Stephen Palley

The Regulatory Landscape for Cryptocurrencies and the SEC’s Case Against Kik

The complex and evolving regulatory landscape for cryptocurrencies has been a topic for many years. After a long period of waiting, the SEC started pursuing fraud causes in the last 1-2 years. But the recent lawsuit against Kik is the first time that the SEC goes after a large, non-fraud case.

We were joined by lawyer Stephen Palley to discuss the Kik case, the US regulatory landscape and recent announcement of the Libra cryptocurrency promoted by Facebook.

Topics we discussed in this episode
  • The SEC lawsuit against Kik
  • The potential path of the process and how it could resolve in the end
  • Why the Kik case is unlikely to provide any regulatory clarity in the next few years
  • What a settlement in the Kik case could look like
  • Whether the Howey test is still a sensible way to regulate securities
  • How US regulators will deal with decentralized exchanges
  • Stephen’s thoughts on Libra
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Brian Fabian Crain: So we’re here today with Stephen Palley. Stephen has actually been on the podcast before quite a few years ago. He wrote this wonderful article back then ‘How to sue a DAO’ and that was exactly three years ago actually June 13th, 2016, and Stephen has been very articulate in the blockchain space. He’s been writing about a lot of legal issues often quite, you know, kind of critical of the space. So he’s been a welcome voice, a contrarian voice at least. And of course now a lot has been happening and we recently had to kick actions and so we wanted to have Stephen on and talk a little bit about that. But also some other regulatory questions, so thanks so much for joining us again Stephen.

Stephen Palley: It’s my pleasure, glad to be here.

Brian: So tell us a little bit. So the last time we spoke you were actually still primarily dealing with having insurance and construction law if I remember correctly and then you were switching law firm and you’ve built a crypto law practice since then. How has that been?

Stephen: So I have this funny law practice where I feel like I’ve got my feet in really in three spaces at this point, one is I’ve got a very old-school almost 19th century kind of dickensian practice where I help companies collect money from insurance companies. I’m an insurance coverage lawyer. So I negotiate insurance policies for large corporate clients. And then when insurance companies don’t pay I sue them or negotiate as the case may be and so I find myself dealing with old insurance policies some of which have language that literally dates back to the 19th or even 18th century in some cases and take depositions of people about an insurance placement process that bears absolutely no resemblance to anything having to do with crypto, but what’s interesting though is insurance is all about it trust really which is sort of how I ended up focusing on crypto, which was a long story short, we may have talked about this last time I was on but I was building a dispute resolution platform to solve a trust problem in litigation and dispute resolution and I stumbled onto Bitcoin as an interesting technological solution to how do you create programmatic dispute resolution without an intermediary? So my own technology company, which I built five years ago now called Impasse Breaker was a failure. I’m really good at practicing law, but I had no idea how to build a technology company, but I taught myself to program reasonably well, but that led me into helping clients build technology. So I helped another client with an advertising platform and micropayments was a problem. Which also made cryptocurrency interesting to me. This was in 2015. And yeah, I went I had my own firm for a while. I joined Anderson Kill three years ago around the time that we last spoke and the firm about a year and a half ago very graciously allowed me to create a cryptocurrency virtual currency practice focusing mostly on disputes. And also I said we should accept Bitcoin and they said okay. So the firm also blessed that. We use bitpay so it’s not like we’re actually taking keys and then for the last I don’t know eight or nine months I’ve been doing a bunch of writing at work with The Block Crypto, which is a wonderful crypto media platform, which I’m sure you’re familiar with. So sometimes I feel like I wear a little bit of a journalist platform, which is kind of fun. Journalism is kind of like law except you don’t have subpoena power and I focus mostly on legal developments in the space so that’s kind of what I’ve been up to in a nutshell since we last spoke.

Brian: There’s been of course lots of developments in the crypto space, you know, things are moving quickly. But if you were to give I don’t know a three minutes kind of high-level take on the last three years. What do you think have been the most important developments and maybe developments that surprised you the most when it comes to like, you know crypto regulation and law.

Stephen: It sounds really arrogant, but I’m honestly not really surprised by very much. I think I predicted very accurately that there would be a regulatory crackdown. I’m not the only person who predicted it but we were kind of at some points I felt like I was the guy in front of a bar where there were free drinks and food that happened to be laced with arsenic saying, you know guys everybody like during the ICO boom saying, you know, maybe think twice about eating all of that. There’s like there’s a price you’ll pay but that all happened rather as expected and I think we’ll see more of that I think as 2019 winds down and 2020 winds up that will continue to happen. I have to say I suppose I’ve been a little bit surprised at Tezos and how broadly and widely that has spread in spite of litigation involving it. I didn’t necessarily see that, I think it also may end up going to show that litigation and regulatory enforcement won’t necessarily stop everything. Maybe that particular project has been a little bit of a surprise to me and I’m not making a prediction about value or the market, I’m just noting that it’s apparently continued to thrive in the technology is I’ve heard a lot of accolades and maybe I didn’t see that necessarily coming. Sometimes what’s interesting is trying to figure out how litigation and regulatory enforcement will impact something that maybe is centralized in certain ways but decentralized in other ways. I suppose I’ve also been a little bit surprised to not see some sort of public enforcement related to Ethereum. That’s been a little bit of a surprise to me. But honestly not that much. The sale itself was at a time when the technology was new, getting Bitcoin was not something that was easy for folks. I’m not sure everyone quite understood what had happened. I think that the DAO report is almost sort of an inflection point for for US regulators for the SEC in particular. But you know for the most part things have happened as perhaps sort of as expected. It’ll be interesting to see sort of how Libra and Bitcoin play out on Parallel tracks. I’m not quite sure what the right take is there this point, I guess I was also, you know, I think we’ll talk about Libra  in a little bit more detail. I’m not surprised that there have already been calls for congressional hearings and I believe one one member of congress has already sent a letter to Libra saying cut it out, cease and desist. It’s not surprising that congress is upset. I mean it’s base book is you know, it’s an organization that doesn’t get a lot of love in congress. I’m a little bit surprised at how fast it came, that’s sort of my recent that’s surprising to me.

Friederike Ernst: Do you have anything that’s surprising to you that surprised you in a positive way because all of these out of the things you mentioned are kind of like I can’t believe they kind of got away with it sort of things, right.

Stephen: It is incredibly cool that you can send value around the world almost instantly and convert it to Fiat almost instantly, take Gemini for example, Brian you can send me a Bitcoin or Ether and I’d have it in my own private wallet in you know, let’s say 15 minutes. I could then send it to Gemini and they could wire me money within two hours. That’s actually amazing. It’s also like if we want to talk about positive, it’s funny you should say that because a good friend of mine has pointed out to me more than once people like a bull more than a bear so much like the advice that I was given was like your insights are really interesting but like maybe try to be more bullish about things but I am who I am and I’m just like Popeye. It’s incredible literally that ten years after the white paper we’re having congregational hearings where people are talking about the stuff. I went to an event at the SEC 2 or 3 weeks ago and the SEC is fully engaged and interested in the space. Now remember that white paper is 10 years old, right and we had an entire day with high-level people at the SEC grappling with the technology and not just focusing on enforcement but thinking about how it can be useful. So what got me interested in the space is actually the technology, not the law, I was wearing a technologist hat when I discovered Bitcoin and I’m still incredibly bullish about the long-term potential of programmable money, peer to peer programmable money without an intermediary without a Swiss Foundation. I think that I got it when I saw it and I still think that that has incredible potential. I think we’ve come a long way in 10 years. Was that bullish enough for you?

Friederike: Yeah that was bullish enough. You said earlier that the DAO  report was kind of seen as an inflection point in the ecosystem and recently the SEC has taken action against a number of projects. Most recently against Kik. Can you give us a little bit of background about that Kik?

Stephen: Sure. So in 2017 shortly after the Kik ICO the SEC apparently commenced an investigation considering whether or not the tokens that Kik sold were investment contracts and securities under US federal law, so a fairly long and involved process, it involved testimony under oath that involves subpoenas of documents and apparently involve millions of dollars in legal fees. Towards the end of that process believe in the fall, November 16 2018 to be precise, the SEC had essentially wrapped up its conclusion. It sent something to Kik’s lawyers saying basically we’ve made a preliminary determination to recommend that the commission file an enforcement action against your clients Kik Interactive and Kin Foundation alleging violations of a part of US Securities laws that require you to register a security with the SEC before selling it to the public. I’m oversimplifying a bit. This was called a Wells notice and in the US once you receive a Wells notice, you can write a letter back to the SEC wells submission trying to convince the SEC not to sue you Kik and Kin did that actually and apparently it wasn’t good enough at least as respect Kik and the SEC sued them on June 4th 2019 in federal court in the southern district of New York, The SEC filed a lawsuit against Kik Interactive alleging that it violated the portion of US Securities laws that require you to register a security before selling it. It’s a pretty long lawsuit ,49 pages. I’ve got my yellow stickies and all of the interesting parts and you know, it’s as I think Brian you listened to a presentation I did last week with with CoinDesk. I was asked about how long this would take. I mean a federal court lawsuit of this nature and complexity can take two to three years to resolve. It could take another year or two to go up on appeal, four five six years before we see any sort of resolution. I know the folks at Kik said they’re prepared to go to the Supreme Court. Whether the Supreme Court considers this and decides to reconsider the Howey test they do have very fine lawyers the SEC does too. I’m skeptical that this makes it to the Supreme Court, but it’s certainly a possibility. But you know, I think one of the questions is this lawsuit going to give us clarity about the law and the application of the Howey test to token in time the future, I don’t think so. Not in the near future anyway.

Brian: I mean the question let’s say to take this to the Supreme Court. So is that in the end though, how kind of clarity would come about is that like, you know, somebody takes it to the Supreme Court and the Supreme Court says okay, you know the Howey test be interpreted this way when it comes to crypto tokens or do you think this is going to play out some different way?

Stephen: Answering that requires a little bit of sort of framework about how law works in the United States. The Howey test is a test that comes from a Supreme Court case and there are a bunch of different ways that law is created in the United States, one way is we have judgment law, case law, common law, that interprets statutes and that’s what the Howey test is but you also have laws themselves. So you have the Securities Act of 1933, The Exchange Act of 1934, which are federal statutes. Those are laws as well. Then we have administrative agencies essentially like the SEC which are given authority by statute to promulgate regulations. So you’ve got statutes. You’ve got regulations. You’ve got cases. Judges only decide the cases that are before them. So it’s theoretically possible though I think unlikely that a federal court is going to say, you know what, the Howey test and investment contract analysis that doesn’t apply to crypto tokens. I can’t figure out why a court would say that what is so special about this asset class that a court would create an exemption to old and established judge-made interpretation of the Securities Act, it’s possible but it seems unlikely. It’s more likely that you would get “regulatory clarity” or you’d get maybe a different way of saying it is sort of an exemption for tokens to Securities Act if you had congressional action, or you had exemptions that were created by state legislators because in addition to complexity federal law in the United States things are even more fun because we’ve got 50 states ,the District of Columbia and some territories as well all of which have their own lawmaking power and their own courts. It’s a federal system. Right? The short answer is it’s unlikely that this is the case that’s going to change the lay of the land anytime soon. I did see a story this morning about proposed legislation that would change accredited investor rules in the United States and would allow people with less income and fewer assets to invest in certain types of assets. That might be an answer sort of a change to crowdfunding laws, but I don’t see the SEC creating a broad exemption for tokens anytime soon. I just don’t see that as being within their ambit.

Friederike: Thank you Stephen, maybe quickly for the benefit of all our listeners, would you be able to give us a short description of what the Howey test actually entails and what it determines? And how it applies maybe with an example of Kik so we can tie this in.

Stephen: Sure, the Securities Act of 1933 and the Exchange Act of 1934 have a definition of securities that includes investment contract, investment contract is not a defined term. The Supreme Court in 1947/1948 in an old case called SEC versus Howey, define an investment contract as an investment of money in a common enterprise with an expectation of profits solely from the managerial or entrepreneurial efforts of others, that’s paraphrase but that’s the basic idea. So it’s a three-part test – investment of money courts have held for some time that investment that, cryptocurrency can be an investment of money. money doesn’t necessarily mean state-sanctioned Fiat. It can be Ether it can be Bitcoin, it can be Brian coin, it could be Palley Coin, you know, there’s a Pally token out there by the way, I thought they were trolling me but it’s decentralized social friendships or something. And then the common enterprise is basically a sort of a joint venture if you will like an agreement to do something together, the expectation of profits solely from the managerial or entrepreneurial efforts of another. There’s actually a pretty good explanation of how the SEC views that in this case. Let me see if I can find it. Basically the SEC says investors who bought Kin tokens, Kik sold something called Kin tokens, investors who bought Kin tokens through the offering and component sales made an investment of money in a common enterprise with Kik and they reasonably expected that they would get profits because of the entrepreneurial managerial efforts of Kik and its agents. So basically they bought tokens in a passive way, pulled together expecting that somebody else would do everything necessary to give the thing value. That’s it in a nutshell and that sort of definition of investment contract applies in the investment and non-investment space. Now the test has gotten some criticism and people have asked for you no more “clarity” with respect to crypto. I mean, I guess when people ask particularly people in crypto often of a libertarian bent ask for more regulation, I kind of wonder about that because sort of the nice thing about that common law judge made test is its dynamic right? It’s not a static test. It is a principles-based the SEC would say it applies to the facts and circumstances of specific cases. And you know, if if you well, I don’t like the term utility token. It does describe something that is not an investment contract and not a security, you could think of software token as being a key that gives you access for example to a digital rights management platform that gives you access to music or in the case of Ether that allows you to write something the utility of the thing is the ability to write to a distributed decentralized database now. I know there are people out there who will say it’s not really a database but let’s call it that it gives you Ether it gives you the ability to write data, right? So things that have existing utility, they could be tokens. Like the thing that allows me to access iTunes. There is a software token some place that gives me the ability to access that library to access my songs. There’s nothing about a token in and of itself that is inherently a security. There’s nothing about a token that is inherently an investment contract. It’s how it’s used and I think the SEC is full of smart people who can look through the maze in the fog of white papers and look at something for what it actually is and I think the problem that a lot of the token sales had and the problem that the SEC points to in the Kik sale of the Kin tokens was in many cases the token was being sold to fund the creation of a thing that did not exist yet with the expectation that by doing so the people buying that token would would profit from it. That’s not necessarily a correct statement of the Howey test, but it’s a correct statement of the business problem.

Friederike: So Kik is a company existed ten years before the token say, right. So basically they had a messaging app that was actually fairly popular for a while with kids and teens and they were failing to monetize that and also it was slowly going out of favor mostly because apparently there were rampant child predators on the platform. So they said they were going to conduct this token sale of the Kin token, which would be used as a form of payment on this platform that they were going to build. So what’s the argument that Kin is making that this is not a security

Stephen: Well they say it’s a currency and that the SEC doesn’t have authority to regulate currency and that its regulatory overreach and they also say that the Howey test is effectively out of date and shouldn’t apply to token cells such as this one. They also don’t say this explicitly but I try to put myself in the shoes of their lawyers and looking at the SEC compliance. So if you go to paragraph 7 of the lawsuit and for folks out there who are interested you can get a copy of this lawsuit. I’m fairly certain it’s available on the SEC website. You go to  paragraph 7 you can see theme that runs through the complaint. I’ll quote “based with a shrinking financial runway Kik decided to pivot to an entirely different business and attempt to what a board member called a Hail Mary pass. Kik would offer and sell 1 trillion digital tokens in return for cash to fund company operations and a speculative new venture. For those of you who are outside of the United States and aren’t familiar with American football a Hail Mary pass describes a move late in a football game. Like there’s like one second left where the quarterback throws, you know from one side of the field all the way to the other side of the field hoping that one of the players catches the ball and makes it into the to the end zone to win the game. That’s a Hail Mary pass. So basically what the SEC says is, you know, you were a failing business, you needed to make money. We got all your documents. We read all of the emails. It is clear that this was an investment scheme that you lumped up using fancy crypto lingo, but basically you were raising money because you couldn’t go to capital markets. You couldn’t go back to your investors. And I think if I were responding to that argument, I would say it’s true the company needed to make money, right? The company times weren’t good. However, just because times aren’t good doesn’t mean there’s something wrong about creating a new product to do better. If that was the case you’d have to sue every company that was facing hard financial times. What we did they would argue perhaps is what we did was what any smart company would do when faced with a difficult financial situation. We’re changing technology. We innovated, we pivoted, we built something new, and if you’re going to criticize us for falling on hard financial times that is a false narrative. It’s a narrative that is unfair and it’s a narrative that you can apply to anybody. You can’t penalize us because we tried to innovate, that’s exactly what we did here. That’s what I would argue and you know suppose if they’re watching they can steal my argument right, but that’s not a bad argument. Now the SEC tells what’s interesting about this 49 page lawsuit, 46 pages of it are facts or allegations, the story. 2 maybe 3 pages of it describe the legal claims. So the SEC is banking on this telling a really strong factual story that supports a very narrow legal theory and there’s something about that that is tactically interesting.

Brian: What is your prediction? Like, how do you think this is going to play out?

Stephen: It’s not like from a fact standpoint like the narrative is not a great narrative for Kik you also have, they use the word investment a lot. There’s a reference to a Bitcoin meetup where Kik CEO said people are going to make a lot of money. They talked about getting listed on exchanges. This is a great quote and it’s probably one of the worst ones. There’s an email where a Kik employee admitted to another by email when discussing lack of guidance they received about the crypto stickers was a picture of a honey badger holding a boombox saying Let’s Jam. That was I guess supposed to be one of the bits of utility where the employee said basically doesn’t really matter. The whole point is to make our legal department happy not the users who are actually investors and probably could care less that they got a sticker pack for their $10,000 investment in Kin. Stuff like that doesn’t look great. But if you are defending Kik you’re going to say all those facts are irrelevant. It doesn’t matter what an employee said. This was they’re not lawyers. You have to look at the actual thing. You have to look at the SEC’s authority to regulate the space. You have to look at what it actually is. So ignore all of that. And if you do that, you’ll see either its currency not a security or the Howey test is wrong and needs to be updated. Look I mean they can win if I were betting and I probably wouldn’t bet on this, but if I were betting at this point, just based on the complaint, it’s looking pretty good for the SEC. My prediction which is total guess, I have not spoken with lawyers for either side. My guess is this settles my also guess is that it didn’t settle previously because the SEC wanted too much but you also have to understand how this played out, ordinarily in a lawsuit if I prepare a lawsuit against somebody I don’t have their files. I don’t have their their awful emails. I have not examined their witnesses under oath, the SEC already did that like for the last 18 months before it filed this lawsuit the SEC sent out subpoenas, examined witnesses, got all of the files, then they received Kik’s legal analysis in the form of their Wells submission. So what’s unusual about this is the SEC already knows the other side’s case already knows the universe of documents. It’s unusual for a case to begin that way. They also well, they can’t take every case and while it’s true that you know, their resources are constrained by budgets, it’s the US government. The fact that Kik might raise five or ten million dollars or twenty million dollars doesn’t matter if the SEC wants to make this a priority, the SEC has a much larger budget that has effectively basically unlimited resources if it chooses to go after someone and the fact that they did means they think they’ve got a really solid case and this is by the way, it’s a beautifully written complaint. I’m sure that Kik’s lawyers will write a beautifully written answer motion to dismiss but it’s top-notch legal work. The other interesting nuance to is that for those who follow this area of litigation law closely in the US this is not a securities fraud lawsuit. So the SEC is not claiming that there was any sort of fraud or sort of intentional misconduct. They are saying that this is a security and you had to register, that is a violation that does not require proof of intent. All you have to show is that it was a security and there was a failure to register period, full stop. I suspect the case will settle. I’m guessing, I may be wrong.

Friederike: You stated that the SEC in principle has an unlimited amount of money to go after this. So Kik is also unusual for a start-up in the sense that they also have a lot of money. So how do you think this would have played out differently if Kik hadn’t raised a hundred million dollars two years ago.

Stephen: Well there are lots of other companies who raised lots of money in ways that may have violated the securities laws. This was a lot of money and they were pretty public about it and they said a lot of things in public that I’m sure caught the SEC’s attention. My suspicion is that there are, so investigations are private. The SEC does not disclose their existence during the investigatory phase. I suspect that there are scores of other companies some of whom raise more money, some of whom raise less money, who are in the middle of an investigation as well, and who perhaps have looked at this and thought well, we don’t want to be involved in litigation with the SEC for the next three four five years and are seeing this as encouragement to settle. They kind of poked the SEC in the eye by saying we’re going to create, they printed a website called Defend Crypto and they basically told the SEC to come and sue them so the SEC did.

Friederike: Maybe not the best people to taunt.

Stephen: You know, if you genuinely I don’t I don’t know these people. I don’t know how sincere they are in their beliefs. But if you sincerely believe that you didn’t do anything wrong and the SEC is out to shut you down and they shouldn’t and you have the resources  maybe you fight. Sometimes the government’s wrong. I mean the beautiful thing about the United States and one of the things I love about being a lawyer is just because the government says something is so doesn’t mean they’re right, you can fight. Now usually the SEC doesn’t do this unless they think they’re going to win but they lose sometimes.

Friederike: The DAO report came out in 2017. Do you think anything that happened before is fine,do you think do you think the SEC will come after any projects that did token sales before the Ethereum or early DAP token sales.

Stephen: I have no idea. I would be completely speculating. I believe that they cited the DAO report in this lawsuit.

Brian: I mean, I remember reading also some previous SEC things and there was always like we’ve published the DAO report, we told this was and you still went ahead and you did it afterwards.

Stephen: Yeah, I think that’s right. I think that represents a bit of an inflection point and I mean I do I go back to the Ethereum token sale,  I don’t remember how many people invested at the time.

Brian: Around 10,000

Stephen: And you had to have Bitcoin to invest right? So you had to know how to set up a wallet. I had to work with private keys. You had to know how to get crypto. You had to know how to receive Ether. It was highly technical. I don’t think it’s unfair for a regulator to look at that and say well alright like technically that looks like it was a securities offering but the reality is maybe we understand that how gas works and maybe it was something that was a hobbyist deal at the time. So we’re not going to come after you for that. I don’t think that that’s an unreasonable approach and some of my friends in the space, you know may not like that, but I can see how a regulator might look at that and say, okay it was early days. We weren’t watching it. Maybe you didn’t know what you were doing. I suspect that they probably had some sense, but that’s not a conversation I was part of. I do think however, though once that report came out it became harder for people to claim like they didn’t know. And the SEC sort of done this they’ve like they’ve ratcheted up the pressure and I believe this is the first, there have been some settlements in failure register cases with a variety of penalties. This is the first lawsuit in federal court. So there are a couple of ways that the SEC can go after you if you violate securities laws, one is they can institute administrative proceedings which are before an administrative law judge. Basically, it’s sort of oversimplifying it’s kind of in front of of the regulator, right. The other way is to go to a federal court in front of a federal judge and the judiciary in the United States is a different part of the government than the regulators are so this is the first time that I believe they’ve gone to federal court in the case of a failure to register a token sale. The other cases have all involved basically orders instituting proceedings. They’ve been respectively consent orders in an SEC administrative proceeding. They’ve kind of ratcheted up the pressure and the sanction in the penalty that they’ve applied and this appears to be sort of a next phase in ratcheting up if you will.

Brian: So maybe just a final question on the Kik stuff. You mentioned that you expect settlement here or you think it’s likely. What could such a settlement look like?

Stephen: Maybe not but you’d have to look at other settlements that the SEC has entered into in other cases. There will probably be some sort of requirement of a rescission offer where the SEC would require Kik to give people the ability to sell their tokens back, they’d be required to register file reports. I suspect given the fact that they made the SEC file a lawsuit there’d probably be some sort of civil penalty that would be imposed. So basically think of it as a fine. They might also require repayment of certain amount of profits to the SEC. I mean given that it may be that the sanction is so ownerís that Kik views it as they don’t survive if they settle in the terms of the SEC is requiring. That may be an issue that needs to be you know, that would have to be fleshed out and obviously it involves facts that I’m not privy to.

Brian: Thanks so much. Let’s talk about another thing that you know is often discussed but highly confusing when it comes to the US, the SEC approach, which is that they’ve said that, you know, Ether sale was basically security, but now it’s not the security and at some point this became not a security and I think they use the terms efficiently decentralized at some point ,now with Kik as well, right? They’re not saying that the token today is a security so it’s kind of unclear whether they consider it to be a security today, but I think it’s been the kind of premise of all of these people using the SAFT to race that okay security but then at some point it launches and they won’t be security anymore. So, how do you think that’s going to play out? Like, first of all, do you think there is going to be this process of you know going from security not security and how are we going to know when what is what?

Stephen: So I don’t think the SEC is ever squarely said in anything that is official that Ether is or is not a security or that the token sale was or was not a securities offering, there have been some statements that have come close to that. But I think they’ve been misinterpreted by certain people. There’s that the sufficiently decentralized business came out of a speech by William Henman last year. I don’t see any reason why something can’t start as a security and then become not a security. I certainly think that is possible in the case of Ether. It doesn’t to me look like it is a security at this moment in time as to whether or not the token sale was a securities offering I don’t think that, I’m not going to a pine on that. Maybe it was maybe it wasn’t will be up to the SEC to decide if it’s going to take any action within I believe there’d be a five-year statute of limitations, which is coming up pretty soon right . The thing about statute of limitations, of course is that can be told or that can be a state or prevented by private agreement. I think that this sort of latest round of enforcement activity and some of the recent litigation makes it difficult for people building new platforms to sell tokens for things that do not yet exist, sort of bottom line. It creates a layer of complexity that’s difficult in the United States. I don’t know if that really answers your question, but I guess I would say if you want to use a token like build a platform, sell the token. If  you want to raise money, raise money. Can you raise money by giving people a promise to receive tokens in the future with the expectation that the tokens may not be securities. I suppose I mean talk to a good securities lawyer and by good securities lawyer I mean somebody who will tell you if you’re wrong. What you don’t want is somebody who’s going to just bless what you’re doing because you’re paying them a lot of money. You need to talk somebody who is willing to get fired for giving you candid advice. I like my good friend Louis Cohen who’s actually somebody I’d recommend that people consult with if they’re thinking about engaging one of these transactions. He made a really interesting point in that CoinDesk thing that we did last week and he’s made it on Twitter and I’ve had conversations with him about, what he’s pointed out is that in other jurisdictions token sales are governed by, you don’t have securities regulators looking at them, the laws that tend to apply are consumer protection laws. And that’s sort of an interesting model when you think about if you’re trying to find alternative ways to regulate these transactions or to ensure consumer protection in the United States. That’s more of a policy issue than a what can I do now, I guess what I would say is if you’re selling to people tokens with a promise of future utility, that is a securities issue that needs to be pinned down. I never liked the SAFT model it seemed confusing to me, but I don’t do transactional securities work. So it’s not those are not things that I ever necessarily blessed, but I certainly don’t see any conceptual reason why something can’t start as a security and become a non-security that doesn’t answer the question of what happens if let’s say you sell a token that is an unregistered security. It becomes a non security you still have liability for the unregistered Securities offering, that’s sort of a fundamental existential question and problem and I don’t know why anybody would want that.

Friederike: You said that in other countries regulators concern themselves more with consumer protection. Whereas the the SEC is mostly concerned with investor protection. Do you think this is a distinction that should be removed. Do you think the Howey test is still applicable as sensible to be replaced and if so by what because basically if you look at things that the regulator’s let people do despite the fact that they are universally agreed to be bad for you. So for instance just go take out a payday loan or something, that’s not forbidden

Stephen: It’s heavily regulated but sure.

Friederike: Yeah, it’s heavily regulated. So you said that in other countries regulators concern themselves mostly with consumer protection as opposed to investor protection like the SEC does, where do you see the difference between the two?

Stephen: That’s an interesting question. So if your focus is consumer protection, you might not have the same sort of limitations on who is able to put their money into a project. You might not have income requirements or sort of asset holdings requirements. You might focus more on avoidance of fraud as opposed to limiting who is able to participate in the funding of projects. Now, we do have obviously active consumer protection regulators in the United States both on the federal and state level. So you’ve got the FTC out of the federal level and on the state level, you’ve got similar regulators and got State Attorneys General who who enforce unfair deceptive practices. So some of those actually include carve-outs for securities for investor investment related claims. I’m not sure if that answered your question, but that I guess the question would be like, can you protect consumers by applying a framework that doesn’t require you to decide that a token is or is not a security. I’d rather focus on sort of overall consumer protection. Now I guess from the SEC perspective one of the ways that they achieve investor protection is by requiring not exactly transparency but disclosure, the reason why you have to file quarterly and annual reports, for example, or other reports with the SEC is so that your investors can understand what sort of the material facts about an enterprise and what risks are related to the investment. I guess the question would be is there something better about doing that within the framework, a rubric of consumer protection laws as opposed to securities regulation.

Friederike: So I guess what I’m getting at is there are many products that consumers can readily engage with that are difficult to understand and may lose you money and people are still entitled to engaging with them so they can go to a payday loan service. Or people can take out a loan against their credit card and you can smoke cigarettes. Whereas investing in securities is not only something that can be difficult to understand. It can also be something that is immensely lucrative. So in a way it could actually be seen as locking people out.

Stephen: Right. So the answer might be look we don’t want to lock people out we want to protect them against fraud. And in order to in order to broaden the pool who can people can participate, you know, maybe by putting twenty five dollars or a hundred dollars in a project we don’t want to rigidly apply securities laws so we’ll look to consumer protection laws instead. I suppose that’s a possibility. For that sort of change to happen in the United States you’re talking about years of lobbying and you know, I mean certainly in the broad scheme and scale of history that’s hardly an impediment to change. You know, it may take a little while longer than people would prefer.

Brian: So one of the interesting things is of course to look at, you know the US also in the kind of broader context of you know, the technological change and the regulatory landscape in the competition there. We’ve seen a bunch of things recently including US exchanges like Bittrex and Poloniex delisting a lot of coins for Americans and Binance has shutdown access and some other ones. At the same time we have new decentralized exchanges that you know still at this point, maybe usability and volumes pretty low but probably in a few years, you know, that will be a real alternative. So how do you think the US Regulators are going to deal with, you know, one, the international pressure and competition and two, just ways like decentralized exchange has to circumvent the rules.

Stephen: I don’t think the SEC will care necessarily that offshore exchanges are freezing Americans out of the ability to buy certain tokens. I just don’t think that that’s anything they are particularly concerned about. If there’s a desire for American investors / consumers to have access to other other sorts of asset classes that’s something that probably requires legislation or either specific legislation or legislative pressure on agencies. As far as decentralized exchanges, so I went to this thing at the SEC it was sponsored by Pin Hub, almost three weeks ago now and it’s clear that they’re grappling with decentralized exchange as one of the things that they asked a bunch of times, they were asking questions about custody and things that suggested that they’re they’re thinking about how peer to peer exchange without custodial intermediary. What that means and how that would work within sort of the framework of existing US Securities laws. I thought that was interesting. It’s certainly something that they are aware of familiar with the thinking about but I will say that just because you call something a DEX doesn’t mean that it is and we know that that’s their view because they shut down in effect the DEX 6 months ago in the United States. I can’t remember the name of the exchange. But just because you call it a DEX, like if it’s a DEX in name only but there’s really just a guy or a company in the middle they will view that as you know, potentially suppose a broker-dealer but someone who’s acting in an intermediary capacity.

Brian: Sure that was EtherDelta and I mean the argument there was okay it’s sort of a DEX but not really that decentralized. So there’s still this guy we can go after. And that’s of course what you exactly expect but then there will be DEX’s that are not like that. I mean, I think already there are some like, you know, Uniswap or DutchX that are pretty genuinely decentralized.

Stephen: So they’re matching engines basically.

Brian: So Uniswap basically has almost like a smart contract that you can kind of like trade with so it has kind of a reserve of assets and then it always has a price and you can basically change one asset for the other, but there’s no order books, there’s no no kind of off chain entity that has to like match trades in something like that. So there’s no way to really shut that down.

Stephen: There’s no custody. EtherDelta also had no custody but I think there was still third parties that match trades. And they earned a fee.

Friederike: They had a centralized order book. I mean, this is also true for Uniswap and truly decentralized exchanges. They also take a fee, but they neither have custody nor maintain any sort of order book that matches trades with each other.

Stephen: Well, the SEC is paying attention. I mean, that’s probably the most maybe the most prescient in sight, you know, if folks are working in this space and they’re doing anything that looks like they are helping either selling securities or helping facilitate the trading of securities, talk to a good securities lawyer. That’s somebody who handles transactional securities work. That’s not an advertisement for me by the way. I don’t do transactional securities work, but call my buddy Louis Cohen. He’s quite good and there are plenty of other lawyers who are out there. But I think the lesson I take away on the transactional side is just because it’s new technology, just because you call it a DEX or peer-to-peer, it doesn’t mean that traditional securities laws don’t apply. It’s a good idea to ask and by the way just because you’re doing something on blockchain doesn’t mean that the regulator can’t figure out who you are.

Brian: So there’s another topic we wanted to talk with you and I think it’s very interesting and novel topic. And of course everyone’s been paying attention which is that Facebook is launching its coin now. I mean, it’s been kind of known for a while, but now there are details, Libra and there are yeah interesting structure there. And of course there will be interesting regulatory and legal issues. So what’s your take on Libra?

Stephen: So I guess Facebook would probably say it’s not really Facebook that’s launching it. But everybody in the world seems to think that it is it was kind of their concept right, and they created an association. I believe it’s going to be in Geneva right is where the Libra  Association is, the Libra Foundation. You guys are in Switzerland, right?

Brian: I’m from Switzerland and I actually am in Switzerland at the moment. Yes.

Stephen: So I thought it was interesting that they used a Swiss Foundation structure though. I believe almost all of the companies involved in a project are American. So there are two takes, one is Facebook sees that there’s something really useful about being able to use money in app, right? In China, I haven’t been my understanding is if you want to pay for something, you’ve got to use WeChat. So there’s like a huge business opportunity. By the same token, no pun intended, Facebook has to look at it and think you know, if we try to launch our own money everybody is going to come down on this hard. We’re going to have huge regulatory risk. How do we get these rails? How do we get a payment rail and sort of cash within our app? How do we get consumer acceptance without taking on all of that risk? Well, let’s get other people who are involved in the space including Visa and MasterCard who’ve got relationships with merchants so they can socialize with with merchants, how do we create something that gets rid of some of our regulatory risk and also maximizes the ability to get people to accept this because I mean peer-to-peer micropayments one person to another in-app that is connected to money that you can actually use to buy stuff. It’s an incredibly powerful idea. Whatever you think of Facebook it is technology that makes sense. And these are also whether or not you use Facebook, whatever you think of the company or the companies involved, it is a massively scalable stack that is international that is always on that billions of people use, and one of the first things that happened was there was an immediate call for congressional hearings. I understand in Europe there’s been some governmental regulatory push back as well. I got to believe that they saw this predicted it and are prepared for it. I have no idea if it’s going to launch and be successful but these are companies that have a massive amount of money, aren’t scared of testifying in front of Congress and have really powerful really powerful tech. And most people I think I pointed this out and some tweets a couple of days ago. Most consumers don’t really care that these companies aren’t looking out for them and abuse or use their data for profitable purpose. So I think it’s a mistake to understate the likelihood of their potential success. I also believe that because they have an incredible amount of money they can work through some of the legal issues. You’ve got money transmission issues. You may be have Securities Law issues. You’ve got consumer protection issues, but you know, they’ve got armies of lobbyists and lawyers and they’ve got companies that can, like one of the key links is being able to socialize this technology with merchants and Facebook and Visa. Having them involved is pretty brilliant.

Friederike: Yeah, for sure. So I think it can’t be understated how much money is behind this. So if you look at Facebook alone Facebook’s cash reserves exceed the Ethereum ecosystem by quite a lot. So basically if you take the market cap of Ether plus all tokens that live on top of Ether that’s still less then Facebook actually has in cash reserve. So yeah, so there’s a lot of money behind this. So what do you think is the motivation for Visa and MasterCard to partake in this because currently they take to the tune of two to three percent per transaction, right? So do you think that that will carry through to this global coin model or do you think they have just realized that they won’t be able to bank on that forever?

Stephen: I mean all they had to do is pay 10 million bucks to a company of that size. It’s nothing like they find it in their sofa like it’s just not it’s not real money. It’s probably worth taking a look at, it does seem like it does feel like the future, the ability like micro payments on Facebook. Why would you not be willing to take a look at that if you’re Mastercard or VISA to experiment. They also have had, you know, MasterCard and Visa have had some litigation over payments and fees. I believe there was just an antitrust settlement in the last year for about six billion dollars by merchants against either Mastercard or VISA or both I don’t recall, so part of it is, I’m just sort of conceptualizing the idea in my own mind, part of it is can you create an offshore foundation that allows you to build rails you can monetize while at the same time laying off the regulatory and legal risk to that association. So can you have your cake and eat it too? I think that business problem for enterprises associated with public blockchain is you don’t have control over software development. You don’t know the quality of the data that is being incorporated into the block. So if you’re running a node, you don’t know what it is that you have. So I’ve been curious about the willingness or ability of enterprises when they really think about the risk to participate in public blockchain ecosystem. It’s not a question of sort of the utility of Bitcoin either by the way. It’s a question of how do Fortune 500 companies look at risk.  It’s also not strictly speaking necessarily a kind of a traditional blockchain data model. I haven’t dug into those technical details yet. But this is sort of a way to if you think of Bitcoin is answering a question, how do we send money quickly or maybe Ethereum how do we create programmable money? If you think about sort of generically the question of how do we send money quickly over borders without significant fee? It’s sort of answers that question and you know the ability to do that within WhatsApp is massive, having a wallet that is a cash equivalent that doesn’t have any exchange rate risk, you know, if you can do that it’s a huge win. I don’t know about the antitrust scrutiny or a competition scrutiny that this will face by regulators but if you can thread that needle it’s a huge weight. If not, I mean, you know, the financial at the investment at this point is immaterial to the folks who are involved. I don’t necessarily buy that sort of meme of we want to bank the unbanked. I think if you want to be cynical it’s a sort of it’s a cynical use of a meme for profit taking companies. Maybe that’s what they really want to do. But you know a lot of the unbanked don’t actually have money to begin with. So I guess the question is does creating this unit of exchange make it easier for people to make money doing certain things maybe.

Brian: Absolutely. I think it would be very interesting to see what the regulatory issues that brings up and how does also will contrast with you know, pure blockchain projects because probably they will be quite different. Thanks so much for joining us today. It was great to dive into these things and we look forward to to keep following your work and of course, this is a topic that will keep on giving and I’m sure will be still speaking about it three years from now as well.

Stephen: My pleasure, sounds good.