Unchained - How Crypto And Blockchain Technology Should Be Regulated

Episode Date: December 12, 2017

Love Unchained? Please take this extremely brief survey to help us obtain more sponsors: https://survey.libsyn.com/unchained Marco Santori, who leads the blockchain technology team at Cooley, and Joshua Ashley Klayman, who leads the blockchain and smart contracts group at Morrisson and Forrester, explain why they disagree on how to ensure a token sale won't run afoul of securities laws, how they think regulation around crypto will likely be formed and why the Bitcliense has made New York a crypto innovation backwater. Show notes: http://www.forbes.com/sites/laurashin/2017/12/12/how-crypto-and-blockchain-technology-should-be-regulated/ Marco Santori: https://www.cooley.com/people/marco-santori Joshua Ashley Klayman: https://www.mofo.com/people/joshua-klayman.html The SAFT white paper: https://saftproject.com/ The Cardozo Blockchain Project SAFT response, "Not So Fast": https://cardozo.yu.edu/sites/default/files/Cardozo%20Blockchain%20Project%20-%20Not%20So%20Fast%20-%20SAFT%20Response_final.pdf Are ICOs For Utility Tokens Selling Securities? Prominent Crypto Players Say Yes: https://www.forbes.com/sites/laurashin/2017/10/02/are-icos-for-utility-tokens-selling-securities-prominent-crypto-players-say-yes/#107e96e34fa4 IRS Nabs Big Win Over Coinbase In Bid For Bitcoin Customer Data: https://www.forbes.com/sites/kellyphillipserb/2017/11/29/irs-nabs-big-win-over-coinbase-in-bid-for-bitcoin-customer-data/ Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, everyone. Welcome to Unchanged, 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 Unchanged, please give the 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 at Laura Shin. This week's episode is brought to you by OnRamp. Your branding and website 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 a perfect website, 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'll be. will not be hearing the echoey atmosphere that you were hearing before. Hopefully it sounds much crisper and clearer. The bad news, as you can probably tell us, 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's 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 this show for season four.

Today's topic is regulation. Here to discuss the myriad ways regulation affects the crypto and blockchain space are Marco Centauri, 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. Hi, thanks for having us. Thanks for having us. So Marco, let's start with you. How did you get in a blockchain and cryptocurrencies, and what do you do in the space?

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. And what are some examples of your clients?

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 Umeri and Auger. 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 counseled to blockchain since before they were a company. And by the way, I just wanted to say, 20Tal doesn't date you. It, I think, gives you a lot of cred in the space. Okay, Josh, what about you?

What do you do in the space? And how did you get into blockchain and cryptocurrencies? Thanks, Laura. So I admittedly started a bit later than Marco in the 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 cryptocurrency, 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. And can you give examples of some of your clients? 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 Cosmuseum. most, we represent a number of large exchanges and relayers. Of the relays, we represent radar relay. Of the exchanges, we are working, for example, with a exchange from Gibraltar, as well as 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 Lake of Black Rock. 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 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. 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 security side and on the security side and on the money services side, it's the sort of state banking, 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. 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. 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 Howie 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. So there are broad definitions found in both the Securities Act and the Exchange Act for what is the security. And so in addition, in that laundry list of categories. One of those is investment contract. So when people talk about the Howie test, the Howie 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 Howie test since the original Howie 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. And what does that mean? Matter 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 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 the token

is a security. And there's actually a good example of that, in recent news, the Plexcoin case, where SEC is recently announced an enforcement action against Plexcoin. There's really no evidence that any security was actually created, but in the manner of sale and 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 and 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. Oh, that's interesting. When you say that there was no venture, meaning like they didn't have anything in a GitHub or what? Well, the idea is that regardless of what's actually going on with the enterprise, whether there 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. This is it's just upon it's just a Ponzi scheme.

And so you don't have any jurisdiction SEC. That's that's not the case here. Oh, that's interesting. It just reinforces. It just reinforces Josh's point. 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 promises. the investment return. So Marco, I know you have a proposed method for what you believe is a way to have a token sale without running a foul of securities laws. What is that method? Well, to sort of level set, we, the method is referred to as the SAFT framework. And we didn't invent the SAFT that, that document that underlies the framework. The SAFT is a simple agreement for future tokens. It's a, it's an instrument. It's a, 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 U.S. And at least a first swing at how you might navigate.

the U.S. 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. And actually, can you quickly define Reg A plus and Reg S? Yeah, Reg. 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 are limited requirements. And the idea being 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 have done if you were in, you know, 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 have 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 staff 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. And 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 U.S. laws. So that's generally the framework. It was a first stab at 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. 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, then a SAF really fits all four prongs of the highway 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 an 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 Valkenberg talk about how there's, I guess, some case with like let's say it was with, 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 is presumably to live in it. But Josh, I know you disagree with Marco's proposal here with this method. Why? 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 participated 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 SAFed white paper and the SAF project was designed to propose a possible solution 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. No, so far we're on board.

And I think what you're doing is articulating one of the real concerns that I continue. you to have with this. So please, please, please go on. 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 Saffed white paper that people, many founders you can understand, they would want some kind of certainty, right, in a, 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 cell. 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 in every staff that even coolly uses. Certainly, many other firms, us included, we are exploring presale and pre-order agreements. So this, this kind of, this disagreement is not to say that there's no way that you could do a presale, pre-order, or a so-called saft. One of the key points that we thought was important to bring to people's attention. 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, the 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, you know, 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 0.9, it wasn't. Also, this is another point that I think is important,

and this is my own just personal view, is that the SAFD 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 a 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 U.S., that throughout this process, you work closely if you are going to use a SAFT, a pre-order agreement, or pre-sell agreement, that you work very closely with your local council 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 personal 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 a 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 council. And if there's one takeaway I'd say from this, it is, please, no matter what kind of process you're going to follow, please reach out to experience counsel because just like the Howie 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 doing a pre-sale to consult counsel.

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Apologies, Laura. 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 takeaway from? Because that's,

that was sort of like what I heard underneath all of your different points. That's the general takeaway. 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, um,

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 presale 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 presale 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 presale because of the

manner of sale could look more like a security than that identical token if it had not had a pre-sale. Okay. 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 concerns raised about the document the actual saft instrument. I think that those concerns are

valid and I you know we don't actually use that straw man sort of starting point piece of paper that we included at the at the back of the 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 a story, I think that if you 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. Where 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 as security, I think a presale acts in the opposite direction. I think that it creates a very compelling narrative to a court or a judge. 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. Enterprise risk is an important concern. And the regulators are tasked, particularly with, 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. I don't think it's black and white either. And I think that most of the lawyers agree on 90% 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 a 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. 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. 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 Coin desk making that argument that here we have this kind of revolution opportunity to change the way that, well, basically change this fundamental inequality in our system through blockchain-based technologies, and instead something like the SAF just perpetuates these inequalities.

That's the word perpetuates. Yeah. I know there's so much more to say in this topic, but we have so many other meaty regulations to discuss. We're going to be talking about the IRS, all kinds of other things. But first, I'd like to take a quick break to tell you. about our fabulous sponsor, OnRamp. If you're starting up a new project or need some design or branding help on an existing one,

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I'm speaking with Marco Santori, who leads the blockchain technology team at Cooley and Josh Clayman, 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? 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 Dow, one of the things that people may pay a little bit less attention to is equally as important as the idea that the Dow token was a security.

And that other point is that the platform that was used for trading the Dow 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 and 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 ATSs

or national securities exchanges. And in the event that a token gets on the exchange, that is a token. a security, then that may trigger registration requirements. It also, in addition to that, you know, there are other, 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 100% kind of sanitize the exchange from getting a token on there that is a security. then 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 are. 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. I'll say just quickly as a brief anecdote,

when the Rule 21A report on the Dow 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 Howie test as SEC had done in the Rule 21A report. And the result was this enormous spreadsheet of risk weighing for every single, almost,

every single existing token in the world. And how many of them failed the Howie test or passed? 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 didn't 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 Dow. 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, it's something that will continue to be a focus for the regulators throughout this whole discussion. 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 of 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 coin-based account during that time. And I don't remember this, it affected millions of customers. And many people said that 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 or more. Now, Coinbase tried to like spend this basically as a victory for them because it had vastly

reduced to a 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? Well, 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, my family asked me yesterday, how do you go about tracking gains and income if you have crypto? So I think, you know, there are, as I understand that there were about 5.9 million users of Coinbase during the period for which the John Do 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 is 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 that, that, you know, that, you know, 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 1099Bs to each of its customers. The challenge with that, and 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. A 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, you know, some people think, oh, 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 really operationalizing how people will do this is another story. 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 interest of time, we're going to just move sort of quickly through some of these last agency sites. 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, 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? 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 application of the technology. 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 regulator's interpretation of the existing law. So they're struggling with limitations, not the least of which is the fact that they are underfunded and understaffed. 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 where the capital are for 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 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 there's, it's a, it's a very complex, very human set of interactions that is determining the course of crypto regulation in the US. 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, you know, 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 from whether, you know, the CFTC or the SEC or the BSA or various money transmitter laws or FinC or others, you know, at the 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. 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? 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 great wide world. Or anything else in crypto.

Yeah. 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 re-examine first principles. So if you ask me, what is the most important thing that will determine the course of enforcement, rulemaking, policymaking in the crypto space, it is existing policy.

Most people think, oh, this is a brand new space. This is all bets are off. I disagree. I think that SEC will look at SEC picking one regular. 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 bad actors can't take advantage of investors? And B, how can I make sure that this remains a vibrant method of raising funds? Earlier, you said that at this moment in time, a lot of people are concerned about the SEC, but that before it was FinC 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? Yeah, so back in 2012, this was not, 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, a 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, these, these are all financial institutions, FIs in the eyes of the U.S. government. And in 2013, FinCEN famously or infamously, depending on which side of the aisle you are, published its guidance, the guidance with the capital G, first guidance that was the starting gun shot in a lot of ways for regulation of this industry. It said that Bitcoin exchanges are money transmitters.

There are 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 in the United States, we have a, 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, 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. And just to give people an idea of just how onerous that is, Coinbase, which is, I don't know if it's, I don't know if it's, 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 bit license, which many people in the cryptospeas love to hate. What is the bit license and why is it so controversial? The bit license is the first technology. specific, first technology specific state license in New York for money services. Most of the other states released guidance. They said, look, these are our 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. It's only three, right? Because the industry moves. I think only three companies have obtained one, Circle, Ripple, and Coinbase.

And BitFriar. Yeah. Okay. Oh, right, BitFliar. 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 overcalibrated. 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 it always happens with regulation, A lot of innovation has been shut out of the state. 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'd hope 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? So, and this goes back sort of to the question about what, 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 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 in any 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.

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 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

are, who included any promises in their white paper beyond what they actually delivered in the market. I think that's, 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 plaintiff's 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.

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? 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. And Josh? Yeah, I'm Joshua Ashley Clayman. If you add the Ashley, it helps because there's someone named Joshua Clayman, who is a University of Chicago professor. But I can be found on LinkedIn or on the MoFo website or by Googling. Okay, great.

Well, thank you both so much for coming on the show. Thank you. Thanks, Laura. And thanks, Marco. 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 slash sites slash Laura Shin. Also, be sure to follow me on Twitter at Laura Shin. 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 Fractual Recording. Thanks for listening.