customer profile that details a customer’s risk tolerance, financial position, and financial literacy. Documents often collected in the KYC process are notarized passports and utility bills, employment status, net worth, source and description of funds, etc. KYC is used to protect the financial institution and the customer.
While KYC/AML plays an important role in investing, not all financial institutions are equally thorough in the collection of KYC/AML data. There have been multiple companies in the digital asset industry that have come under fire for lax approaches to the KYC /AML verification process. By contrast, there are also multiple instances of companies in the digital asset industry that have taken proactive approaches.
Why are KYC and AML practices important?
While it would be nice to live in a world absent of bad actors, this is simply not reality. KYC/AML plays a role in creating safe and fair financial markets for everyone. They also provide a means of recourse against those found to be acting in bad faith.
There are drawbacks in trying to foster fair markets though – notably, a loss of privacy. Yes, honest investors may gain better safety, but they are also forced to give up vital identifying information about themselves. This is a valid concern; when giving up personal data, you are entrusting that it will be safely guarded by the receiving entity. Unfortunately, financial institutions are not immune to data breaches as recently made evident by the Canada Revenue Agency which had a breach of more than 48,500 accounts.
Lax Data-Gathering
Despite the noted benefits of KYC/AML, there are many companies that have opted for a half-hearted approach to these practices. The following are only two recent examples in a pool of many which highlight this.
Binance Sued
One of the largest cryptocurrency exchanges in the world, one would assume that Binance would partake in good KYC/AML practices. This, however, is not the case in the eyes of Japanese exchange, Zaif. This lesser-known exchange is now suing Binance over its ‘lax’ KYC/AML practices. The lawsuit stems around a hack of Zaif in 2018, which resulted in roughly $60M of stolen assets being laundered through Binance – an occurrence that Zaif believes would not have occurred if the KYC/AML procedures used were up to par.
ePayments Shut Down by FINRA
In this instance, payment processor, ePayments, went under a FINRA imposed lockdown in early 2020. While the company has remained quite tight-lipped regarding the reasoning for this, it is known that the lockdown stems from a lax approach to KYC/AML. In recent days, ePayments has provided a small update, indicating that it is commencing a platform restart soon – albeit with the discontinuation of support for cryptocurrencies – after months of overhauling its KYC/AML approach.
Learning by Example
Although there are those that have not placed enough emphasis on KYC/AML, others have watched and learned from these transgressions. The following are examples of this, showing both service development, and adoption.
BnkToTheFuture Invests in/Adopts Blockpass
This recent announcement is more than just an investment. BnkToTheFuture will be incorporating a tailor built solution by Blockpass, meant to facilitate comprehensive and efficient KYC/AML procedures.
Securitize makes KYC easy
Industry leading, Securitize, recently launched a new service, dubbed ‘Securitize ID’. This service was built to bring new efficiency to KYC/AML procedures. It essentially allows for an investor to be ‘whitelisted’ after completing KYC/AML processes through Securitize. Being whitelisted involves assigning a unique investor ID, which is then recognized by co-operating companies – meaning the process does not need to be repeated countless times.
A Growing Industry
If anything can be derived from these various examples, it is that the world of blockchain needs to take KYC/AML seriously. While there may not have been services to fit these needs at one point in time, this is no longer the case. Moving forward, expect to see increased adoption of these services tailor-built for KYC/AML, as companies look to avoid the wrath of regulators, and ensure fair markets for clientele.
Investors continue to flock towards assets such as cryptocurrencies and digital securities as, not only a new form of currency but a hedge against global economic uncertainty. As a result, regulatory bodies around the world have had to adapt or clarify approaches towards these alternative asset classes. The latest to do so is the Nigerian Securities and Exchange Commission.
Before jumping into what a few of these approaches are, the Nigerian SEC took the time to allay fears of an unnecessarily strict approach.
“Digital assets offerings provide alternative investment opportunities for the investing public; it is therefore essential to ensure that these offerings operate in a manner that is consistent with investor protection, the interest of the public, market integrity and transparency. The general objective of regulation is not to hinder technology or stifle innovation, but to create standards that encourage ethical practices that ultimately make for a fair and efficient market.”
Default Classification
In this recent address to the public, the Nigerian SEC was explicit in its approach towards digital assets, stating,
“The position of the Commission is that virtual crypto assets are securities, unless proven otherwise.”
By taking this stance, it removes the guesswork surrounding the treatment of digital assets. Essentially, it does not matter if an asset fails to fit the definition of a security. In order to be deemed something else, this needs to be proven to the Nigerian SEC on a case-by-case basis. Only then, with the approval of the regulatory body, can an asset be reclassified.
Where the Onus Lies
In addition to establishing its position that all digital assets are to be treated as securities by default, the Nigerian SEC elaborated on where the onus lay for those looking to change the classification of an asset.
“…the burden of proving that the crypto assets proposed to be offered are not securities and therefore not under the jurisdiction of the SEC, is placed on the issuer or sponsor of the said assets.”
Essentially, the Nigerian SEC will not be taking it upon itself to classify every asset. It is the responsibility of a tokens issuer to prove the most appropriate classification.
All Token Offerings Regulated
While the first two points of clarification maintain a focus on investors, a third was made to provide clarity to companies hosting capital generation events.
These events, which include ICOs, DSOs, and IEOs, are all subject to regulation by the Nigerian SEC. There are no forms or variations that ‘skirt’ around existing regulations. As all digital assets are deemed securities by default, this classification spills over into events meant to facilitate their sale/distribution. It is stated,
“…all Digital Assets Token Offering (DATOs), Initial Coin Offerings (ICOs), Security Token ICOs and other Blockchain-based offers of digital assets within Nigeria or by Nigerian issuers or sponsors or foreign issuers targeting Nigerian investors, shall be subject to the regulation of the Commission”
In the ICO boom of 2017, companies around the world took part in these popular means of raising capital. While many were scams, there were still many well-intentioned companies that simply were not well informed. As a result, many hosted ICOs, under the impression that securities laws would not apply when this was simply not the case.
This stance by the Nigerian SEC was made in an effort to avoid this confusion moving forward. While ICOs may not be as popular as they once were, token offerings still regularly occur in the form of DSOs and IEOs.
SEC Nigeria
The Nigerian SEC in its current form was founded in 1979. Much like similar regulatory bodies, it is tasked with ensuring fair and transparent capital markets through the creation and enforcement of regulations.
Chairman, Olufemi Lijadu, along with a 9 person board, currently oversees operations.
In Other News
At the beginning of today’s look at the actions of the Nigerian SEC, we alluded to similar occurrences in a variety of nations. Some of these occurrences involved real change, while others simply clarification. The following are a few examples of these.
On September 11, the SEC announced charges against FliK and CoinSpark, as well as five individuals associated with the two companies. The charges stem from two fraudulent ICOs (FliK and CoinSpark) held in 2017.
With 2020 being a disaster in many ways, it is easy to develop a short term memory of past years. Unfortunately for the bad actors that took part in past fraudulent ICOs, the Securities and Exchange Commission (SEC) remembers.
SEC Charges
The charges surrounding these two ICOs are various. Not only did the events represent the illegal sale and distribution of securities, but they were rife with other fraudulent activity.
- Illegal sale and distribution of unregistered securities
- Misrepresentation
- Appropriating and misusing investor funds
- Market manipulation
As a result of these charges, all parties have opted for a settlement with the SEC – each of which consists of restrictions on future market participation, along with fines that range from $25,000 – $75,000 USD.
Naming Names
The aforementioned charges are particularly noteworthy, due to the names attached to these projects. Of the 5 individuals charged, two are well-known celebrities.
Clifford ‘T.I.’ Harris – T.I. is a rapper/actor that not only promoted, and sold FLiK tokens, but also misrepresented himself as a co-owner of the project.
Ryan Felton – Primarily a film producer, Ryan Felton was the main orchestrator behind both illegal securities offerings. The SEC took the time to comment specifically on his actions, stating, “The federal securities laws provide the same protections to investors in digital asset securities as they do to investors in more traditional forms of securities…as alleged in the SEC’s complaint, Felton victimized investors through material misrepresentations, misappropriation of their funds, and manipulative trading.”
Off the Hook?
If there is one individual that may yet rest easy, and be happy with the conclusion of this saga, it would be Kevin Hart.
When the SEC first began investigating the actions of those affiliated with FLIK, Kevin Hart was among those named. Fortunately for the superstar actor/comedian, recent developments indicate that there have been difficulties proving his involvement.
For the time being, there was no mention of Kevin Hart in the SEC’s most recent communication.
Securities and Exchange Commission (SEC)
Founded in 1934, the SEC is a United States regulatory body. Its purpose is to foster fair and transparent markets, through the creation and enforcement of regulations pertaining to assets deemed securities.
Chairman, Jay Clayton, currently oversees operations at the SEC.
In Other News
When looking at some of the other high-profile cases to be settled with the SEC, news of FLiK and CoinSpark seems relatively minor. Despite this, when looking at the big picture it becomes clear that no ICOs are safe from enforcement actions by the SEC. These smaller cases discussed today are simply the latest in a long line of similar instances.
By not letting anyone ‘off the hook’, the SEC is sending a clear message moving forward that the blockchain industry needs to remain mindful of existing securities regulations, and that companies will be held accountable for their actions.