Odd Lots - Why A Florida Orange Grove In 1946 Is The Key To Understanding Regulation Of ICOs

Episode Date: April 16, 2018

By now, everyone's heard of ICOs (Initial Coin Offerings) where companies issue their own currency-like tokens. They boomed massively in 2017, alongside the whole cryptocurrency craze. But very few people really get what they are, and how they fit into the regulatory landscape. On this week's Odd Lots podcast, we speak with Peter van Valkenburgh, the director of research at Coin Center, who explains why you have to go back to a 1946 case involving a Florida orange grower to understand how regulators see these newfangled financial instruments. See omnystudio.com/listener for privacy information.

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And I'm Joe Wisenthal. So Joe, I got an interesting email earlier this week. Was this that thing you tweeted? Yes, it was. Well, you could say that about practically any email that I received. Because we both just tweet all of everything that's in our inboxes right away. That's really sad, isn't it? Okay, but one thing in particular I tweeted about And it was an advertisement for an upcoming ICO, an initial coin offering. Right.

I think anyone who's been on the internet in recent months, particularly if they're into tech or finance, has been inundated with ads for initial coin offerings. I get them all the time. I used to get them on Facebook. I get them in my Gmail. It's like this new token and get a 10% discount on this token that will give you access to Wi-Fi or whatever it. is. Actually, that's probably one of the more linear ones. But I don't think anyone really has any idea what these are or what the deal is. It's also weird and new. This one in particular was

illustrated with a little cartoon rocket. It also said the company had signed an agreement with the world's largest NASDAQ exchange, whatever that is. But the thing that got me the most about this particular ad was it said, we received the approval of U.S. securities and exchange Commission and U.S. Securities and Exchange Commission is in quotes. Everything about this is so beautiful. Look, I'm not going to judge this ICO, but if I were an investor to me, this would be some at least caution signs just from how you described it. All right, but the reference to securities and exchange commission, and I'm doing air quotes right now, and you can't see me doing that over the phone, obviously, got me thinking about

ICOs and regulation because obviously this is a perennial issue. How are ICOs regulated and are they actually securities in the eyes of the U.S. legal system? Right, because the basic idea is companies are, you could say, issuing their own de facto currencies, selling them. And they want to do that as freely as possible or many of them would like to sell for any amount to anyone in the world. but they and they would say, okay, we're not really selling securities. These are tokens that give access to a network or something. But if they are securities, then from a regulation standpoint, that would impose upon them a lot of obligations in terms of disclosure and who can buy.

And so the question of whether these are actually securities and the law governing, whether these are securities or not, is of a pretty big stakes for a lot of people. Huge stakes. And it actually gets to some really interesting legal theory. which we are now going to go on to discuss. And I think you have the guest with you, right? Yes. I'm very excited to bring in Peter Van Velkenberg. He's the head of research at Coin Center, which is a cryptocurrency think tank in Washington, D.C. He is going to help us wade through the thicket of regulations, which may or may not apply to ICOs. So, Peter, thank you very much for joining us.

Hey, thanks for having me, guys. I've been chuckling this whole time, listening to you guys. I also work with the SEC in quotation marks. Do you work with the SEC not in quotation marks as well? Hopefully. I can only imagine, Peter, that for as many ads as Tracy and I get on social networks and in our email, you must see like 10 times as many of these pitches for ICOs than basically anyone else in the world. I tell you, ad blocking software is important when you have my job. job in my Google search history. It's really, it's critical. It's not just a luxury. And I don't

mean to starve the media companies of their revenue, but I just can't look at this stuff all day. So before we dive into securities law and how these decisions are actually made, Peter, maybe you can just give us an overview of where we stand right now when it comes to the legal definition of ICOs. Yeah. Okay. So there just isn't one. And that makes sense and it's not too surprising because it's a brand new thing. And it's sort of an informal term that the community came up with, I don't know who in the community, somebody who I really would love to have a stern talking to about two years ago because it sounds like IPO. And somebody said, oh, well, we're going to create an initial batch of these new tokens or coins. And we're going to release them

to the public and have an offering. And so we'll call it an initial coin offering. And it won't confuse anybody and people will be excited about it, which I think really is terrible. branding because if you have a good faith argument that your thing isn't a security, and some people do, and I think some people don't, but if you have a good faith argument that your thing is in a security, why the hell would you use the term or a head nod to the term for the thing that the SEC regulates as securities, IPOs? It just makes no sense. So there's no legal definition of ICO because it's just this emergent term. It's like slang in our space. There's varying treatment of what an ICO is or might be or should be under the law.

And that's because we have flexible standards for a lot of things in U.S. law and sometimes new things that seem like they were unregulated actually fit into an existing flexible standard and then are actually regulated. And one of these flexible standards, and we've been dancing around it in this talk so far, is the standard for when something is, the standard for when something is. a security and then therefore regulated like a security in the U.S. So in Europe, just this quick background, they have a much more black letter test. They have a civil law background instead of a common law background. They basically have a statute that enumerates these things are securities and it's, you know, equity shares, it's pensions, et cetera. In the U.S., we have that black letter list in the 1933 securities law, the Securities Act,

rather, but we also have an undefined term in that list called investment contract. And that undefined term is like, you know, Joe, Tracy, what's an investment contract to you? What's an investment contract to me? You know, it doesn't have a really definitive common meaning. So that term had to be defined by courts to be, you know, narrow enough not to cover all things that people invest in, but broad enough to cover the sort of things that we want to make sure investors are protected from, the things that really look kind of like schemes where you rely on somebody else to make profits. And so that term was defined in a 1946, I think it's 46 case, was about a guy who was selling

tracks of land in an orange grove to suckers in New England and promising them that he'd maintain the fruit and sell it at market and give them the profits of the fruit that grew on the track of land in the orange grove that the New England investor purchased. Just to pause here, because I think this is sort of the critical case that people will be talk about today when they try to gauge whether something is a security or not. We are talking about the theoretical regulation of ICOs, and it all stems from someone selling tracks of oranges in 1946 in Florida. Yeah, tracks of an orange groves. So Howie would invite people down to his Florida hotel and take them on a tour of the groves and people would say, oh, these orange groves are

beautiful. And how he would say, it's funny, you should say that. These orange groves are for sale. And then he'd sell you a tract of land in the Orange Grove. And he'd also have you sign a contract where you say, I appoint Howie and his staff to go pick the fruit and sell it at market and give me the profits. And Howie's obligated to give me the profits. And this combination of the nominal interest in property and the agreement to maintain the property and sell the oranges for profit, at least in the eyes of the Supreme Court, and in the SEC who brought the case of the Supreme Court,

looked like an investment contract of the type that we'd normally regulate as a secure. It fit this test. And it makes sense because you're not really just buying land in Florida. You're kind of buying a fractional interest in Howey's Orange Grove, literally a fraction of the land in the grove, but also a fraction of the profitable, hopefully profitable efforts of Howie in running in a successful Orange Grove. So this is like a flexible test that's there to reach things that aren't like stock certificates evidenced in paper, kept in the basement of the DTCC in New York, but instead things that are basically similar in economic relationships between buyer and seller, but evidenced in other ways, more informal ways. And so it makes sense that when people start selling tokens, you have like a nominal interest in a property, and sometimes where you don't just get the token, like it's not just Bitcoin, you don't just get a Bitcoin, you also get a token and promises from somebody who says they're going to develop this thing into something as successful as Bitcoin or as as awesome as Ethereum or whatever. Between owning the token,

and relying on the person who sold you the token to make the network that powers the token better, it starts to look like owning the land in the Orange Grove and relying on Howie to make the Orange Grove profitable. How much does a transferability of your interest in either an Orange Grove or a token play into whether or not those are classified as securities? It's a great question. It's not formally in the test. So the test is, was there an investment of money?

money in a common enterprise with an expectation of profits derived from the efforts of a third-party promoter. Notice nowhere in that test does it say transferability, even though what we come to expect is when something's a highly liquid and highly transferable asset, you can sell it. And you can sell it with greater ease. And if demand rises for this thing, you might make profit from it. And the fact that it's liquid and easily sold or easily transferable might be indicia of people's feelings about how profitable they are. And to put some, like, less vague meat on those bones, just look at cryptocurrencies and tokens and ICOs, which are all, you know, these transfer, like extremely liquid transferable assets that anybody can sell. And you can sell them on very easy to use

exchanges that look a lot like, you know, online stock trading. And because they're so easy to transfer, I think a lot of people think, oh, I could buy some of this and then just wait for the price to go up a little and sell high, you know. And so maybe that transferability enters into this legal test because it bolsters one's expectation of profits, whereas if you buy something immobile that you'll have difficulty selling, maybe you really bought it because you just wanted to have it, not because you were expecting of making a quick profit. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world.

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That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcasts. I'm kind of curious. You mentioned in the beginning that you think there are projects that have a good faith argument to not being securities. But the way you described the Howie test is like basically any ICO I can think of seems to fall into this category, especially the aspect of the third party, which promises to sort of develop the network. The projects that you think maybe don't or aren't categorize as securities, how are they different? Yeah. So, you know, you wouldn't be alone if you thought that most ICOs are securities. And, you know, Jay Clayton, chairman of the SEC, said as much in his Senate banking testimony about a month ago, said every ICO I've seen is a security. But then you've got to ask, are we talking about the ICOs we've seen this last year? Because 2017 was really like the top of the growth curve for ICOs, I think. And I think we're seeing a retrenchment now. And it's when it really the public consciousness. We had token sales going all the way back to 2014. I think the first was

MasterCoin. Ethereum had a token sale to sell ether back in 2014, 2015. In those early days, there wasn't all the hype. You didn't have Floyd Mayweather sitting on his private plane with a table full of money saying, and buy this ICO, it's going to make me rich, and it'll make you rich, too. You didn't have liquid secondary markets where you could instantly go, you know, you have your marker of a token that in the future will be valuable like Bitcoin or Ether might be valuable, you know, query whether that's true or not, but you have this marker. You wouldn't be able to transfer it or sell it easily. If you bought Ether in the pre-sale, you were kind of just waiting for Ether to exist as a network for smart contracts. You weren't able to go onto an

exchange and fence it and sell it to somebody else. Today, when people do ICOs, there's almost always relatively soon, after the initial coin offering, a market where you, you you can go trade it and you can do day trading. And this also means that people can do nasty things like pump and dump scams and all that sort of thing, all before there's even a product or any kind of real functionality behind the token. So on the side of like what I'd say are the good guys here are, first of all, and it's really important to point out, anybody who didn't do an ICO but has a token. Because there are plenty of projects that released cryptocurrencies or tokens

and they're developed by open source developers. So there's no single company behind them. But a bunch of people worked together to build a network that describes a scarce token, and they never sold them to anyone. They came into the world through mining, just like Bitcoin's come into the world through mining, as a reward for people who were providing useful services to the network, who actually made this decentralized network function. So I think that doesn't look like a security at all to me. You'd have trouble making the investment of money prong because people didn't actually buy the tokens. They got them as a reward for contributing to a network resource. and you'd have trouble making the expectation of profits prong

because this is really a network that actually accomplishes some work. Like you can actually use Bitcoin to send money to, you know, a foreign country at a low fee compared to alternatives using the dollar or things like that. And so those two factors, the usefulness and the fact that it's, you know, not something that people invested in in a centralized way. And also the fact that it's backed up by a big network of participants, like a whole bunch of people around the world mine Bitcoin, they don't all work for the same company.

They're like individuals who are unaffiliated and just enjoy the technology and just enjoy providing this network service, the Bitcoin network. It's very different than W.J. Howie, who had an Orange Grove and was asking people to give them money for his Orange Grove. It's more like the gold industry writ large. So that's what I think really doesn't look like a security. And then there's some middle ground where things now function a lot like Bitcoin on the network. but in the early days, they had a sale. And just to be totally frank and open, that's Ethereum. I think Ethereum is as decentralized as Bitcoin.

Generally speaking, there's places we can argue about whether it's a functioning decentralized network in the same way as Bitcoin or whether there's some liabilities or benefits that they have over Bitcoin. But the long and short of it is it's decentralized. It's a bunch of people around the world running the Ethereum open source software, and that's what makes ether scarce, and that's what makes it valuable. as a tool for running smart contracts. But go back to the early days of Ethereum,

and they did have a sale, and you did, in the very early days of Ethereum, rely on the efforts of those sellers to deliver the tokens to you once the network was live. So there was that moment of trust. But, again, I think it was really early with Ethereum. Most people were buying them to use because they were excited about the idea

of a global virtual machine, which is one way of thinking of Ethereum. And then once they got them, they actually use them to write smart contracts, and we're seeing tons of smart contracts in Ethereum, you can't usually use a stock certificate to do anything. It's just there as a marker of your investment. So this looks like something, I think, radically different. And then at the far, far end of the spectrum, I think very far away from Ethereum and from Bitcoin, are things where there is no product, there is no service or functionality that the token gives you. There is

rapid and I think somewhat disgusting promotion of the thing as an investment, sometimes from celebrities, sometimes from, you know, market watchers, sometimes from people who are pumping and dumping and dumping. And you really are relying on just this promoter to make good on their promises of building something that's going to be valuable in the future. And maybe you don't even know what it's supposed to do. You've just been told that it's going to be valuable. Those things in the far end, I think, totally are securities. And I worry about the reputational risk of those things looking like obvious securities that haven't complied with U.S. laws harming the real innovations because it could trigger overbearing regulation with respect to things like Ethereum and Bitcoin.

Well, so, Peter, a lot of people think that there hasn't been enough regulation so far, and they're sort of scratching their heads as to why the SEC has, you know, in some cases, has been dragging its feet on this issue. So are you saying that it's definitely not a blanket case that all ICOs are securities, that it's more nuanced than that. Yeah, I do think it's more nuanced than that. And I think some people are confused about the difference between ICOs and cryptocurrencies. So just to be clear, I don't think any of the running cryptocurrencies like Bitcoin and Ethereum should fall under SEC jurisdiction.

I think they actually fall under CFTC jurisdiction, which we could talk about it another time. Within the realm of ICOs, where people have actually sold an initial distribution of tokens to the public, I think a lot of them qualify as securities. And I disagree. I think the SEC has actually done a lot of work going after these things. They came out with a report last summer where they were sort of like, hey, everyone pay attention. We're about to do some stuff here because a lot of these token sales are securities issuance. And after that, so they didn't police anything retroactively. They didn't go after anyone who sold tokens before that report, which I think is, it's not something that the SEC has to do. If they wanted to, they could go after people retroactively.

But I think it's a prudent thing to do. Look, like, announce your position as an agency. Some of these things are securities. And then if people continue to not follow securities laws when they are making something that looks like what you just wrote a report about, then go after them. And that's what we've seen. We saw several, I think, thoughtful and well-placed enforcement actions

against first obvious scams, and then some people who were maybe a little too naive and didn't realize that what they were doing was issuing a security. Peter, let's say Tracy and I decided to do an ICO for the Oddlots podcast and maybe it was something like coin holders got some share of the profits and maybe you had to pay or you had to subscribe to the podcast. You had to use the coin. Is Oddlots profitable? We'll address that later. But let's say we're like spoken like a true lawyer. Let's say we're like, obviously, this is a security.

We're not even going to pretend otherwise this is a security. Are the rules in place clear enough such that even if we totally wanted to abide by security's law, we knew which side of the highway test we were on, that there's a clear path for us to do it, or is it still vague such that even if you want to be on the right side of the law, there's still some ambiguity? at that point, it's super clear. If you're transparently saying, you know, we're selling odd lots profits, come get them, they're hot, then you're obviously selling a security. And if you admit to that, then you just comply with securities laws. It doesn't matter that the evidence of the fractional ownership interest, i.e. the security or the share, is something that exists on a

blockchain as a token, or is something that is a bearer certificate, like in the, what is it, the second diehard movie where they're like stealing bearer bonds, or is a registered instrument that trades on NASDAQ and there's a copy of the certificate kept in the basement of the DTCC. These are just different technologies for recording that fractional ownership interest. It doesn't matter what technology you use. That doesn't, I mean, it's going to matter for maybe efficiency purposes or other things. It's not going to impact your legal calculus. Your legal calculus is the same in all cases.

You're selling securities. You need to file with the SEC to have a registration, a public filing, or you can take advantage of some of the other alternatives to public filings, public registration, which are things like Reg D, Rule 506, where you say, I'm only going to sell this to accredited investors in a kind of private placement, so I don't need to do a full registration. or maybe reg A plus where you can sell to the general public and not do a full registration and full disclosures, but you can only raise up to $50 million selling your fractional interests in odd lots profits. Those are all really standard ways of complying, and we have seen some token sellers go down this route.

Some people have said, look, the thing I'm trying to build long term is decentralized like Bitcoin and Ethereum. I don't think it'll be a security. But as I'm trying to build it, I want to raise money. and the people who invest in it are going to rely on me to build it well. So in that period where I'm selling this future token, I'm going to sell it as a security nakedly. I'm going to say, look, you're relying on me to deliver something that's going to be profitable to you,

this future network with this decentralized token. And in the meantime, until the network is decentralized, I'm going to comply with all securities laws because I have to because I don't want to break the law. And we've seen people sell tokens like file coins, sold tokens for a decentralized file storage network that will exist in the future through reg D rule 506 filing where they only sold to accredited investors. Now some people don't like that because it means that only rich people get to buy a future interest in what could be transformational

technology. And I'm sympathetic to that viewpoint that that's maybe not healthy and it's kind of an egalitarian, but that's just a problem that you're having, you know, anybody who has a problem with this with the way we do investor protection. Almost all speculative, but also high risk, high return investments are restricted to accredited investors these days, whether their tokens or not. And that does have problems, but it's also a way of protecting mom and pop. Peter Van Velkenberg, thank you for your insight on this. And we look forward to having you on our advisor page when we do the Odd Lots ICO. Really appreciate your insight. Only with my consent. Peter Van Velkenberg, head of research at the coins.

Thanks for having me, guys. So, Joe, I don't know whether to be horrified or impressed that basically a 70-year-old legal precedent is now applicable to all sorts of new types of things, including initial coin offerings. You know, these things that basically rely on this brand-new technology that no one who is thinking about Orange Groves in Florida was considering back then. I think I'm impressed. I like the idea that there's just sort of these general principles that we can apply. I mean, sure, at some point, there are going to be completely different types of organizations, maybe, and we'll have to come up with something more specific. And I'm sure, obviously, regulators are going to keep refining things.

But I like the Howie Test. It's sort of simple, the idea of a third party endeavoring on behalf of the partners for profit. I think it's a pretty good rule that probably not much reason to upgrade it. Well, I guess we'll get to find out just how applicable it is to ICOs, right? Because the SEC has talked about sent, well, it has actually sent a bunch of letters to various ICO operators asking for more information. So they're clearly taking an interest in all of this. So I imagine we'll be hearing a lot more about how relevant the Howie test is to the current period very soon. Yeah, I think there's going to be a lot in 2018. Also, you have to figure that market conditions end up having a sort of forcing effect on these things. So right now, Q1 was a pretty brutal year for all things crypto. And if that continues, you're going to have a lot more people who have lost more money. And I imagine you'll have lawsuits and people saying, oh, I bought into this. I didn't realize I was security and I shouldn't all kinds of things. So I think it's going to be. going to be a pretty interesting year on the legal front. And I just want to make one more point

that I love how it always comes back to Florida. Oh, yeah. We have a long and rich history of covering Florida financial market developments. It's just so perfect that these sort of questions about what is a legitimate investment offering comes back to this weird Florida Orange Grove where the people came down and they're like, oh, yeah, buy some oranges and we'll sell the oranges for you and give you money. It's just, It's perfect. It's very Florida. Yeah, absolutely. All right. Well, this has been another episode of the Odd Lots podcast.

I'm Tracy Allaway. You can find me on Twitter at Tracy Allaway. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. And you should follow our producer, Tofor Forges, at Forrest T, as well as the Bloomberg head of podcast, Francesca Levy at Francesca today. Thanks for listening. The news doesn't stop on the weekends. constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews, all the stories that hit home on your days off.

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