American Union Bank, New York City. April 26, 1932.
Over the last year, the application of securities regulation to blockchain technology has become a popular topic. Entrepreneurs and developers are building exciting new applications while trying to stay on the right side of the law, and lawyers are beginning to grapple with a strange new financial technology. As a sign of the importance of the issue, the first presentation at Devcon (the annual Ethereum developers conference) in Shanghai this past September was given to Peter Van Valkenburgh of Coincenter to give a lecture about US securities law (thrilling to me, less so for most attendees). More recently, some very smart people at Coinbase, ConsenSys, USV, Coincenter and Debevoise & Plimpton LLP published a Securities Law Framework for blockchain tokens.
This post is meant as a short introduction to the issue for non-lawyers, focused on the basic history and policy objectives of securities regulation. In my experience, most commentary on this issue neglects to start with the basics necessary to grok the big picture. In a follow-up post, I’m going to dig more into the legal substance to make a more pointed argument about the challenges of applying existing law to blockchain tokens.
I am assuming the reader is familiar with the concept of a “blockchain token” - if not, I provide an overview of the concept in another article here.
What are securities, and why are they regulated?
“Securities” are a broad category of financial asset. The type of security most people will be familiar with are shares of company stock. Many other financial assets are considered securities, such as bonds and derivatives.
In most jurisdictions, securities are highly regulated. In order to sell shares in your company (to “issue” shares), you must comply with a complex set of regulatory requirements that usually involves disclosure - in other words, an obligation to disclose certain information about your company. Think of this as a form of consumer protection - in order to sell a security to an investor, you need to reveal certain information that regulators have decided is necessary for someone to make an informed purchase - like financial statements, or the identities of the company's directors. These regulations don't apply to all companies of course - there are many exceptions (called "exemptions" in Canada) to these rules that allow, for instance, small companies to raise money from family members without going through a burdensome process.
Securities regulation in the US and Canada were a response to the crash of 1929 and the depression that followed. Before the 1930s, there were few restrictions on financial markets. It was common for companies to wildly exaggerate their current or future profits, and sell shares on the basis of information that was unverified, misleading, or completely false. Following the market crash - fuelled in part by wild speculation - there was a sense that regulation was needed to prevent these kind of deceptive practices and more generally stabilize capital markets.
The definition of a “security” in the US and Canada is expansive. The point is to protect investors who are entering into a certain type of contract. The definition must be expansive to encompass the wide variety of possible investment schemes that have been dreamt up over the years. If the definition of a security were narrow and formalistic, it would be easy for issuers to evade securities regulations while still taking advantage of investors.
Application to blockchain tokens
With this broader policy perspective in mind, it should be clear why some feel that securities regulation will impact the blockchain industry. Blockchain technology gives us a new way of creating & conducting financial relationships. Inevitably, some of these financial relationships might fall within the category governed by securities regulation. Like any other form of money or financial asset, this technology can be used for investment schemes that take advantage of the public.
Most of the public commentary I’ve seen so far on these issues skips past the broader policy concerns. Understandably, the concern for most entrepreneurs right now is that they stay on the right side of the law as it is, and do whatever they can to ensure that their tokens are not considered securities.
But as an industry we also need to think about the medium and long term. Because securities regulation is such a policy-driven area of law, we need to be alive to the broader concerns that motivate securities regulators. Staying clear of existing definitions of what constitutes a security is fine for now, but ultimately securities regulations will change over time, and could be expanded to explicitly include certain uses of blockchain tokens.
I’m hopeful that this can be done in an intelligent way, and that many of the unique capabilities of blockchain technology could satisfy the policy objectives of securities regulation, mitigating the need for a large regulatory burden. This is more likely to happen if entrepreneurs & developers work closely with regulators, developing their applications in a way that is mindful of these broader concerns.
In part 2, we'll dive into the legal test for what constitutes a security and the challenges of fitting blockchain tokens within it. While this will focus on Canadian law, US readers will likely still find it informative as (1) our test is derived in large part from Howey, and (2) the argument is general enough to be applicable broadly.
The above post discusses law, but is not legal advice. If you require legal advice about your particular situation you should hire a lawyer.