Show notes
How crypto and blockchain technology should be regulated The SAFT white paper The Cardozo Blockchain Project SAFT response, “Not So Fast” Are ICOs For Utility Tokens Selling Securities? Prominent Crypto Players Say Yes IRS Nabs Big Win Over Coinbase In Bid For Bitcoin Customer DataTranscript
Laura Shin:
Hi, everyone. Welcome to Unchained, the podcast where we hear from innovators, pioneers, and thought leaders in the world of blockchain and cryptocurrency. I’m your host, Laura Shin, a senior editor at Forbes covering all things crypto. If you love Unchained, please, give this show a positive rating or review on iTunes. Also, spread the word on Facebook, Twitter, Slack, Telegram, and wherever you discuss crypto, and don’t forget to follow me on Twitter, @LauraShin.
This week’s episode is brought to you by ONRAMP. Your branding and web site are the first things your users will see, and in the current wild west of ICOs and blockchain startups, you need to stand out from the pack. ONRAMP is a full-service creative and design agency that will help amplify your brand with the perfect web site, logo, collateral, or custom design project. Get big results in no time by visiting thinkonramp.com. Before we dive in today, some good news and bad news.
The good news is that I finally have a new mic, so hopefully you will not be hearing the echo-y atmosphere that you were hearing before. Hopefully, it sounds much crisper and clearer. The bad news, as you can probably tell, is I have a terrible cold, so you will be listening to my scratchy voice in its full glory. I also wanted to give you all a heads-up that today is the last episode of season three. I can hardly believe it. This means that after today’s episode, we’ll be taking a month-long break, but we will be starting season four in early January, so be sure to tune back in. Some of our most-requested guests are going to be on the show for season four.
Today’s topic is regulation. Here to discuss the myriad ways regulation affects the crypto and blockchain space are Marco Santori, who leads the blockchain technology team at Cooley, and Josh Klayman, who leads the blockchain and smart contracts group at Morrison and Forrester. Welcome, Marco and Josh.
Marco Santori:
Hi. Thanks for having us.
Joshua Ashley Klayman:
Thanks for having us.
Laura Shin:
So, Marco, let’s start with you. How did you get into blockchain and cryptocurrencies, and what do you do in the space?
Marco Santori:
Well, I’ve been in crypto since late 2012, when I first got involved by posting on web forums, and I once saw an ad for a Bitcoin miner by Butterfly Labs, which is, of course, no longer a thing, and it dates me considerably, but it was the concept of a financial system that people could own themselves that really got me interested in crypto. And since then, we’ve been chasing that dream of decentralized finance, both me and the folks on my team. We have represented the largest exchanges, the largest wallet providers, the most active investors, and more recently, I think, some of the best token sales.
Laura Shin:
And what are some examples of your clients?
Marco Santori:
You know, we don’t kind of rattle off client lists, but I will say that some of the more well-known token sales that we’ve worked on in the space include Filecoin and Numerai and Augur. We represent some of the larger exchanges, and one of the, obviously Blockchain.info is the largest wallet service in the world, and we’ve long been counsel to Blockchain, since before they were a company.
Laura Shin:
And by the way, I just wanted to say, 2012 doesn’t date you, I think gives you a lot of cred in this space. Okay, Josh, what about you? What do you do in this space, and how did you get into blockchain and cryptocurrencies?
Joshua Ashley Klayman:
Thanks, Laura. So, I admittedly started a bit later than Marco in this space. My background is as a leverage finance and corporate lawyer. So, I represented a lot of banks and financial institutions, and while I had heard about cryptocurrencies, Bitcoin, the like, what really got me involved and interested was when I started seeing that some of our clients were beginning to explore the space. For example, certain banks were starting to develop incubators, or starting to look into the development of smart contracts.
And since one of the things that they were saying that they were most interested in doing was reducing legal spend, that certainly was a reason for us all to go very deep on this. Currently, we represent a number of different kinds of transactions. We’ve been working on token sales. We work with a lot of hedge funds that want to trade crypto. We work with banks providing acquisition financing for, say, acquisition of token exchanges and others in the space. We work with broker dealers, relayers, exchanges.
We work on smart contracts matters, and for institutions developing blockchain-based trading and other platforms. We work with venture funds, and we’re even working with some institutions that are considering provision of Bitcoin futures.
Laura Shin:
And can you give examples of some of your clients?
Joshua Ashley Klayman:
Sure. Similar to what Marco said, we don’t typically reveal names of clients. However, I can name a few. For example, venture funds include those like Outlier Ventures. Some of the token-sellers that we’ve represented include Cosmos. We represent a number of large exchanges and relayers. Of the relayers, we represent Radar Relay. Of the exchanges, we’re working, for example, with an exchange from Gibraltar as well some of the other large exchanges, and we work with a lot of major global financial institutions, banks, and asset managers, such as, for example, those in the league of Blackrock.
Laura Shin:
Okay. So, as you can see, just from the client list that you guys have given, there’s many different types of players in this industry, and for that reason, there’s many different regulatory agencies that could also have jurisdiction, you know, for the various different players. So, as a lawyer in this space, for all the different types of projects that you might take on, what are all the different agencies you have to keep in mind, and like, can you give a very brief description of each of them, and explain how cryptocurrencies might fall under their jurisdiction?
Marco Santori:
Sure. You know, early on, everybody was talking about FinCEN, the Financial Crimes Enforcement Network, which is a bureau of the Department of the Treasury that is tasked with administering the Bank Secrecy Act. So, they in 2013 famously published the Guidance, that brought the cryptocurrency industry for the first time under federal regulation officially. So, the Department of the Treasury, when you’re dealing with money, obviously the Securities and Exchange Commission, the SEC, when you’re dealing with securities and investments.
CFTC, when dealing, the Commodity Futures Trade Commission, when you’re dealing with commodity futures and commodity derivatives in general. There’s state regulators, both on the securities side and on the money services side, it’s the sort of state banking regulators. The lesson to take from this is that blockchain technology and cryptocurrencies aren’t regulated as a technology, generally speaking. It depends on the application. So, whatever they’re used for, it’ll fall under the appropriate regulator, and sometimes the inappropriate regulator.
Joshua Ashley Klayman:
And I would just add to that list a few more. For example, the IRS, also state regulators in both the money-transmitter and securities spaces, and of course, all of the regulators abroad, because many of these transactions are global in nature.
Laura Shin:
Okay, so, let’s start with securities law, because that’s kind of really of the moment, and the SEC, at least for now, is the agency that most people think of when they’re thinking about regulation in this space. I actually, before we dive into this, just want to briefly describe a security for, or define a security for the listeners who may not know, although if you are interested in this, I recommend that you check out the episode with Coin Center from the fall of 2016. That was a great episode, and they dive pretty deep into some of the different things that we’ll be discussing in this section.
But just for the purposes of our discussion, many people, when they’re thinking of a security, they go back to the Howey Test, which is one of the landmark cases that defined a security, and there are four prongs to the Howey Test. First is that it’s an investment contract in a common enterprise, with the expectation of profits dependent on a third party or promoter, and you need to fit all four prongs to be defined as a security. So, for Marco and Josh, do you want to maybe kind of take that definition and apply it to tokens to give an example of maybe a token that’s kind of an obvious security?
And it could be, you know, one that has already been labeled one by the SEC, or one that went the way of choosing to be regulated as a security.
Joshua Ashley Klayman:
So, there are broad definition found in both the Securities Act and the Exchange Act for what is a security. And so, in addition, in that laundry list of categories, one of those is investment contract. So, when people talk about the Howey Test, the Howey Test is the test that the SEC has announced will be used to determine whether a token is an investment contract. So, there are other types of securities out there that would not be subject to that test, and the bottom line with that test is that it is a facts and circumstances test, and there have been many years of case law that have interpreted aspects of the Howey Test since the original Howey case, which is a 70-plus-year-old case.
In addition to the four prongs, many believe that other certain factors may matter, including manner of sale.
Laura Shin:
And what does that mean?
Joshua Ashley Klayman:
Manner of sale is the way in which a token-seller would be selling or promoting the token. So, you could have a token that you might not, on its own, think has the characteristics of a security, but if it is being promoted by the token-seller or by some agent or other promoter as being a great investment that’s going to increase, you know, X percent, and you’re really marketing that token as a security, many believe that that will have an impact on the overall facts and circumstances test as to whether a token is a security.
Marco Santori:
And there’s actually a good example of that in recent news, the PlexCoin case, where SEC brought, has recently announced an enforcement action against PlexCoin. There’s really no evidence that any security was actually created, but in the manner of sale, in the manner of offering that PlexCoin used, they were advertising guaranteed returns, and they were of course outrageous returns, and SEC stepped in. And frankly, behind the scenes, very little was going on. There was no security activity. There was no venture behind the scenes, or at least SEC alleges. So, manner of sale has recently been proven to be a very important issue.
Laura Shin:
That’s interesting. When you say that there was no venture, meaning, like, they didn’t have anything in a GitHub, or what?
Marco Santori:
Well, the idea is that regardless of what’s actually going on with the enterprise, whether it is an enterprise at all, or whether it’s just a Ponzi scheme, if it’s advertised as a security because of this manner-of-sale concept, if it’s being marketed as a security, SEC has jurisdiction to step in. So, you know, you could imagine a dystopia where some defendant could claim, “No, no, no, there’s really no security here. It’s just a Ponzi scheme, and so, you don’t have any jurisdiction, SEC.” That’s not the case here, which it just…
Laura Shin:
That’s interesting.
Marco Santori:
…it just reinforces Josh’s point.
Joshua Ashley Klayman:
Thanks, Marco. Yeah, I mean, the Cyber Unit had said, you know, that this was an outright, I’m not going to give an exact quote, but they indicated that this was a cyber scam or cyber fraud. But the fraudulent claim really relates to the manner of sale and promising the investment return.
Laura Shin:
So, Marco, I know you have a proposed method for what you believe is a way to have a token sale without running afoul of securities laws. What is that method?
Marco Santori:
Well, to sort of level-set, the method is referred to as the SAFT framework, and we didn’t invent the SAFT, that document that underlies the framework. The SAFT is the Simple Agreement for Future Tokens. It’s a security instrument that a lot of people were using out on the west coast for a number of months before we found out about it, before our clients brought it to us. They were using it to sell tokens to accredited investors or investors in general prior to the functionality of the token, prior to the launch of the token-based network.
And we took a look at it, and we were curious as to whether this thing would actually work, whether it would pass muster under the existing securities laws. And the document itself had some flaws, and we thought that we could rework it, and we did, and we published it, along with a broader framework and set of principles for how token sales might be regulated in the US, and for, and at least a first swing at how you might navigate the US securities laws in connection with a token sale.
And very roughly, at a high level, it goes like this. At first, when there’s no network, when there’s no token that works, you can sell this instrument, this SAFT, to investors, pursuant to the securities laws, which means you can do a private placement with accredited investors, you could use Regulation A-Plus, you could use Regulation S, all of these exemptions from the registration requirements of the securities laws.
Laura Shin:
And actually, can you quickly define Reg A-Plus and Reg S?
Marco Santori:
Yeah. Regulation S is just one of the many exemptions from the securities laws that allows you to sell securities without having a registration statement in place. So, Regulation S is for offshore offerings. Regulation D is for private placements. Regulation A-Plus is known as the mini-IPO, where you actually can sell to the public without going through all of the requirements of the securities laws for doing an IPO, only sort of some of them. They’re limited requirements, and the idea being that you don’t actually create these non-functional tokens, these trading sardines that are only good for handing back and forth and speculating on exchanges.
You don’t create those things. Instead, you just sell a piece of paper, you sell a document pursuant to the securities laws, like you would do, like you would’ve done if you were selling to venture investors. Then, you take the millions and millions of dollars you raise from selling this document, and you put them to work building the network. Maybe it fails, maybe it succeeds, but your early investors are taking on that enterprise risk that otherwise would’ve been taken on by the public.
And then, once the token is functional, once it works, once the network does everything that you said it was going to do, you can create the tokens, deliver them to the investors, and the SAFT is extinguished. They get their tokens, and you can also sell those tokens to the public if you wish. The investors can sell those tokens to the public if they wish, you know, the idea being at that point, the thing works, it’s more of a product, it’s more of a commodity than anything, and the people who are buying it aren’t taking on enterprise risk anymore.
If they take on risk, it’s product risk. It’s the kind of risk that the public is supposed to take on under at least the US laws. So, that’s generally the framework. It was a first stab as a way to get these tokens out to the public while still obeying at least the spirit of the securities laws, and we think the letter of the laws as well.
Laura Shin:
And so, that framework also kind of relies on this, at least to my interpretation, it relies on this idea of a utility token not being a security, which is something that hasn’t, the SEC hasn’t really commented on yet, but to my mind, the way I interpret your proposal is that before the network launches, that it, then a SAFT really fits all four prongs of the Howey Test, because it’s an investment contract in a common enterprise, with an expectation of profits, and the success of this venture depends on this third party who’s building this network.
And then, once the network launches, then, you know, it’s harder to say that the success of it depends on that group of people, plus it’s not necessarily investment contract because maybe people are trying to use the network sort of like, especially if, for people who go back and listen to that Coin Center episode, you’ll hear Peter Van Valkenburgh talk about how there’s, I guess, some case with, like, let’s say it was with a, I think a Manhattan condo. So, in this example, maybe you purchase a condo, and of course, you expect that someday the value of it will go up, and so when you sell it, it’ll be worth more.
But that’s not really, you know, the main reason you’re buying it. The main reason you’re buying it is presumably to live in it. But Josh, I know you disagree with Marco’s proposal here with this method. Why?
Joshua Ashley Klayman:
So, first I’d like to say that many of us, including Marco and I, are working together to try and find compliant ways that we all agree on. It’s not so much that I have a very strong disagreement with Marco’s position. However, there are some risks that many of us, or some of us who participate in the Cardozo Blockchain Project report, that we thought it was important to bring to people’s attention. The reason for this, just before I go into what the actual disagreement is is that as Marco noted, the SAFT white paper and the SAFT Project was designed to propose a possible solution, you know, and to invite discussion.
However, what happened, and Marco, at any point in this if you disagree with what I’m saying, of course jump in…
Marco Santori:
No, so far we’re onboard, and I think what you’re doing is articulating one of the real concerns that I continue to have with this. So, please go on.
Joshua Ashley Klayman:
Okay. So, what we were seeing was that some people either hadn’t heard or hadn’t wanted to hear this idea that this was a proposal, and that this was not the final answer. There was also a form of SAFT that was attached to the SAFT white paper that people, many founders, you can understand, they would want some kind of certainty, right, in a land where there’s a lot of gray and a lot of facts and circumstances. And so, some people were seizing upon this form, and deciding that this was the answer, and that this was settled in stone.
So, people would actually come to me and come to others and say, “Hey, yeah, so, we have this idea. We’re going to do a token sale, and of course, we’re going to do a SAFT first,” and you know, if you would start questioning things or probing, they often would say things like, and this was actually said to me, “You need to get smart on the SAFT.” So, it was important to actually have some sort of public response, just to say, hey, listen, you still, you need to consult lawyers in any event, and you shouldn’t be using this form, and there are some risks associated with it.
So, with that, I’ll kind of go into what some of the concerns are, and I will say that in prior discussions that Marco and I have had, it seems that some of the more strong statements, at least in the form, are not necessarily used in every SAFT that even Cooley uses. Certainly, many other firms, us included, we are exploring pre-sale and pre-order agreements. So, this disagreement is not to say that there’s no way that you could do a pre-sale, pre-order, or a so-called SAFT.
One of the key points that we thought was important to bring to people’s attention, and this goes back to the idea of manner of sale, the actual form of SAFT that was attached to the SAFT white paper, it had statements in it made by the token-purchasers that basically said they were purchasing solely for investment and to derive a profit from the tokens, and not for consumptive use. The reason that this is potentially a challenge, if you’re trying to end up at the end of the day with a token that may not be a security, of course, at that later point you would still have to do the full analysis to determine whether you thought that token was a security.
The challenge with having this initial first step is that if you view the transaction as a single transaction, and a token as the single token, at the end of the day, you could end up in a position where the token is made available, and a material portion, even potentially a majority of the tokens that were purchased, may have been purchased by purchasers who explicitly said that they were not going to use the token, and that they were only purchasing for investment.
And in fact, you would have a token-seller that was in the position of having pretty much encouraged that purchase for investment. So, since it is a facts and circumstances analysis, while it certainly is a better fact potentially, at the end of the day, the token that sold has immediate consumptive use, and can be used. That’s a good fact, right? But it’s potentially a worse fact that you may have, as the token-seller or others, have encouraged purchasers to purchase for investment. So, that’s why we say that there are some risks involved in just that very setup.
Now, a few other things I’ll just hit on briefly. If people want to see in great detail more of this, they can look at the Cardozo Blockchain Project report, but a few other things. Some of these are my own thoughts that aren’t necessarily in the report. One is that there’s no bright-line test for when something has utility. So, that, there needs to be some sort of understanding and nuance there, in terms of when you determine that the token is functional versus pre-functional, and that can be hard in a software situation, because, you know, we all have, if we’re using computer software, there are updates, there are patches.
Things are continually being done, and it’s hard to say that when something becomes 1.0, it’s suddenly functional, whereas at .9, it wasn’t. Also, this is another point that I think is important, and this is my own just personal view, is that the SAFT form that was attached to the SAFT white paper did not contain a description of the token to be sold. Now, ideally, you would have your white paper completely baked, right, and you’d have a full description of what’s being sold, or at least, if that’s not possible, at least you would have some minimum characteristics of the token to be sold that you’d include in that.
Now, why would you want to do that? Well, because when the token is actually delivered, there’s always the possibility that the purchasers who purchased pursuant to a SAFT or pre-order or pre-sale agreement, that they may have, they may get the token and say, “This isn’t what I wanted. This isn’t what I ordered. This isn’t what I bought.” And while it’s very hard to stop someone from suing you, or from, you know, bringing a case, it may discourage its fact-finder, be that a judge, a jury, an arbitrator, from having to do a full look at every email that was sent, at all kinds of conversations, everything else that was said either before, during, or after the sale.
If you can kind of get that fact-finder to stay within, or encourage them to stay within the four corners of the pre-sale document, the SAFT, or whatever you’re going to call it, that would be helpful to the token-seller. And then, one last quick point on this is that it’s important, particularly if you are having a token-seller that is based outside of the US, that throughout this process you work closely, if you are going to use a SAFT, a pre-order agreement, or a pre-sale agreement, that you work very closely with your local counsel around the world.
For example, and I’m not a Swiss lawyer, and by the way, nothing on this podcast by any of us is legal advice or investment advice, or frankly, in my case, it’s not on behalf of my firm, just my person thoughts, but in the case of, for example, a Swiss foundation, if you were to pair a SAFT, a pre-order agreement, or a pre-sale agreement with this Swiss foundation, there are aspects of a Swiss foundation, as I understand it, that make it hard to actually say that you can enforce the requirement to later sell the tokens by the Swiss foundation, because usually the most that you can do with respect to a Swiss foundation is to make a recommendation to the Swiss foundation that it then later sell tokens.
So, it’s important to work, of course, closely with local counsel, and if there’s one take-away, I’d say, from this, it is, please, no matter what kind of process you’re going to follow, please reach out to experienced counsel, because just like how the Howey Test has been interpreted by many, many, many cases, and it isn’t just those four prongs that one might think of, there are nuances to it that have been developed over many years. It’s important if you’re considering a pre-sale to consult counsel. Apologies, Laura.
Laura Shin:
So, in a way, your objection basically boils down to doing something like this kind of takes out all the nuance, and because whether or not an offering is a security depends on the facts and circumstances of that case, this sort of gives people a false sense of safety, or creates some sort of bright line that maybe doesn’t actually exist. Is that sort of, like, the general take-away from…because that was sort of, like, what I heard underneath all of your different points.
Joshua Ashley Klayman:
That’s the general take-away. I will say this, though. If you are looking at the facts and circumstances of a particular token, and you can wait until the token does have functionality, so to speak, or does have, you know, some, it’s at some later point, that’s a positive in general for that facts and circumstances. But I guess the point is that by merely having a pre-sale that’s sold for investment purposes, that goes into your facts and circumstances.
So, if you imagine a token that did not have that investment pre-sale, and you’re just doing the analysis of the token, whether or not it’s ready to go, right, versus if you have the same token that had a significant investment pre-sale, it’s possible that the token with the pre-sale, because of the manner of sale, could look more like a security than that identical token if it had not had a pre-sale.
Laura Shin:
Okay.
Marco Santori:
So, let me respond briefly to that, and then there are a couple of things that I want to confess about the SAFT framework in general. So, one, I think that the concerns raised about the document, the actual SAFT instrument, I think that those concerns are valid. And you know, we don’t actually use that strawman sort of starting point, a piece of paper that we included at the back of the white paper, the example instrument. We don’t use that exact language. It was sort of a first stab, and I think, you know, it’s probably the least important part of the SAFT framework in general, right, because you can substitute different terms for each particular deal.
But one of the objections that I hear quite often is that a SAFT might actually make the token sale look more like a security, and as someone who’s litigated for much longer than I’ve actually been, you know, a magical internet money lawyer, that objection doesn’t ring true to me. I think that if you can compare Story A to Story B here, Story B makes a lot more sense to a court, Story A being we sold this thing, and a bunch of people took on enterprise risk, and they may have lost their investment funds, but oh well. Whereas Story B is, well, there was enterprise risk early on, and we gave that enterprise risk to accredited investors.
We made them take on the risk that this whole enterprise fails, and then, when the thing worked, at least it did what we said it was going to do in the white paper at the initial launch. Then we sold it to the public, and they took on product risk. I think that’s a much more compelling story. So, far from creating a greater risk that the ultimate token be considered a security, I think a pre-sale acts in the opposite direction. I think that it creates a very compelling narrative to a court, or a judge.
Joshua Ashley Klayman:
It may. I think, again, I think there’s so much gray in this, and because it’s facts and circumstances, there are different ways you can look at things. I mean, certainly, you’re right. An enterprise risk is an important concern, and the regulators are tasked, particularly the SEC, with protecting the investing public, and they are particularly concerned about retail investors. At the same time, though, I mean, for pre-sales of tickets, pre-sales of Teslas, things like that, you know, there are other circumstances where there are purchasers that are incurring enterprise risk. So, I don’t think it’s a black and white thing, I guess is the best way to say it.
Marco Santori:
I don’t think it’s black and white either, and I think that most of the lawyers agree on 90 percent of this. Where we diverge is on whether functionality can be used as a heuristic. That’s really what this sort of SAFT debate comes down to, it’s whether functionality is a coherent concept, first of all. Right, and that’s a meaningful objection, I think, and two, whether a token ever really is functional. But that said, there are some real problems with the SAFT. Even if you’re buying hook, line, and sinker everything that we talk about in the white paper, let’s say it’s right, what are the problems still if it’s right?
I think the greatest problem is that it just continues to embed the same systematic inequalities as the existing securities laws. You know, as an industry, we could be using the token sale framework as a lever to change the way the world thinks about investments, but because of the laws that exist, and because the SAFT approach is an attempt to navigate the existing laws, we have kept venture capitalists at the table. We have given them a superior position, the opportunity to make more money, the opportunity to take on more risk and more upside than we give to the general public.
I think that is, in my mind, the most compelling objection to the SAFT framework. It’s not about what’s written down on the SAFT instrument. That changes from deal to deal. The systemic issue is the real issue, and unfortunately, I think that’s a problem with the existing securities laws, more than it is with the SAFT framework. But I confess, that’s one of the things that keeps me up at night.
Laura Shin:
Well, I’m glad to hear that. Actually, one of the better rebuttals I’ve seen online to your white paper was an article that Michael Casey wrote in CoinDesk, making that argument that here we have this kind of revolutionary opportunity to change the way that, well, basically change this fundamental inequality in our system through blockchain-based technologies, and instead something like the SAFT just perpetuates these inequalities.
Marco Santori:
That’s the word, perpetuates.
Joshua Ashley Klayman:
Yeah.
Laura Shin:
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I’m speaking with Marco Santori, who leads the blockchain technology team at Cooley, and Josh Klayman, who leads the blockchain and smart contracts group at Morrison and Forrester. So, before we move on to some of the other agencies, there’s one last question I wanted to ask about when it comes to the SEC. A lot of people are saying that some of the actors who run the biggest risk with them are the exchanges. Why is that?
Joshua Ashley Klayman:
I think one of, well, a potential reason for that is this. When the SEC came out this summer with its enforcement action focused on the DAO, one of the things that people may pay a little bit less attention to is equally as important as the idea that the DAO token was a security. And that other point is that the platform that was used for treating the DAO token was an exchange, and that it should have registered as a national securities exchange or availed itself of an exemption from registration, such as by becoming an ATS, an alternative trading system.
Now, one of the reasons that the exchanges, I think, are in a particularly challenging position is that if, okay, exchanges by their nature deal with more than one token, and if you’re an unregulated exchange right now, as many have spoken out, either on the internet or otherwise, they have said that they do not want any tokens on their exchange that are securities, because many of these exchanges do not want to register as ATSes or national securities exchanges. And in the event that a token gets on the exchange that is a security, then that may trigger registration requirements.
It also, in addition to that, you know, there are other sorts of things that may arise under Investment Company Act, Investment Advisor Act, broker/dealer laws. So, if a token gets on an exchange that is a security, and remember, there’s no bright-line test, so it’s very difficult to absolutely, a hundred percent kind of sanitize the exchange from getting a token on there that is a security, and all kinds of potential requirements may arise. Now, there are certain exemptions that sometimes come into place.
For example, it’s possible that one could structure certain things to look more like a bulletin board, and on this type of thing, I would defer to colleagues of mine or others in the space who are broker/dealer lawyers, as I am not one. But things like transaction-based pricing, which a lot of exchanges require, those often may make certain exemptions from registration as an ATS, or other. They may make them not work, in other words. So, I think that’s one of the reasons that they’re in a particularly challenging place.
Marco Santori:
I’ll say just quickly, as a brief anecdote, when the rule 21(a) report on the DAO came down, you know, we read it, and we saw this intentional calling out of the exchanges, and that triggered some tremendous projects from a legal perspective, because we represent some of the largest exchanges in the world. We sort of reach these economies of scale, where we sat down and we spoke to our clients, we realized what they needed was a taxonomy of the entire token ecosystem.
So, we sat down, reviewed every single token out there that was being listed on our clients’ exchanges, put them each through the Howey Test as SEC had done in the rule 21(a) report, and the result was this enormous spreadsheet of risk-weighing for every single, almost every single existing token in the world.
Laura Shin:
And how many of them failed the Howey Test, or passed, or…?
Marco Santori:
Right. It’s the one test you don’t want to pass if you’re a utility token, and it depends how you look at it, right? If you believe all pre-functional tokens to be securities or most pre-functional tokens to be securities, you’re kind of in a bad way, as an exchange. But mostly, we made the distinction between securities tokens and utility tokens, and that’s something we can talk about in our discussion, but at a very high level, there are tokens that are intended to be really merely highly liquid substitutes for existing investment products, like a limited partnership interest, in the case of the DAO.
And then there are the ones who are intended to be utilities, they’re intended to have some functional consumptive use, and we think that that’s probably where SEC will, it’s certainly where SEC is focusing efforts now, and we think it’s something that will continue to be a focus for the regulators throughout this whole discussion.
Laura Shin:
Okay. So, we’ll see what it is that the SEC puts out on that score, but let’s move on to the next big agency that everyone’s worried about, which is the IRS. I had an episode last winter on the Coinbase case, which actually seems to have been resolved. I do not know whether or not Coinbase will appeal this decision, but essentially, about a year ago, the IRS demanded all the customer information on customers over a period of three years, and that goes down to, you know, customer service requests, all the transactions, like, literally anybody who had a Coinbase account during that time.
And I don’t remember, it affected millions of customers, and many people said that it was, it would be a violation of privacy, and so, finally after some time in the courts, in the last few weeks the IRS did win a partial victory, because they were able to get such information on any customers during that time period who engaged in transactions of 20,000 dollars or more. Now, Coinbase tried to, like, spin this, basically, as a victory for them, because it had vastly reduced the number of customers affected to somewhere around 14,000, but obviously, it’s still, has pretty staggering implications for privacy. So,
I wanted to ask you guys what you think this means now for Bitcoin and cryptocurrency businesses, as well as people who own crypto, going forward?
Joshua Ashley Klayman:
I think, it’s funny, this has been on a lot of people’s minds for a long time, and even some people who are coming in new to the cryptocurrency space. Somebody, actually, in my family asked me yesterday, “How do you go about tracking gains and income if you have crypto?” So, I think, you know, as I understand it, there were about 5.9 million users of Coinbase during the period for which the John Doe summons covered, and fewer than 800 or 900 had reported any kind of income or gains with respect to cryptocurrency.
So, I think what this tells people in that they need to be aware and they need to be tracking their transactions, and that, you know, the IRS knows and is aware that crypto is here, and that people are making money off of it, which they already should have been aware of. Now, one of the real challenges, though, is how one goes about tracking gains. I know that it’s been proposed that certain, that for example, an exchange might deliver 1099-Bs to each of its customers. I think on one hand that’s a great idea, that’s a great idea because it allows people to have access in a clear way to what their gains were and to what they need to report to the IRS.
The challenge with that is, though, that it only works if those, at least as I understand it, if those token-sale purchasers keep their tokens within one particular exchange ecosystem, because if you move your tokens out of a particular exchange, say, Coinbase, then you potentially lose the cost basis for the tokens. And so, tracking may be very difficult. I think there’s also a lot of questions about, some people think, well, I can do a like-kind exchange or something similar to that.
I’m not a tax lawyer, so let me just say this, but I do, my understanding is that, you know, even though some people may wish to say that when they sell Bitcoin and they purchase another token, that they may not need to report that, any gains or anything like that at that time. I think it’s an open question, and as I understand from our tax guys, there are certain cases out there about whether different kinds of gold coins can be used for exchanges in a 1031 fashion, or whether a male and female cow can be, whether they are the same.
So, I think there are a lot of questions. So, now we know we need to be aware, if we didn’t already know, of these tax concerns, but you know, really operationalizing how people will do this is another story.
Laura Shin:
Yeah, I do think that there is some software that’s being developed, or has actually been functional for a while. One that I know of, although I haven’t used it, is Libra Tech. So, actually, just in the interests of time, we’re going to just move sort of quickly through some of these last agencies I want to discuss. So, one other thing that I wanted to ask about is the SEC and the CFTC seem to be kind of fighting a little bit, or, I don’t know if “fighting” is the word, but to not entirely agree who has jurisdiction over certain things. So, in what situations would one agency apply versus another?
Marco Santori:
Well, I think you’re right, it’s not a fight. I don’t think it’s a fight at all. I think this is the same thing that happens whenever there’s a piece of new technology that’s being used for a variety of different things. I mean, it would be like saying which, you know, asking which regulatory agency should regulate Bitcoin or blockchain technology is a lot like asking which regulatory agency should regulate the internet. Well, it depends on the use, it depends on the actual applications of the technology, not on the nature of the technology itself.
So, I think that SEC and CFTC are coordinating, but you know, we don’t have a monolithic government, we don’t have a government, certainly not at the federal level among the agencies that simply makes a decision and does what it wants to do. It’s not a good way of thinking about it. What’s really happening is that each regulator is constrained by the regulations in place, by the statutes in place that limit those regulations, and then the courts that will limit the regulators’ interpretation of the existing law. So, they’re struggling with limitations, not the least of which is the fact that they are under-funded and under-staffed.
And whereas I think there are a cadre of people who are both intellectually and practically very interested in figuring out what is the right answer, with a capital R, for crypto regulation, they also have to regulate bad actors in the traditional world. They have to regulate all, and regulate and enforce against, and manage all of the same activity that existed before crypto. So, a lot of these people, a lot of these regulators, crypto regulation and thinking about crypto is not their day job, and I think that for a lot of them, they don’t, you know, they would like it to be their day job, but others would not.
So, it’s a very complex, very human set of interactions that is determining the course of crypto regulation in the US.
Joshua Ashley Klayman:
If I can just build on that for a second, I think Marco’s exactly right. You know, there are a lot of overlaps, and while that may be a bit challenging for certain token-sellers in the space, and of course requires a kind of team approach with counsel who cover a variety of different areas within a team, I think one positive that I think comes from these overlapping jurisdictions, and you know, coverage, is some people seem to have the idea that if a particular token is not deemed to be a security by the SEC, or a particular token sale is not deemed to be a sale of securities, that it’s somehow completely unregulated, and that there are no laws that govern it, and that is anything but the truth.
I mean, aside form whether, you know, the CFTC or the SEC or the BSA or various many transmitter laws or FinCEN or others, as a very basic, in addition to all of those potential things, there are rules of contract and fair dealing, and rules about fraud, and just general contract laws that apply. So, there is a whole framework that every token sale will be subject to, even if that token sale is not deemed to be a sale of securities.
Laura Shin:
And so, going forward, we’ll probably start to see regulators take some actions. What factors do you think that they’ll consider when deciding which issuances to pursue?
Marco Santori:
I think it comes down to policy, and you know, you said “issuances,” so I assume you’re talking about token sales, but there’s obviously a…
Laura Shin:
Yeah, or anything else in crypto, yeah.
Marco Santori:
Yeah, and I think this applies to all of the applications of blockchain technology. Blockchain technology is a category-creator, a category-definer. It is the thing that is going to make people, make regulators, make judges, make juries think and reexamine first principles. So, if you ask me what is the most important thing that will determine the course of an enforcement, rule-making, policy-making in the crypto space, it is existing policy. Most people think, this is a brand-new space, all bets are off. I disagree.
I think that SEC will look at, SEC, picking one regulator out of the air, I think they will look at new technologies, they will look at new issuances, they will look at participants in those systems, and think, how do I best, A, protect investors, and B, encourage capital formation? That’s what they’re going to come back to every single time. It happened with Bitcoin, when we thought about how do I prevent money-laundering and how do I make sure Grandpa gets his money at the end of the day, and it’s going to happen in the case of tokens as well.
How do I make sure that this, that bad actors can’t take advantage of investors, and B, how can I make sure that this remains a vibrant method of raising funds?
Laura Shin:
Earlier you said that at this moment in time, a lot of people are concerned about the SEC, but that before, it was FinCEN that a lot of people were concerned about, and why is that? What is it that they regulate, and how does that apply to the crypto space?
Marco Santori:
Yeah, so, back in 2012, this was, it was not even yet a developing area of the law. No federal or state regulator had really said anything substantive publicly or officially about it. The first regulator to make a footprint in this space, to draw a line in the sand, was the Financial Crimes Enforcement Network, FinCEN, the bureau of the Department of the Treasury that is tasked with administering the BSA, the Bank Secrecy Act. It’s the same law that applies to banks, obviously, to money-transmitters, casinos, check-cashers, payday-lenders, these sort of, these are all financial institutions, FIs, in the eyes of the US government.
And in 2013, FinCEN famously or infamously, depending on which side of the aisle you are, published its Guidance, the Guidance with a capital G, the first Guidance that was the starting gunshot in a lot of ways for regulation of this industry. It said that Bitcoin exchanges are money-transmitters. They’re a money services business on the federal level. They need to register with FinCEN, they need to have a compliance officer, they need to start reporting suspicious activity, keeping records of transactions and their customers’ identities for five years or more. I mean, you can rattle off all the requirements.
But you know, in the United States, we have a system of dual sovereignty, so not only did the federal government start having requirements, but because of that first starting gunshot for the industry, the state government started getting involved, and each state requires money-transmitter licensing. And so, now, if you want to be a Bitcoin exchange, or frankly, any custodial or intermediary service in the United States, almost any custodial or intermediary service in the United States, you not only have to give Uncle Sam a heads-up, register with FinCEN, but you also have to get 53 different licenses, potentially, for the kind of business that you do.
And so, it was, well, it was a real game-changer when that happened, and it set us on the course that we are right now.
Laura Shin:
And just to give people an idea of just how onerous that is, Coinbase, which is, I think it’s, yeah, I think it’s the most well-funded startup in the space, they still don’t have all of the state money-transmitter licenses. But actually, let’s just segue into state regulations, because I know this is of interest, particularly the BitLicense, which many people in the crypto space love to hate. What is the BitLicense, and why is it so controversial?
Marco Santori:
The BitLicense is the first technology-specific state license in New York for money services. Most of the other states released Guidance. They said, look, these are existing laws, this is how they apply to cryptocurrencies. New York took a different path. They decided that we needed a piece of technology-specific law, which is frankly, you know, I’ve been on record as being very critical of this, but the law essentially said, look, if you’re using virtual currencies in any of these enumerated ways, you need a license. That was in addition to their existing money-transmitter law.
It was created during this sort of media frenzy, very well-televised process of notice and comment where, I think the industry probably feels that most of the notice and comment, sorry, most of the commentary, I should say, was ignored, and that the regulator had already decided to create as broad a license as possible despite industry and community input, and that’s what they ended up with at the end of the day. Almost all virtual currency activity is regulated in New York, requires a license, which today takes any number of months or years, probably years at this point, to get. Very few have been granted. And because the…
Laura Shin:
It’s only three, right?
Marco Santori:
…industry moves…say again?
Laura Shin:
I think only three companies have obtained one, Circle, Ripple, and Coinbase.
Marco Santori:
And bitFlyer…
Joshua Ashley Klayman:
bitFlyer, yeah.
Marco Santori:
…as well.
Laura Shin:
Okay. Right, bitFlyer.
Marco Santori:
So, there’s four, and what’s happened is that the pace of this new activity moves so quickly that nobody really understands all of the risks, but the people in power at the Department of Financial Services at the time decided that they needed a license for it, without knowing what the risks were. And so, as a result, it was over-calibrated. Now, there have been no token offerings, for example, in New York. There is very little virtual currency activity in New York. New York has become a crypto-innovation backwater in a lot of ways.
Sure, people have been protected, no question, but at the same time, and as always happens with regulation, a lot of innovation has been shut out of the state.
Laura Shin:
Okay. Well, we’re super-low on time, but just quickly, for the last question, because we’re going to miss out on a whole slew of agencies that I had hoped to discuss, if you want to just give any predictions for what you think will happen going forward in terms of regulation, or give even any advice to any of the players in this space around this, what would either your prediction or advice be?
Joshua Ashley Klayman:
So, and this goes back sort of to the question about what do you think agencies are going to focus on when cracking down, I agree with what Marco said. I also think more explicitly, you know, agencies are going to crack down more and more on bad actors who are willfully bad actors, who are engaging in fraud, scams, particularly things that involve retail investors or retail purchasers, as opposed to only accredited investors and where there’s a great financial harm. My recommendation to people would be that they seek counsel experienced in the area, and that they also, as part of their various quests, whether it’s in the token-sale context, or hedge fund-trading crypto, or whatever they’re going to do, that they engage the right third parties.
I mean, there are whole cottage industries of folks who are able to provide know your customer and anti-money laundering checks, terrorist-financing checks, credit investor checks, auditing, smart contracts, auditing white papers, doing all sorts of things to help folks comply with the regulations. I think that’s pretty much what I would say.
Marco Santori:
I’ll add a very specific prediction, and it’s something that I just, that sort of occurred to me a couple of days ago. Everyone’s worried about SEC in the token space, and the federal regulators are obviously a major factor in decision-making, but every, I say once a week I get a question that says, hey, I heard a rumor that SEC was coming down on XYZ, on such-and-such a date, is that true? And XYZ always changes from people doing pre-functional token sales generally, to people who included any promises in their white paper beyond what they actually delivered in the market.
I think that’s an important focus, but it’s not the whole picture. In fact, I think that there’s actually a very good chance that we don’t get guidance from SEC. I think there’s a very good chance that this plays out in the courts first, and it plays out because of plaintiffs’ lawyers. It plays out because of class-action lawsuits. It plays out because in one way or another, aggrieved parties from token sales have hauled the developers, the issuers of these tokens, into court, and the very first thing that will be decided in most of these cases is a question of what law applies. Is it securities laws, or is it just consumer-protection laws?
And I think there’s a very good chance that these issues get decided, they get determined in the federal courts first, because of these private actions, before SEC says anything. SEC could potentially sit back, learn, monitor, root out bad actors, but when it comes to the tough decisions of line-drawing, let the courts decide. Let the process work. It’s a possibility.
Laura Shin:
Interesting. Yeah, I did go to a conference where the SEC spoke, and the people there just seemed super, kind of thoughtful and deliberative, and just to have a very considered take on things, and to not be reactionary, but they definitely sent the message, don’t perpetrate fraud. So, we’ll see what happens. Well, this has been a great discussion. How can people get in touch with both of you? Marco?
Marco Santori:
I’m super-easy to find. I think I’m the only Marco Santori in this industry, so feel free to plug my name into a search engine. I’m easy to find.
Laura Shin:
And Josh?
Joshua Ashley Klayman:
Yeah, I’m Joshua Ashley Klayman. If you add the “Ashley,” it helps, because there’s someone named Joshua Klayman who is a University of Chicago professor. But I can be found on LinkedIn or on the MoFo web site or by Googling.
Laura Shin:
Okay, great. Well, thank you both so much for coming on the show.
Marco Santori:
Thank you.
Joshua Ashley Klayman:
Thanks, Laura. And thanks, Marco.
Laura Shin:
Thanks so much for joining today’s episode with Marco and Josh. To learn more about them, and to find previous episodes of the show with other innovators in the blockchain and crypto space, check out my Forbes page, Forbes.com/sites/LauraShin. Also, be sure to follow me on Twitter @LauraShin. New episodes of Unchained come out every other Tuesday. If you haven’t already, please rate, review, and subscribe on iTunes or wherever you get your podcasts. If you liked this episode, share it with your friends on Facebook, Twitter, or LinkedIn.
Unchained is produced by me, Laura Shin, with help from Elaine Zelby and Fractal Recording. Thanks for listening.
