When FDR appointed Joseph Kennedy to form the Securities & Exchange Commission and become its first Chairman in 1934, he may not have realized at the time how much the legislation would withstand the test of time. There have since been amendments to the two main pieces of legislation that govern the US securities markets; the Securities Act of 1933 and the Securities Exchange Act of 1934. One amendment we saw as a major change was the passing of Sarbanes Oxley which in 2002 in the wake of the collapse of Enron and Arthur Andersen. The legislation holds auditors to a higher standard, among many other things, and also required issuers to test internal controls over financial reporting, among many other things. Has it worked well since its adoption to prevent fraud, you ask? Maybe. Maybe not. Ask the endless procession of sots who lost their homes in the wake of the Great Recession. The ability to mechanize the foresight of oncoming risk is a far more protective measure than regulation. That doesn’t mean that the US doesn’t have a beautiful regulatory framework. They do. But when things go bad, the SEC usually just shows up with gauze, band-aids and an endless supply of body bags. They don’t “prevent” fraud any more than an auditor is engaged to specifically detect it during routine annual comprehensive audits. Wait. What? I said; “It is not within the scope of a comprehensive audit engagement with an issuer to specifically detect fraud”. So why does Bank of America pay PwC an average of USD$100 million every year for a comprehensive audit? To provide trust. The auditor provides an opinion, not a fact, that the financial statements “present fairly” in all material respects, the financial and operational condition of the issuer.
Open Letter from US Congress to SEC
Last week’s letter from US Congress addressed to SEC Chairman, Jay Clayton asked some questions. Let’s examine; The letter expresses concern about SEC doing more to clarify its position; Before we proceed, we are not giving legal or investment advice, but please indulge us for a minute. We’ll try to speak English. The Securities Act of 1933, as amended, is a perfect interlock with the Securities Exchange Act of 1934. The difference between the two is that the 33 Act deals with initial, or “primary” disclosure and the 34 Act deals with ongoing, or “secondary” disclosure. It is not meant to be interpretive. It is statutory. Period. Are we clear so far? SEC is. What is truly amazing is that the 33 Act, as amended, applies just as easily, if not easier, to the primary issuance of peer to peer transferable cryptographic tokens as it does to paper certificates. It doesn’t matter what they do, how they do it or if they’re made of atoms or bits. Fact is, if your “offerees” are depending on you to make the tokens and, more importantly, they expect them to flicker on a ticker, THAT’S IT! It’s a security! End of story. Its well settled law. No need to dig tunnels around 100 F Street. The front doors are wide open. So, what does that mean? To simplify, look at it this way. It took you six months to write that whitepaper. Right? Well…assuming real science and thought went into it. If not, all the more reason for the public to admire and behold such a majestic construction of statutory beauty. If so, your lawyer can “wrap” it with the disclosure of relevant risks, a description of the financial condition of the entity, a description of the tokens, who invested money (or tokens), how they gave it to you, etc, etc. Your lawyer will also include a subscription agreement with representations of the issuer and the subscriber. This does not cost USD$200,000! Primary disclosure is an art as much as it is a science. Tell people the dangers! Don’t underestimate investors. They like danger and they will appreciate you being forthright and honest. What happens now? Is it that easy? One more thing. File a Form-D with SEC before you leave the house. It’s like an umbrella. Enforcement action is like rain. Your lawyer will tell you which 506 box to tick. Its only four pages and it only costs about USD$.60 per page at your friendly neighborhood EDGAR agent. They will tag, bag and file it in 15 minutes. That’s it. You’re pretty much done. OK, let’s examine Section 1. of the letter to Clayton. It states; “SEC should clarify the criteria used to determine when offers and sales of digital tokens should properly be considered investment contracts and therefore offerings of securities”. Really? Please reread what we just told you above, or else. Let’s examine Section 2. of the letter, which states; “Do you agree that a token originally sold in an investment contract can, nonetheless, be a non-security as Mr. Hinman stated? Can the resultant token be analysed separately from the original purchase agreement, which may clearly be an investment contract? And, if so, could the resultant token, nonetheless be a non-security”? So, this is a concept that is relatively easy to deal with. Let’s deconstruct the question; (i) “Do you agree that a token originally sold in an investment contract [a security] can, nonetheless, be a non-security as Mr. Hinman stated”? Not at the time it is offered and sold. Well settled. See SEC v. W. J. Howey Co., 328 U.S. 293 (1946) And we seriously doubt Hinman ever said that in the context that the question was asked in the letter. “Can the resultant token be analysed separately from the original purchase agreement, which may clearly be an investment contract? And, if so, could the resultant token, nonetheless be a non-security”? Again. Not at the time it is offered and sold. The second part of the question really asks; “Can a security transform into a non-security after a period of time”? Hinman’s public statements about Ether and Bitcoin suggests that it depends on the extent to which its maintenance becomes decentralized. Ethereum was clearly a security at the time it was offered and sold but it transformed as it grew into a headless, leaderless, ownerless public network after a few thousand nodes decentralized its ongoing issuance, growth and gas utility. Once again from the token purchaser’s prospective; am I depending on a bunch of developers? Yes. Is it gonna flicker on a ticker? Yes. So, I should expect to make money. Right? Absolutely! Well settled law, folks.
Be a Security Until You Are Not
So, what does everyone really want? They want to list the tokens immediately after the offer and sale is completed; enable the purchasers to resell the tokens immediately; all before the network army starts to march in decentralized fashion. Not gonna happen in the USA. This is where it gets complicated. First; the 34 Act governs what is and what is not a securities exchange. There are no registered exchanges in the US that are technically equipped to list a token yet. Patrick Byrne wants to and his Overstock (OSTK-NASDAQ) tZERO subsidiary will very soon. Second; after the offering is closed, an issuer must provide periodic ongoing disclosure in order for primary token purchasers to “resell” the tokens. The concept behind this requirement is that the purchasers in the secondary market need to be informed about the financial and operating condition of the company as well as insider and affiliate purchase and sale activity. Holders of tokens purchased in a primary or, “initial” offering must comply with holding periods. If the token issuer filed a registration statement with SEC which was subsequently declared effective and the issuer commenced its reporting obligations under the 34 Act, the holding period is six months if the tokens purchased were not covered in the registration statement. See SEC Rule 144. If the token issuer has not commenced reporting under the 34 Act, and/or is not a reporting company, the holding period is one year. No token issuer so far has ever prosecuted through its effectiveness, a registration statement on Form S-1 or any other SEC form, nor has any pure token issuer ever commenced reporting under the 34 Act. This is an expensive and complicated procedure to initiate and maintain. There are, however, many levels of financial reporting. If an issuer is not equipped to report periodically, it will likely suffer delinquencies and will breach the “current information” requirements which allow resales of tokens by holders to occur. See Section 2 of SEC’s publication on Rule 144. It happens all the time to the thousands of issuers listed on the OTC Markets.
Decentralized Continuous Audit & Reporting Protocol EcosystemTM
Auditchain is proposing that token issuers “plug in” to its Decentralized Continuous Audit & Reporting Protocol EcosystemTM, an alternative financial statement reporting, assurance and disclosure methodology for token issuers who must provide current information in order for resales of the tokens to take place. Auditchain was founded with a focus on solving major problems of regulatory conflict relating to subjective and conditional disclosure, laborious manual audit and reporting methodology, the reduction of the time lag of financial statement information and the substantial anticipated reduction of error and fraud. Auditchain proposes new standards of transparency, data standardization and accountability for financial reporting as well as improved security, substantially increased risk controls and greater assurance for stakeholders. Auditchain will be conducting a token generation event (“TGE”) commencing with its pre-sale phase on November 15 at 9AM CET (UTC+1). 250,000,000 AUDT will initially be launched on the Ethereum network which includes; (i) 160,000,000 allocated to early adopters, (ii) 25,833,333 allocated to the team, (iii) 25,833,333 allocated to advisers, (vi) 25,833,333 allocated to partnerships and (v) 12,500,000 allocated for the bounty campaign. Included as part of the early adopter allocation will be a total of up to 42,685,996 AUDT to be airdropped after the TGE*. The Airdrop will reward those that hold AUDT and do not move or sell them and is being referred to as a “Proof of HODL” Airdrop. The AUDT Token, intended to be sold to early adopters in the global accounting, audit and financial reporting supply chain, will drive the new trustless assurance economy. AUDT will allow enterprises, assurance providers and other service providers to pay for services and earn AUDT on the Auditchain network. *Terms and conditions apply. See website for details regarding TGE participation and KYC/AML validation.