by T. GormanPosted on Posted in SECActions

Digital assets or crypto currency – frequently a coin with defined characteristics tied to a blockchain ledger – have risen to prominence in recent years. Certain forms of these assets are regularly traded on platforms, typically exhibiting volatile returns. In contrast, some instances offerings of these assets are little more than the latest fraudulent scam in which fraudsters seek quick profits at the expense of unsophisticated investors.

Over their short life, crypto assets have significantly evolved. While these assets originated with an “off the grid” message that sought to escape the scrutiny of regulators, recently the focus seems to have changed. Now there are ads claiming that the “revolution needs rules” and announcing that a particular iteration of crypto is regulated – i.e. a safer investment. At the same time those favoring the use of crypto assets continue to struggle in defining the role of the assets in the market place. Some continue to dismiss these assets as little more than nonsense.

Regardless of one’s view of the assets, one point is clear: Federal regulators continue to try and fit the new assets into traditional regulatory structures which varying results. This phenomenon is well illustrated by the recent Joint Release issued by the Financial Crimes Enforcement Network or FinCEN and the CFTC and SEC (collectively the “regulators”) (Oct. 11, 2019) (here).

The Joint Release

The regulators’ Joint Release focused on the currency type attributes of digital assets. It was designed to “remind persons engaged in activities involving digital assets of their anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act.” Those obligations apply to entities that the BSA defines as “financial institutions.” That definition includes “futures commission merchants and introducing brokers, obligated to register with the CFTC, money services businesses as defined by FinCEN, and broker-dealers and mutual funds obligated to register with the SEC,” according to the Joint Release. The obligations of those in this space include the requirement to establish an effective AML and record keeping program which includes suspicious activity reporting or SAR requirements.

The announcement was specifically targeted at “digital assets.” As the Joint Release states: “For the purposes of this joint statement, ‘digital assets’ include security-or commodity-based instruments such as futures or swaps.” While market participants use a variety of labels and terms to identify such instruments, the critical question is the substance involved, not the label.

Rather, as the Joint Release states, it is “[t]he nature of the Digital asset-related activities a person engages in [that is] a key factor in determining whether and how that person must register with the CFTC, FinCEN, or the SEC.”

If the person engages in certain “commodity” related activities, for example, registration may be required with the CFTC. In that instance its AML/CFT activities will be overseen by the CFTC, FinCEN and the National Futures Association. If the person or activities fall within the definition of a financial institution or a money-changer, its AML/CFT activities will be overseen by FinCEN and perhaps others. If the person or activities fall within the definition of certain security regulated activities its AM/CFT activities will be regulated by the SEC, FinCEN, and perhaps the Financial Industry Regulatory Authority or others, according to the release. The key is the nature of the activities.

Comment

The release makes it clear that certain digital or crypto assets may well be subject to supervision by multiple regulators and/or self-regulatory associations. Key is not the terms used or the even the definition of the terms used but the nature of the activities. Stated differently, it is the substance of the activities not their form which will determine regulation.

The Joint Release makes it clear that efforts to be “off-the-grid” by structuring around regulation will in all likelihood fail. While some in the crypto space seem to have reached this conclusion, others clearly have not. It is thus likely that many involved with crypto assets will continue to face government enforcement actions centered on the key jurisdictional issues tied to the nature of the activity – commodity, banking and money changing and securities. The crypto/digital asset revolution will, in all likelihood, face significant difficulties being “off-the-grid” in the future.

Tagged with: ,

by T. GormanPosted on Posted in SECActions

While most public companies do not have duel class, shares there is a growing minority that have adopted the format. In many instances adopting the practice permits a person who may, for example, be the company founder and viewed as a leading visionary to retain control and manage for the long term. This structure, which is largely a function of state law and exchange listing standards, can disenfranchise most shareholders for at least a period of time if not permanently. While some argue that this is a simple matter of shareholder choice, others oppose the practice.

Recently, Rick Fleming, Investor Advocate at the SEC, addressed the practice at the ICGN Conference in Miami. His remarks were titled “Dual-Class Shares: A Recipe for Disaster” (Oct. 16, 2019) (here).

The remarks

As the title of Mr. Fleming’s remarks suggest, he is not an advocate of dual-class shares. He began his remarks by suggesting that while this was a hot topic a few years ago, “recent events should have us revisiting the issue with greater urgency.” The basic theory of having duel-class shares, according to Mr. Fleming, is to permit the pubic to acquire shares in a firm by going public while retaining the benefit of the enterprise being guided by the founders who created it. Shareholders are effectively compensated for the lack of voting rights by the fact that the structure “allows the founders to guard against activists who demand short-term profits at the expense of long-term growth,” Mr. Fleming noted.

This approach has been effective in some instances, the Investor Advocate allowed. In many other instances it is questionable at best. There is a “growing body of research” which suggests that over the long-term firms with dual class structures tend to underperform. There are also inherent dangers in the structure for shareholders over the long term. Those include: The potential for self-dealing; outsized optimism; insular “group-think” among the entrenched management; poor accounting controls; a tendency to take the “eye-off-the-ball” and burn cash in ancillary projects; the declining mental health of the entrenched founder; and abusive working conditions.

While these issues may not arise for some time or be present in each company, over the long term the practice tends to create what Mr. Fleming called “a festering wound that, if left untreated, could metastasize unchecked and affect the entire system of our public markets. The question, then, is what can be done to avoid the inevitable reckoning.”

There is no quick fix for this important issue. The SEC, for example, was thwarted by the courts in a suit brought by the Business Roundtable when it sought to block super-majorities. Nevertheless, shareholders have options, Mr. Fleming insisted. Those include addressing the issue with stock exchanges which can deal with the question through their listing standards. Shareholders can also address the question with organizations such as the CFA Institute and the Council of Institutional Investors. These organizations, and others, can effectively deal with the question Mr. Fleming insisted.

Comment

Mr. Fleming has presented a significant issue that should be carefully considered. There is no doubt that in certain instances dual-class shares can benefit investors. Those benefits may include encouraging firms that otherwise might be reluctant to sell shares to the public to undertake an IPO and permitting a visionary founder to continue managing the firm with a long term view, avoiding the short term results oriented approach that may infect a public firm that is required to report quarterly.

The “parade of horrible” prospects Mr. Fleming presents should also be considered. While the list clearly does not apply to every firm, absolute power can have undesirable side-effects. Perhaps more importantly, as a firm grows and matures it may benefit from the recruitment of professional management. New management may augment, and perhaps at some point replace, the “visionary founder” whose time may be better spent envisioning the next great iteration of the company, which is how the enterprise was created, rather than pondering operations spreadsheets. While in the first instance duel class shares is a question of state law and exchange listing standards, history more than substantiates the fact that the Commission has a significant and important role to play here.

Tagged with: , ,