Facebook’s Cryptocurrency

Facebook just announced a Facebook cryptocurrency called Libra.

To me, the timing seems poor. Over the last year or so, Facebook has suffered one public relations black eye after another regarding its privacy policies, it compliance with an order of the Federal Trade Commission, its role in disseminating conspiracy theories and election interference, and its dominance in the social media industry. A Facebook cryptocurrency will, by definition, give Facebook even more private information and even more financial power. Already, regulators and members of the public are shouting “No!”

A few thoughts about what this means:

  • Not long ago, some predicted that cryptocurrencies would lead to a better world, a world that would be more free, more decentralized, where consumers could interact with one another without middlemen. Libra, a cryptocurrency created by one of the most powerful companies in the world, seems to promise exactly the opposite.
  • It didn’t take long to get from idealism to disappointment, but the arc itself is typical of technologies, from radio to automobiles to the internet. We expect technologies to save us, then they don’t.
  • Are tokens securities? Does Howey apply? Facebook’s announcement shows that those questions are small potatoes in the scheme of how cryptocurrencies may re-shape the financial world.
  • Undoubtedly, Facebook is in this for the data. Will consumers care? Probably not.
  • Facebook might be first, but how long can it be before Google and Amazon — especially Amazon — issue their own cryptocurrencies?
  • Regardless of political persuasion, governments aren’t going to allow Facebook or anybody else to compete with their national currencies. We are already seeing opposition from Democrats and Republicans alike, and we can expect more.
  • And the next step: How long can it be before the U.S. dollar itself is given the features of a cryptocurrency, in effect competing with Facebook?
  • The price of bitcoin increased on the announcement, but I think that’s exactly wrong. The announcement shows that bitcoin and other cryptocurrencies will be left behind as big companies take over, just as a few big companies now monetize the once-egalitarian internet.
  • In the same way, I expect the announcement to stifle innovation in the cryptocurrency industry generally, just as the existence of Facebook already stifles innovation in social media and Microsoft once stifled innovation in software. Nobody wants to compete with the giant.

As all six readers of this blog know, I’m a believer in Crowdfunding from a capitalist, ideological perspective. I believe in making capital available to entrepreneurs everywhere, no matter where you grew up, no matter who your parents are, and in making great investments available to ordinary Americans, helping to narrow the wealth and income gaps that do so much harm to our society.

Frankly, Facebook and Libra feel like a step in the opposite direction, toward a world where knowledge and wealth and power are more concentrated and ordinary Americans are so many data points to be monetized. I’m certainly interested in hearing a different point of view.

Questions? Let me know.

Mark Roderick is one of the leading Crowdfunding lawyers in the United States. He represents platforms, portals, issuers, and others throughout the industry. For more information on Crowdfunding, including news, updates and links to important information pertaining to the JOBS Act and how Crowdfunding may affect your business, follow Mark’s blog, or his twitter handle: @CrowdfundAttny. He can also be reached at 856.661.2265 or mark.roderick@flastergreenberg.com

Blockchain Is A Technology, Not A Philosophy

John Barlow died last Wednesday. Mr. Barlow wrote lyrics for the Grateful Dead, dabbled in Republican politics in Wyoming, and, more famously, had big dreams for the internet. He referred to the internet as “the new home of the mind” and demanded of governments, “I declare the global social space we are building to be naturally independent of the tyrannies you seek to impose on us.”

Good things have come from the internet, no question, but for the most part Mr. Barlow’s dreams have not materialized. Twenty five years later, the internet means mainly Facebook and Google for most people, along with a loss of privacy, e.g., Equifax. The internet has made it easier to work from home and collaborate and start social movements like #MeToo and #TeaParty, but also allows Russia to interfere with our elections. We’re connected all the time, yet somehow feel more lonely. And all the information circling the globe leaves us with a citizenry somehow less informed than when television came in three black and white channels.

Mixed results are not unique to the internet. Pick any technology – electricity, automobiles, television, nuclear power – and you’ll find the same story of idealistic dreams transformed or broken on the shoals of the real world. We imperfect human beings keep asking technology to save us from ourselves, and it never can.

Which brings us to blockchain.

Speaking at a crypto-conference in New York the day Mr. Barlow died, I heard a speaker predict that blockchain would replace the banking system, that cryptocurrency would eliminate national currencies, that we are about to witness a fundamental change (for the good) in the human condition. You can read articles in serious business publications about the “ethos” of blockchain, how the technology will replace our broken trust in private and government institutions.

In my opinion that thinking isn’t just wrong but dangerous. Blockchain is not going to replace the banking system, and shouldn’t. Cryptocurrencies will replace fiat currencies only in countries without a functioning currency of their own. If you see a country where Bitcoin is the currency of choice, it’s like seeing a guy on the subway with an IV in his arm:  you’re not sure what’s wrong, but you know he’s sick.

If you think blockchain has an ethos, you’ll sell tokens without bothering about securities laws. You’ll encourage wage-earners to invest their savings in a cryptocurrency whose price chart makes Pets.com look stable, having decided that it’s not so much a “currency” as a “store of value.” Most dangerous, you’ll convince yourself that technology is a substitute for morality.

Like every technology, starting with fire, blockchain can improve the human condition only if we tether it to our needs.

Fortunately, based on what I saw at the conference on Wednesday, there’s a lot of tethering along with the hype. Among other things, we heard from entrepreneurs using blockchain technology to:

  • Improve healthcare outcomes
  • Give consumers control over their financial records
  • Facilitate business and consumer payments
  • Reduce fraud in the financial markets
  • Make sense of our antiquated system of property ownership

With the grandiose predictions and the mystification and, frankly, some wishful thinking by lawyers, the blockchain industry has earned a black eye in the minds of many, including government regulators. Even so, light shines through. As an industry, let’s dedicate ourselves to using the technology wisely, making it work for ordinary people, being more transparent than the law requires, thinking long-term, and above all, remembering that how blockchain is viewed 25 years from now depends not on technology, but on imperfect human beings like us.

Questions? Let me know.

Can A Crowdfunding Issuer Sell Its Own Securities?

Securities Cash  Register

Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?

For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.

For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.

Section 18(a)(1) of Securities Act

Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:

Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.

Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?

Here’s the statute again, with extra words removed:

No law requiring registration or qualification of securities transactions shall apply to a covered security.

A sale of a security is definitely a “securities transaction.” So here’s the question:  does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.

But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.

For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.

What’s At Stake

If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.

The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.

I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.

And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.

What To Do

The simplest solution is to sell through a clearing broker licensed in every state.

Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).

If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.

Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.

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My thanks to Jillian Sidoti, Esq. and Anthony Zeoli, Esq., who provided valuable insight.

Questions? Let me know.

The Liability Of Issuers In Crowdfunding (Parental Discretion Advised)

You’re thinking about raising money using Crowdfunding, but are concerned about legal liability. Here is a non-exclusive list of ways you can be liable as an issuer.

When I say “Exchange Act” I mean the Securities Exchange Act of 1934, and when I say “Securities Act” I mean the Securities Act of 1933. The “CFR” is the Code of Federal Regulations.

Rule 10b-5

17 C.F.R. §240.10b-5, issued by the SEC under section 10(b) of the Exchange Act, makes it unlawful, in connection with the purchase or sale of any security, to:

(a)  To employ any device, scheme, or artifice to defraud,

(b)  To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c)  To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Back in 1946, courts established a “private right of action” under Rule 10b-5, meaning that an investor who has been damaged by a violation of Rule 10b-5 can sue the person who made the misstatement. That often means the issuer, but can also mean an officer or other representative.

Rule 10b-5 applies to all Crowdfunding offerings.

Section 12(a)(2) of Securities Act

Section 12(a)(2) of the Securities Act imposes liability on an issuer or other seller of securities who:

Offers or sells a security. . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

Rule 12(a)(2) applies to Title III and Tile IV, but not to Title II.

Section 17(a) of Securities Act

Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer of sale of securities, to:

(1) employ any device, scheme, or artifice to defraud, or

(2) obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light

of the circumstances under which they were made, not misleading; or

(3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Section 17(a) applies to all Crowdfunding offerings.

Special Liability Provision of Title III

New section 4A(c) of the Securities Act extends a similar concept into Title III. A Title III issuer is liable if:

The issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of such untruth or omission; and does not sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

This new provision defines “issuer” broadly:

As used in this subsection, the term “issuer” includes any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of section 4(a)(6) of this title, and any person who offers or sells the security in such offering.

The SEC says that even funding portal itself would likely fall within the definition of “issuer” and thus be subject to statutory liability under section 4A(c).

Section 4A(c) applies only to Title III.

NOTE: Rule 10b-5, section 12(a)(2), section 17(a), and section 4A(c) are very similar, but with a few key differences, including these:

  • A plaintiff making a claim under Rule 10b-5 must prove the defendant acted knowingly or was reckless.
  • A plaintiff making a claim under section 12(a)(2) or section 4A(c) must show only that the statement in question was false, leaving the defendant to prove that it did not know, and with the exercise of reasonable care could not have known, that it was false.
  • Section 12(a)(2) allows claims against the person who sold the security to the plaintiff. Section 4A(c), on the other hand, could impose liability on the issuer even in the case of a “secondary” sale, meaning a sale by an existing stockholder.
  • Section 12(a)(2) applies only to misstatements or omissions in a prospectus or made orally. Section 4A(c), on the other hand, applies to misstatements or omissions anywhere.
  • Section 17(a) does not provide a private right of action, meaning it’s about a penalty imposed by the SEC, not a lawsuit brought by an investor.
  • In making a claim under section 17(a), the SEC need show only negligence on the part of the defendant.

Failure to Register Offering

Section 5 of the Securities Act generally requires all offerings of securities to be registered with the SEC. All Crowdfunding offerings rely on statutory or regulatory exemptions from the registration requirement. Rule 506(c), Regulation A, intrastate Crowdfunding, Title III – these all provide exemptions from the registration requirement of section 5.

But all those exemptions are conditioned on satisfying certain requirements. To qualify for the exemption under Rule 506(c), for example the issuer must take reasonable steps to ensure that every investor is accredited and form a reasonable belief that every investor is accredited. If an issuer fails to satisfy all the requirements of an exemption, then the issuer has engaged in an illegal, unregistered offering and is liable under section 12(a)(1) of the Securities Act.

Failure to Use Licensed Broker

Section 15(a) of the Exchange Act requires any person acting as broker to register with the SEC. If an issuer sells securities through a person who should be licensed as a broker but is not, the issuer could be liable under any of several legal theories:

  • Use of an unlicensed broker could cause the issuer to lose the exemption from registration.
  • The failure to notify investors that the issuer is using an unlicensed broker could give rise to liability under Rule 10b-5 or section 12(a)(2).
  • The issuer could be liable for aiding and abetting the unlawful actions of the unlicensed brokers.

Failure of Principals to Register as Brokers

Section 3(a)(4)(A) of the Exchange Act generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for others.” The issuer itself is not required to register as a broker, because the issuer is effecting transactions in securities for itself, not for others. This is commonly referred to as the “issuer exemption.”

But the issuer exemption doesn’t protect employees of the issuer who engaged in selling the issuer’s securities, including the founder, the President, the CEO, the Marketing Director, and the Director of Investor Relations. A different SEC regulation, 17 CFR §240.3a4-1, provides a limited safe-harbor exemption for these so-called “associated persons.” However, it’s not hard for an issuer’s associated persons to fail to qualify for that exemption.

If an associated person should be registered as a broker but isn’t, not only is he or she personally liable, but the issuer itself now faces all the potential liabilities associated with using an unlicensed broker!

State Common Law Rules

Issuers can be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including:

  • Fraud
  • Misrepresentation
  • Breaches of fiduciary obligations
  • Breaches of contractual obligations (g., under an Operating Agreement)
  • Breach of the implied covenant of good faith and fair dealing

State Statutory Rules

States regulate the sale of securities as well. An issuer can be liable under state securities laws for:

  • The failure to register an offering under state law.

NOTE: Suppose you’re selling securities under Title II Crowdfunding (Rule 506(c)). The starting place is that sales of securities under Rule 506(c) are not subject to state registration. But if you fail to take reasonable steps to ensure that all your investors are accredited, not only do you lose your Federal exemption, you also lose your exemption form state registration as well!

  • The use of an unlicensed broker-dealer.
  • The use of deceptive offering materials.

Criminal Rules

If an issuer really screws up, it could even be subject to Federal and state criminal penalties, including:

  • Criminal penalties for intentionally violating securities laws
  • Criminal penalties for mail fraud
  • Criminal penalties for wire fraud
  • Criminal penalties for violating the Racketeer Influenced and Corrupt Organizations

Liability of People

Entrepreneurs sometimes are under the mistaken impression that operating through a corporation or other legal entity protects them from all personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a bevy of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!” she says.

No. She did it, so she’s personally liable, corporation or no corporation. If her employee did it, the story might be different (unless he was drunk when she handed him the keys).

The same is true in securities laws. Assume that if you’re running the issuer, all the potential liability I’ve described applies to you personally as well.

Is Crowdfunding Too Dangerous?

No, definitely not.

With the exception of section 4A(c) of the Securities Act, which is limited to Title III, you’ll notice that all of the potential liabilities I’ve described apply to old-fashioned private placements and public offerings, not just to Crowdfunding. Crowdfunding introduces two new variables:   the number of investors and the anonymity of investors. But the legal framework is identical.

Did I ever mention that issuers should buy insurance?

Questions? Let me know.