The Current SEC Disclosure Framework Is Unfit for Crypto

1. Introduction

In Part III of our series on SEC registration, we explain why Chair Gensler’s attempt to brute force crypto assets that may not even constitute “securities” into an ill-fitting disclosure framework is bad policy: it fails to provide crypto asset users and investors with the information they need, while also denying crypto entrepreneurs a viable path to compliance.1

As we note in Section 2 below, the current SEC disclosure framework was established in the 1930s and designed to regulate the securities issued by centralized companies for fundraising. However, as discussed in Section 3, crypto asset markets differ from securities markets in fundamental ways. Unsurprisingly, without major changes to the SEC’s current disclosure regime, the SEC is unable to effectively regulate crypto asset markets.

Section 4 discusses two key issues that need to be clarified to determine whether transactions involving the sale of crypto assets are required to be registered in the first place. Section 5 then highlights how the current disclosures required by Form S-1, one of the most widely used registration forms, do not provide the right mix of information to crypto asset users or investors.2

This is not to say that developers of crypto projects should be exempt from having to make any disclosures when they fundraise through the sales of crypto assets. Rather, our point is to highlight why regulators need to be more thoughtful about developing a viable framework that gives tokenholders the information they need and deserve.3

2. Current SEC disclosure regime was developed for securities issued by centralized companies

Securities such as stocks and bonds represent a legal claim against, or interest in, the assets and profits of a specific legal entity. Those legal entities are controlled by company management and a group of “insiders” who have access to non-public information that can affect the value of the company’s securities and can be exploited to the detriment of the public and the market.

As discussed in Part II, federal securities laws address information asymmetries by requiring issuers of securities to register and publicly disclose material information to enable investors to make informed investment decisions. While the Securities Act of 1933 (the “1933 Act”) is the principal federal statute governing public offerings of securities, it is supplemented by various rules and regulations promulgated by the SEC that include additional requirements for public offerings of securities, including Regulation C,4 Regulation S-K5 and Regulation S-X.6 In addition, most issuers of registered securities are required to keep these disclosures current by filing quarterly and annual reports, as well as disclosing material events as they arise.

Critically, the SEC disclosure framework is entirely dependent on the existence of a centralized legal entity that issues the securities - i.e., the framework presumes that there is an entity, the “issuer”, which creates a legal relationship with investors by distributing an instrument that represents that legal relationship (e.g., stocks or bonds). It is this legal entity, this issuer, that of necessity is the driver of the value to investors in securities. Accordingly, when a company registers an offering of securities on the SEC’s Form S-1, it is required to provide a number of disclosures about the company’s history, operations, financial statements, leadership, risks it may face, and other information about its business. While these disclosures are clearly relevant for investors trading securities issued by centralized legal entities, they fail to adequately inform crypto asset users and investors because, as shown in the next section, the disclosures do not reflect crypto assets’ unique qualities.

3. Markets for crypto assets differ fundamentally from securities markets

Crypto asset markets differ in meaningful ways from securities markets. As a result crypto requires a different regulatory framework with disclosures tailored to the unique nature of crypto assets and market regulation that reflects the “stack” on which crypto assets trade. As explained below, an adequate disclosure framework for crypto assets that are sold in investment contract transactions must, at a minimum (a) distinguish between the legal rights against issuers that define securities and the technological abilities in protocols that define many crypto assets; (b) reflect that, unlike securities, crypto assets exist independent of the entity that initially sold these assets in fundraising transactions; (c) reflect that crypto assets can accrue value differently than securities; and finally (d) reflect that crypto assets operate, trade and settle on a very different technology “stack” than that used for the trading of securities.

a. Most crypto assets do not provide legal rights against an identifiable “issuer,” but rather provide technological abilities enforced by a blockchain-based protocol

As compared to stocks or bonds, crypto assets typically do not represent ownership of an interest in a legal entity, nor any type of legal claim against one.7 Even when crypto assets are originally “minted” by a development company, they generally do not make the token holders part owners of that company, nor do they provide any legal rights to dividends or other income generated by that company. Crypto assets also do not typically provide any governance rights applicable to a company, such as the right to elect the board of directors or to vote on other matters directly affecting the company.

Instead, owners of crypto assets are endowed with certain technological abilities within a protocol that are enabled by smart contract code. While these technological abilities are sometimes referred to using terminology borrowed from corporate law (e.g., “governance rights”), they are completely different from traditional corporate legal rights. The code associated with crypto assets can provide token owners with abilities that are enforced ex-ante through technological permissioning. The specific technological abilities of crypto assets is publicly verifiable by sophisticated actors. Importantly, a crypto asset’s technological abilities can also be outside of the control of the individual or entity that originally deployed the code that created the crypto assets and related protocol.8

In stark contrast, securities rely on legal rights against a centralized entity, like a shareholder’s right to receive a dividend from a company or vote to elect its board. These legal rights need to be enforced through an ex-post adjudication by a judicial or similar proceeding. As discussed further in Section 5(a), an appropriate disclosure regime needs to recognize and address this critical difference between legal rights and technological abilities if it is to provide adequate information to tokenholders. Current securities regulations simply do not accomplish this.

b. Crypto assets can exist independent of the existence of an “issuer”

Crypto assets are also fundamentally different from securities because they can exist and function as intended independent of the ongoing existence of the legal entity that created them. In some instances, crypto assets may even be created programmatically through a process that does not involve any legal entity that could be classified as the “issuer” of the assets.

Securities of necessity depend on their issuer—the legal entity that created them—for their continued existence. For example, if a company dissolves, its shares cease to exist in any meaningful way, becoming at best a useless paper memento of strictly historical interest.

However, crypto assets lack this dependence on an “issuer” and can continue to exist notwithstanding the dissolution of the company that created or “minted” them.9 Crypto assets created using an immutable protocol deployed on a public blockchain will retain their full on-chain functionality despite the dissolution of the entity that created them. This is because, as we discussed above, crypto assets do not depend on legal claims against a corporate entity, but rather on technological abilities provided by smart contract code deployed on a distributed protocol. This results in an arrangement that can be much more resilient in the face of extraneous or endogenous factors that may affect the going concern value of the issuer of securities or its ability to meet contractual promises contained in instruments it issued.

In addition, some crypto assets are created programmatically in a process that does not require the actions of a legal entity (or individual) at all. For example, the Ethereum blockchain programmatically distributes new ether tokens to validator node operators that stake existing ether tokens to be able to validate transactions on the network. Those new ether tokens are not “issued” by a corporate entity for capital formation purposes, but rather automatically distributed to validators pursuant to the network’s consensus mechanism as a reward for confirming transactions and contributing to the security of the network. Other protocols also enable the programmatic creation of new crypto assets as “wrappers” for other crypto assets, like wrapped versions of a token otherwise residing on one blockchain network on another network. There is a similar “issuerless” process for creating liquid staking tokens.10

Therefore, the current disclosure regime’s myopic focus on the concept of an issuer, wholly appropriate when looking at securities, is at odds with the nature of crypto assets which exist independent of any issuers.

c. Crypto assets accrue value differently than securities

Another key difference between crypto assets and securities is how each of them accrues value. It is basic financial dogma that the price of a company’s shares reflects the markets’ expectations of that company’s future financial performance (“discounted cash flow”). However, the value of many crypto assets is not tied to the financial performance of any centralized entity. This is most evident when looking at the markets for the most widely adopted and decentralized crypto assets like BTC or ETH which, like other commodities markets, are largely driven by general market forces and expectations of the future demand for use of the related protocol.11

But even in the context of nascent crypto projects that were launched by a development company, the value of crypto assets is often largely driven by factors other than the financial performance of the development company.12

People obtain crypto assets to use them within blockchain networks and applications or to hold them in anticipation of increased future demand for such use, as opposed to securities which are only ever passively held. A crypto asset’s utility as well as the underlying protocol’s mechanism design can therefore influence the value of the crypto asset more than the financial performance of the entity that created them.

Moreover, given the open-source nature of most crypto asset-based projects, many crypto assets also accrue value from the contributions of a diverse group of developers outside of the development company or “founding team,” some of whom may remain pseudonymous. It is not uncommon for a development company to write the initial codebase for a new network or application, mint a native crypto asset, and subsequently seek to decentralize control of the project. For example, the development company may opt to transfer the permission to upgrade the smart contracts related to a specific network or application to crypto asset holders or a DAO so that future upgrades are decided by consensus. The developers can also transfer the permissions to a “burn” address, ensuring that no one is able to make any future changes.13

Further, such networks and applications may even be subject to “forks” and upgrades that are not supported or anticipated by the original developer. For example, the current Ethereum network is actually a fork of the original Ethereum network created in 2016 and now known as “Ethereum Classic”.

As more applications emerge that build upon an original network or application and the original creators of the crypto asset have less and less control and influence over the project, purchasers of the crypto asset are less likely to rely upon the “efforts” of the original creator. It is also likely the creator will no longer have better information about the value proposition of the network or application relative to the broader decentralized community.

d. Crypto assets operate on a fundamentally different “stack” than securities

Crypto assets are also unique because they are traded on a fundamentally different technology “stack” than that used in the markets for securities. The shares of public companies, in particular, are traded, settled and custodied using a relatively archaic system that provides opportunities for numerous rent-seeking intermediaries. Therefore, while Chair Gensler may like to refer to his brokerage account as containing “digital assets,” these assets operate fundamentally differently than crypto assets.14

Publicly offered securities are typically issued using a paper certificate or are “dematerialized” (i.e., “certificateless”). The certificate or electronic record for a dematerialized security typically includes information about the security, such as the name of the issuer, the name of the holder and details regarding transfer restrictions. It is common for a security to be registered in “street name,” or in the name of the purchaser’s broker-dealer, rather than in the name of the purchaser. Many broker-dealers are members of The Depository Trust Company (or “DTC”), which is a not-for-profit SEC-registered clearing agency that custodies stock certificates and manages records of dematerialized securities. National securities exchanges require retail investors to purchase and sell securities on the exchange via intermediation by a broker-dealer that is a member of the exchange and such transactions are settled by a clearing agency, such as the DTC.

In contrast to stock and bond certificates, crypto assets can trade and settle peer-to-peer on a 24/7 basis and be custodied directly by their owner, all without the need for any intermediaries. In addition, public permissionless blockchains rely on independent and unaffiliated entities to operate the nodes that process transactions, secure the network, and approve software implementations, which means, among other things, that major changes to the network require adoption by independent parties.

The current regulatory framework for securities reflects the legacy market structure of the securities market. Forcing the trading of crypto assets into this framework would significantly hobble the development of the technology in the US by requiring it to run on the very rails it seeks to replace.

4. Clarity is needed to determine whether registration is required

Despite Chair Gensler’s repeated claims that there is regulatory clarity for crypto projects, due to the SEC’s failure to provide actionable guidance on (a) when transactions involving crypto assets are securities transactions, and (b) if they are securities transactions, what type they are, it is impossible for projects to conclusively determine the fundamental question of when registration would be required and how such registration should be effected.

a. When are crypto assets securities

At this point, there is a general consensus that at least some crypto assets, in particular, BTC and its various forks or variations, are not securities. In addition, while Chair Genlser has been unable to convey a concrete view on this subject, most thoughtful commentators have concluded that ETH is also not a security—certainly, the CFTC has reached this conclusion.15 However, there is no clear agreement as to how the judicially mandated Howey and Reves tests would apply to most other crypto assets.16 As a result of the inherent complexities of these legal tests and the SEC’s unwillingness to meaningfully clarify their views as to how these tests should be applied to crypto assets,17 projects are incapable of making a definitive determination as to the status of most crypto assets.

Both the Howey and Reves tests call for an assessment of the specific facts and circumstances associated with a given transaction to determine whether the federal securities laws apply. The tests are typically applied remedially, after a transaction has already occurred and a dispute has arisen which the parties are seeking to resolve in court. The “20/20 hindsight” and heavily fact-dependent nature of the analyses called for by these precedents can make it challenging for projects distributing crypto assets to apply these tests prospectively. The entity selling tokens must consider the totality of the facts and circumstances surrounding the transaction in advance and then speculate about how a court would view the arrangement in hindsight. Further, even where an initial fundraising sale of crypto assets can be safely categorized as a securities transaction, the treatment of the assets themselves is often much less clear. For example, it appears that the SEC’s view is that events that occur after the crypto assets have been initially sold (e.g., reliance on future efforts to upgrade a network or application, responses to an exploit, etc.) could impact whether the asset itself should be treated as a security, at least temporarily.

The securities analysis of tokens has been further complicated by the SEC staff’s suggestion that a token’s status can “morph” from being a security to a non-security (and potentially even back again!).18 Projects like Hiro, discussed in Part II, and more recently Web3 Foundation (in respect of the Polkadot network’s native token, DOT), have publicly taken the position that their tokens were once investment contracts and therefore a security but are no longer.19 However, as previously discussed, there is currently no clarity as to when, if ever, it is appropriate to consider that a token has either become, or ceased to be, a security.

b. If crypto assets are securities, what kind of securities are they?

In addition to clarifying whether (or when) crypto assets are securities, the SEC must clarify what type of securities they are.

The current SEC disclosure regime is designed for traditional corporate entities that generally issue equity and debt securities for purposes of raising capital. For example, Form S-1 requires issuers to determine whether the securities to be offered are equity or debt securities for purposes of evaluating the need to make certain disclosures.20

The SEC most commonly characterizes crypto assets as “investment contracts,”21 a term the Supreme Court defined broadly enough to encompass both equity or debt securities for registration statement purposes.

Although the SEC staff has not provided formal guidance on the topic, it has indicated that some crypto assets that are investment contracts should be considered equity securities under Regulation C.22 However, some practitioners have pushed back on the SEC’s reasoning, arguing that the agency misreads the statutes.23

The distinction between equity or debt (or something else) is critical because it has many downstream effects for the entity deemed to be the issuer. For example, if the crypto assets that are investment contracts are deemed to be equity securities then the Section 12(g) registration requirements of the Securities Exchange Act of 1934 will apply. In addition, outside of the area of securities law, in the context of crypto assets that can earn a reward from staking or other activities, the distinction between equity and debt can affect the characterization of any income stream and their tax status.

5. Current disclosure requirements do not provide the right information about crypto assets

Assuming that some crypto assets are considered securities and therefore subject to registration, the current SEC disclosure framework will need to be significantly adjusted and clarified in order to provide the market with the right mix of information about those crypto assets.

a. What information about crypto assets is “material”?

Issuers of registered securities are required to publicly disclose all “material” information related to an investment opportunity so that investors may make an informed decision. The Supreme Court has reasoned that information is “material” if such information would be reasonably viewed by an investor as significantly altering the total mix of information made available.24

However, since the disclosure requirements of Form S-1 and Regulation S-K are tailored for offerings of securities by centralized corporate entities seeking to raise capital to run a business enterprise and, as we explained in Section 3, crypto assets differ fundamentally from this, the current disclosure requirements do not capture material information for crypto assets. In fact, the typical information required by securities laws could be misleading to crypto asset investors, who may believe that information is material simply because the SEC mandated its disclosure, when it is not. Moreover, some of the material information that crypto asset users and investors would want to know is publicly available to technologically sophisticated participants.

Despite adding controversial disclosure requirements related to topics like climate change,25 the SEC has not provided any guidance with respect to the types of disclosures it views as material in the context of crypto assets that are securities. As a result, the question of what information would be relevant (or “material”) to purchasers has been left to ad hoc determinations by the sellers of these crypto assets. Nor has the Commission tailored a distinct registration statement form for crypto asset security offerings, as it has done for other types of securities.26 The need for this guidance was even acknowledged by Chair Gensler who noted that “it may be appropriate to be flexible in applying existing disclosure requirements,” and that “[t]ailored disclosures exist elsewhere — for example, asset-backed securities disclosure differs from that for equities.”

In the subsections below, we analyze the current disclosure requirements that are inadequate with respect to crypto asset securities, as well as various missing disclosures.

b. Current disclosure requirements are focused on information that is not material for owners of crypto assets

i. Business and financial information

Form S-1 and SEC Regulation S-K require the issuer to provide a detailed description of the issuer’s business and “revenue-generating activities, products and/or services,” along with audited financial statements.27 In addition, besides having to provide a full suite of audited (and, if applicable, unaudited interim) financial statements, registrants must include a highly detailed discussion of those financial statements known as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (or “MD&A”). While it may be possible for some sellers of crypto asset securities to provide such information, in many instances this information may not be particularly material and could wind up actually being misleading to purchasers.

Unlike the typical initial public offering, a crypto asset security offering may be conducted by a seller with little to no operating history and no recent periods of profitable operations. Most importantly, assuming that the seller (or an affiliate) has completed the development of the crypto asset and associated blockchain network or application, the selling entity may not have any future business or revenue-generating plans that would be relevant to an initial or subsequent purchaser. Simply put, the original creators of crypto assets often have little relevance to the value of the asset being sold and only become less relevant over time.

Information about the issuer’s ongoing business activities and financial statements may therefore not be material to investors on an ongoing basis. By contrast, investors will likely deem to be more material certain information about the network or application that is unrelated to the business of the selling entity and that is not contemplated by Form S-1 and associated disclosure regulations.

The technical requirements of Form S-1 and Regulation S-X (as to financial statement information) may also present challenges for issuers that can result in purchasers being misled. For example, Regulation G requires issuers that present non-Generally Accepted Accounting Principles (“GAAP”) information to present the closest GAAP measure and a reconciliation. Since accounting standards like GAAP have not yet been updated to reflect the unique qualities of crypto assets, in practice this makes it very difficult to clearly present financial information that can be most relevant for disclosure.

ii. Issuer and team information

Form S-1 and Regulation S-K are tailored for securities offerings made by a single legal entity issuer with a traditional management structure. For example, the issuer is required to disclose biographical information for the executives,28 board of directors and certain other significant employees,29 along with their compensation and benefits, holdings in the company, and other information.

However, as we have noted above, information related to the management of the legal entity deemed to be the “issuer” will often be less important in the context of crypto asset securities than it is for most other types of securities. Crypto assets are often launched by a distributed community that does not have a clear hierarchy or clearly defined bounds. In some extreme situations, the asset seller itself may dissolve and the team move on to do other things. In others, the original team will remain and continue working on the project, but over time purchasers may come to care more about third-party contributors who may not work on the project full time or have any formal relationship to the legal entity. It is not clear what level of disclosure would apply to these contributors. If covered by the disclosure obligations, they would not have the option of remaining anonymous, as is common today.

iii. Use of proceeds

Form S-1 requires the issuer to describe the registrant’s planned use of proceeds. However, crypto assets are often distributed in ways that do not accrue any direct proceeds to an “issuer.” For example, as mentioned above, the Ethereum blockchain programmatically distributes ether to validators that stake ether, but there is no centralized entity that receives proceeds in connection with these distributions. Additionally, it is common for crypto assets to be “air dropped” for free to users of an application or holders of a particular type of crypto asset.

Moreover, the use of proceeds may not be determined by the issuer of the crypto assets and such proceeds may accrue to another person rather than the original seller, making it impossible for the seller to adequately disclose the relevant information in a registration statement. For example, it is common for a group of founders, who sometimes form development companies, to distribute a token and direct the proceeds to a community “treasury” (i.e., a blockchain address typically controlled by a “multi-sig” wallet typically by the vote of the tokenholders themselves.

c. Missing disclosures

In addition to focusing on information that is not relevant, current disclosure requirements also do not cover a number of features unique to crypto assets that would be considered material when making an investment decision. Since others have written extensively on the subject of disclosures for crypto assets, we only highlight some themes below.30

i. Governance

While the current SEC disclosure framework focuses extensively on the corporate governance rights that the holders of securities have relative to an issuer, the disclosure framework completely misses the “governance abilities” that crypto assets have relative to their native protocols. As described above in Section 3(a), crypto assets largely derive their value and functionality on the basis of technological power they can exercise in a network. Understanding “governance” in the context of crypto assets therefore calls for different disclosures than in the context of securities.31

For example, it is critical for holders to understand the extent to which their token votes or other actions are self-executing or “on-chain,” as opposed to “off-chain”, relying on a legal or social enforcement mechanism. A tailored disclosure framework would also delve into how code upgrades can be implemented, including highlighting whether specific smart contracts are upgradeable and if so, which network addresses have the upgrade permissions and who controls those addresses.

ii. Security

While the SEC has enacted rules mandating public companies to disclose information related to cybersecurity risks and incidents, it has not provided any guidance for how these apply to crypto assets. Given the severity of the cybersecurity threat in crypto, a tailored disclosure framework that focuses on the unique security issues raised by crypto assets and networks is required to protect investors and users.

For example, the developers could be required to disclose any code audits provided the related software documentation and accompanying commentary. In addition, any incentives for white hat hackers to submit bug bounties or perform rescues would be material.

iii. Network or Application Design

Unlike companies that offer stock or bonds, sellers of crypto assets are typically offering an asset associated with a blockchain network or application. Although most projects publish the open-source code associated with the network or application, most purchasers of crypto assets lack the technological sophistication to read and understand the code. Accordingly, purchasers of crypto assets are likely to be particularly interested to learn more about the technical design of the network or application in making a decision to purchase the crypto asset. Indeed, the blockchain network or application may continue on well after the issuer is no longer operational.

iv. Tokenomics

The “tokenomics” of crypto assets is highly material to investors but not currently covered by the disclosure requirements. For example, information including the initial allocation of the tokens, total supply of tokens and future issuance schedule can have material impact on a crypto asset’s value.

v. Consumptive Use / Utility

Securities are by and large passive investment instruments that cannot be used or consumed in the same way as a commodity or collectible. But crypto assets are generally designed to be used within a blockchain network or application. Accordingly, purchasers of crypto assets are likely to desire information related to how the crypto assets can be used - or the crypto assets’ “utility.”

6. Conclusion

As we have shown above, the current securities framework was tailor-made to regulate fundraising by centralized legal entities issuing securities, such as a company selling shares to the public in its “IPO.” However, crypto assets differ fundamentally from securities and therefore raise different investor disclosure considerations. Unfortunately, the current SEC Chair and staff have failed to recognize the uniqueness of crypto assets and are instead engaged in a campaign to attempt to brute force crypto into an ill-fitting disclosure regime. This campaign will ultimately harm the same public the SEC is tasked with protecting.

As Nobel prize winning economist George Akerlof argued in his seminal paper “The Market For ‘Lemons’”, the quality of goods in markets that lack disclosure standards and exhibit information asymmetries between participants degrade over time. Applied to the market for crypto assets, Akerlof’s theory shows how the SEC’s insistence on applying an ill-fitting disclosure framework to crypto assets will result in the quality of crypto assets degrading, with direct harm to users, investors and the market generally.

While the SEC Chair’s repeated catchphrase that crypto projects must “come in and register” might make for a good soundbite, it is no substitute for thoughtful policy. In order to fulfill its mission, the SEC must radically change course and work with the crypto industry to develop tailored disclosure requirements that provide crypto users and investors with the information that they need.