Semi-Public Offerings? Pushing the Boundaries of Securities Law

The 1933 Securities Act struck a simple bargain: the wealthy get to invest in risky private companies, while the general public can invest only in publicly traded securities. For 75 years, that bargain has held. For whatever reason—whether because the wealthy are savvier investors or because their wealth gives them the requisite cushion to absorb the heightened risk private securities pose—we have cordoned off private offerings from the average investor. Reforms like those of the JOBS Act of 2012, which introduced equity crowdfunding and changes to Regulation A loosened the reins, but only marginally. The fact remains that firms seeking to raise over $1 million must take the expensive and lengthy process of registering a public offering with the SEC or else shoehorn their offering into an exemption from registration requirements. But SEC Chair Jay Clayton recently signaled an interest in revisiting the bargain declaring: “We also should consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment, or other criteria rather than just the wealth of the investor.”

In Semi-Public Offerings? Pushing the Boundaries of Securities Law, I suggest a way forward that opens up investment opportunities to the general public, increases entrepreneurs’ access to the capital markets, and uses technologies undreamt of in 1933 to protect against fraud. I do so using as an illustrative example a new kind of offering has allowed entrepreneurs to raise money directly from the general public, and in the process has strained the traditional ’33 Act bargain that has relegated the general public to publicly traded investments for decades.

An initial coin offering (ICO) is an offering of specialized crypto tokens, or “coins,” on a blockchain. The offerings promise that those tokens will operate as the medium of exchange when investing in a blockchain venture or accessing services on a digital platform that may exist at the time of offering or may be developed in the future. The funds raised in the ICO are used to continue to develop the blockchain technology and bring it to market. Typically entrepreneurs offer their coins in exchange for existing cryptocurrencies such as bitcoin or Ethereum, but they can also be sold for fiat currency, such as U.S. dollars or British pounds.

If the previous paragraph sounded like techno gobbledygook, focus on the numbers. ICOs raised about $4 billion in 2017, circumventing the traditional regulatory strictures of the 1933 Act by arguing that their offerings were not securities at all. Instead, they stripped their offerings of governance and ownership features, and characterized them as mere tokens meant for consumption (known as “utility” or “consumption” tokens), rather than investment contracts over which the SEC could legitimately claim jurisdiction. By analogy, imagine a musician who sells tickets to a future concert well in advance in order to raise money for the venue and cost of production. The argument goes that, because these ICOs do not promise governance rights or profit distribution, they are merely offering a “ticket” to use their services in the future.

The SEC isn’t buying it. Regulators have proved deeply suspicious of ICOs, and for good reason: their early success also attracted fraudsters. A Wall Street Journal study of 1,450 ICOs revealed 271 with signs of fraud including “plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams.” The SEC has vociferously rejected efforts of ICOs to create an end run around the ’33 Act’s bargain by allowing the general public to participate in ICOs.

In Semi-Public Offerings I use the emergence of the ICOs as the opportunity for a thought experiment. If we wanted to create a mechanism whereby entrepreneurs could access the public markets in a way that honors the goals of the U.S. securities laws, what would it look like? I suggest in the essay some ways forward that could assuage the SEC’s concerns, grant entrepreneurs access to new sources of capital, and allow the general public to participate as investors in early stage blockchain ventures. This approach begins by returning to first principles, focusing on what the securities laws do, and how to replicate those functions on the blockchain. But even blockchain skeptics can take from the essay a chance to rethink the public securities offering mechanism developed back in 1933.

The complete paper is available for download here.