You go away for a few years to work in Africa and when you get back the U.S. capital markets seem to have gone right through the looking glass. For those that never left, the issuance of bizarre security types is just another small evolutionary step like the frog sitting in a pot of water warming to a boil. I’m on the other side of that boiling frog parable. I am the frog tossed into the already boiling.
I should have recognized these trends, as they were apparent for decades. Today’s craziness is only the inevitable outcome of changes to the types of securities and “other stuff” that can be sold to investors and changes to the rules of who can buy risky paper.
Remember: Companies (and individuals for that matter) are always happy to raise money without giving up anything of value.
Years ago1, there was a security type known as “Killer Bees”.
Then someone figured out that entrepreneurs could retain complete control of their board post-IPO by creating an A-B share structure, retaining the killer Bs for the founders and selling the As to the unsuspecting public. Unusual for years, the idea caught on with technology companies. Google, Facebook and many others have dual class share structures.
So now it is accepted practice to sell shares that grant only heavily discounted voting rights to the public. Facebook, always driving to extremes in line with their cultural motto, “be a hacker”, in 2016, proposed the issuance and listing of a C-class share that had no voting rights! They ultimately backed away in the face of a class action lawsuit but we suppose that one day it will happen.
So when people see bizarre and incompetent behavior by the CEOs of these companies and then pose the question, “Why doesn’t the board do something?” These boards don’t have any meaningful power because they simply serve at the pleasure of the founders. They are rather like a panel of figureheads similar to the Supreme Court in Venezuela.
That brings us to the title of this piece, ICO or “Initial Coin Offering”. An ICO is the sale of a token (the coin), with some possible future benefit attached. The market developed to circumvent traditional venture capital and avoid the costs and restrictions of security issuance. Although the “coins” were dressed up in the typical complex blockchain accounting mumbo jumbo, in essence they were securities that violated several aspects of the U.S. code.
One player told me that an ICO was like construction financing with a service benefit attached. For example, you buy a coin to help with financing a new motel and you get the right to stay one night in the Garden Inn that is planned for construction in Lodi next year. Of the assorted risks, one is that the motel will never be built.
ICOs had a couple huge benefits for issuers. They could raise vast amounts of money in a few hours and they did not have to actually give up anything of value in exchange. Even better, since they were not registered securities you could sell them to any fool with Internet access.
This last bit came by virtue of the “Jumpstart Our Business Startups” or JOBS Act. In 2012, our esteemed, but generally innumerate representatives, were distressed at the unfairness of all the money being made by rich investors in Silicon Valley. They decided to level the playing so that the hoi polloi could have the same access to these hot deals as the connected cognoscenti. The part they missed was that most of these deals don’t actually deliver any profits to investors.
As many, including your truly, pointed out at the time, this part of the JOBS Act was to democratize investment losses – a laudable objective to be sure.
But then, the JOBS act did give some legal standing to existing crowd funding operations like Kickstarter and Indiegogo.
There were rules about how much people could invest but with millions of participants there was no way to police them. In this regard, Zack Danger Brown was able to raise $55,000 to develop a new recipe for potato salad2. There were a couple of hugely successful companies funded this way – notably Oculus VR. Of course, the crowdfunders did not enjoy any of those returns, as crowdfunding cannot be structured as an equity or financial return instrument. That would be a “security”.
There are no records on the performance of the $4 billion raised for the 157,000, Kickstarter projects, but we suppose that since the typical Angel investment returns a negative 100%, these “potato salad” type deals can’t be much better.
So with ICOs we have the confluence of these two trends. Companies willing to sell odd contracts or coins or tokens to raise money without delivering anything of value and millions of people who can legally “invest” in those opportunities.
Ripe for fraud? Yes, indeed. Fortunately, the SEC has awoken and begun to take action. They recently ruled that most of these ICOs are securities. According to the Supreme Court’s conclusion in SEC v. Howey, “If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security.”
The SEC recently won an injunction against the pending Blockvest LLC, ICO. “We allege that this ICO is using both the SEC seal and a made-up crypto regulatory authority to trick investors into believing the ICO was approved by regulators,” said Robert A. Cohen, Chief of the SEC Enforcement Division’s Cyber Unit.
Clearly, a “woke” SEC has clearly crimped the style of folks like Reginald Buddy Ringgold, III, founder of Blockvest LLC.
Note to self. Never invest in a company founded by a guy named Buddy.
1. With my increasing status as a geezer, I love writing phrases like, “years ago”.
– Jim Anderson